Audit Exam 1 Review

Information asymmetry means that the manager generally has more information about the true financial position and results of operations of the entity than does the absentee owner. Information risk is the risk that information circulated by a company will be false or misleading. Principal (Absentee owner) provides capital and hires an agent to manage resources. Agent (Manager) hires an auditor to report on the fairness of the agents financial reports. The agent pays the auditor to reduce the principals information risk. The initial demand for auditing comes not from the principal but from the agent. The three types of services that provide assurance are: auditing, attest, and assurance services. These three services all encompass the same process: o The evaluation of evidence to determine the correspondence of some information to a set of criteria, and the issuance of report to indicate the degree of correspondence. Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users. o The phrase systematic process implies that there should be a wellplanned and thorough approach for conducting an audit. o This plan involves objectively obtaining and evaluating evidence. Two activities are involved here: The auditor must objectively search for and evaluate the relevance and validity of evidence. Attest services occur when a practitioner is engaged to issuea report on subject matter, or an attestation about subject matter, that is the responsibility of another party. o Note that financial statement auditing is a specialized form of an attest service. Assurance services are independent professional services that improve the quality of information, or its context, for decision makers. o To summarize, assurance services can capture information, improve its quality, and enhance its usefulness for decision makers. The conceptual and procedural details of a financial statement audit build on three fundamental concepts: audit risk, materiality, and evidence relating to managements financial statement information. The first major concept involved in auditing is audit risk, which is the risk that the auditor may unknowingly give a clean opinion on financial statements that are materially misstated.

Audit risk is the risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated. The auditors standard report states that the audit provides only reasonable assurance that the financial statements do not contain material misstatements. The term reasonable assurance implies some risk that a material misstatement could be present in financial statements and auditor will fail to detect it. o However, the concept of reasonable assurance means that an auditor could conduct an audit in accordance with professional auditing standards and issue a clean opinion, and the financial statements still might contain a material misstatement. The second major concept involved in auditing is materiality. The auditors consideration of materiality is a matter of professional judgment. o Materiality is the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement. o The focus of this definition is on the users of the financial statements. o In determining materiality, a common rule of thumb is that total (aggregated) misstatements of more than about 3 to 5 percent of net income before tax would cause financial statements to be materially misstated. Relevance refers to whether the evidence relates to the specific management assertion being tested. Reliability refers to the diagnosticity of the evidence. You can think of materiality as the fineness of the auditors filter. A lower materiality amount requires the auditor to use a finer filter in order to detect smaller errors. If a misstatement is considered so material that it pervasively affects the interpretation of the financial statements, the auditor will issue an adverse opinion, indicating the financial statements are not fairly stated and should not be relied upon. The Sarbanes-Oxley Act effectively transferred authority to set and enforce auditing standards for public company audits to the Public Company Accounting Oversight Board. o The act imposed several other important mandates, including that audit firms rotate audit partners off audit engagements every 5 years, and that public companies obtain an integrated audit, (including audits of both financial statements and internal controls). The audit committee, consisting of members of the board, oversees the internal and external auditing work done for the organization.

Most business enterprises establish processes that fit in five broad process categories, sometimes known as cycles. These five categories are: o The Revenue Process: Businesses generate revenue through sale of goods or services to customers, and collect the proceeds of those sales in cash, either immediately or through collections on receivables. It must also collect cash on those sales either at the point of sale or though later billing and collection of receivables. o The Purchasing Process: Businesses must acquire goods and services to support the sale of their own goods or services. o The Human Resource Management Process: Business organizations hire personnel to perform various functions in accordance with the enterprises mission and strategy. o The Inventory Management Process: Service providers (such as auditors, lawyers, or advertising agencies) rarely have significant inventories to manage, since their primary resources typically consist of information, knowledge, and the time and effort of people. The inventory management process for a manufacturer includes the cost accounting transactions to accumulate and allocate costs to inventory. o The Financing Process: Businesses obtain capital through borrowing or soliciting investments from owners and typically invest in assets such as land, buildings, and equipment in accordance with their strategy. The enterprise must design and implement accounting information systems to capture the details of those transactions. It must also design and implement a system of internal control to ensure that the transactions are handled and recorded appropriately and that its resources are protected. Assertions about classes of transactions and events for the period under audit o Occurrence transactions and events that have been recorded have occurred and pertain to the entity. o Completeness all transactions and events that should have been recorded have been recorded. o Authorization all transactions and events have been properly authorized. o Accuracy amounts and other data relating to recorded transactions and events have been recorded appropriately. o Cutoff transactions and events have been recorded in the correct accounting period. o Classification transactions and events have been recorded in the proper accounts. Assertions about account balances at the period end: o Existence assets, liabilities, and equity interests exist. o Rights and obligations the entity holds or controls the rights to assets, and liabilities are the obligations of the entity.

Completeness all assets, liabilities, and equity interests that should have been recorded have been recorded. o Valuation and allocation assets, liabilities, and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are properly recorded. Auditors typically consider the completeness assertion to be the most important assertion for liability accounts for two reasons: o First, when all obligations are not properly included in the liability account, the result is an understatement of liabilities and often an overstatement of income. o Second, management is more like to have an incentive to understate a liability that to overstate it. Until 2003, the Auditing Standards Board (ASB) was responsible for establishing auditing standards in the U.S. The ASB is sponsored by the AICPA, a private, nongovernmental professional association. When Congress passed the Sarbanes-Oxley Act of 2002, it gave the PCAOB the authority to either set auditing standards for public company audits itself or to delegate that role to another party. The PCAOB is a quasigovernmental organization overseen by the SEC The generally accepted auditing standards are composed of three categories of standards: o General Standards (three) 1. The first general standard recognizes that an auditor must have adequate training and proficiency. Which is gained through formal education, continuing education programs, and experience. 2. The second general standard requires that the auditor maintain an attitude of independence on the engagement. 3. The third, the auditor must exercise due professional care in the performance of the audit, which means, perform his duties with the skill and care that is commonly expected of accounting professionals. o Standards of Field Work (three) First, the auditor must properly plan the work and supervise the assistants. Second, the auditor must gain a sufficient understanding of the entity and its environment, including its internal control, to assess the risk of material misstatement of the financial statements, whether due to error or fraud, and to effectively plan the nature, timing, and extent of further audit procedures. Nature refers to what procedures are performed Timing refers to when the audit work is done (whether at interim or at period-end) Extent refers to how much work is done. o Standards of Reporting (four)

Whether the financial statements are presented in accordance with GAAP Whether those principles are consistently applied Whether all informative disclosures have been made What degree of responsibility the auditor is taking, as well as the character of the auditors work. Ethics refers to a system or code of conduct based on moral duties and obligations that indicate how we should behave. Professionalism refers to the conduct, aims, or qualities that characterize or mark a profession or professional person. Opinion Shopping is when clients seek the views of other CPAs, hoping to find an auditor who will agree with the clients desired accounting treatment. Professional Skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. S forms, which are used for issuing the securities, contain the audited financial statements of the registrant. The risk that the relevant assertions are misstated consists of two components: o Inherent risk (IR) is the susceptibility of a relevant assertion to misstatements that could be material, either individually or when aggregated with other misstatements, assuming there are no related controls. IR is the likelihood that a material misstatement exists in the financial statements without the consideration of internal control. o Control Risk (CR) is the risk that a material misstatement that could occur in a relevant assertion will not be prevented, or detected and corrected on a timely basis by the entitys internal control. Inherent risk and control risk exist independently of the audit. In other words, the auditor has little or no control over these risks. Auditing standards refer to the combination of IR and CR as the risk of material misstatement (RMM). Detection Risk (DR) is the risk that the auditor will note detect a misstatement that exists in a relevant assertion that could be material either individually or when aggregated with other misstatements. Nonsampling Risk is the risk that the auditor might select an inappropriate audit procedure, misapply the appropriate audit procedure, or misinterpret the audit results. Detection risk has inverse relationship to inherent risk and control risk. If inherent risk and control risk are low, the auditor can accept higher detection risk. If the auditor assesses the achieved audit risk as being less that or equal to the planned level of audit risk, an unqualified report can be issued. If the assessment of the achieved level of audit risk is greater than the planned level, the auditor should either conduct additional audit work or qualify the audit work. Three steps are involved in the auditors use of the audit risk model at the assertion level: o Setting a planned level of audit risk. o Assessing the risk of material misstatement.

o Solving the audit risk equation for the appropriate level of detection risk. Unless otherwise stated in the text, the risk of material misstatement refers to misstatements caused by errors or fraud. The auditors understanding of the entity and its environment includes knowledge of the following categories: o Nature of the entity o Industry, regulatory, and other external factors. o Objectives and strategies and related business risks. o Entity performance measures. o Internal control.