Chapters 8 - 10 Flashcards Preview

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Flashcards in Chapters 8 - 10 Deck (115):
1

Three main reasons for audit planning

- Enable auditor to obtain sufficient appropriate evidence
- Help keep audit costs reasonable
- Avoid misunderstandings with the client

2

Eight major parts of audit planning

- Accept client and perform initial audit planning
- Understand the client's business and industry
- Assess client business risk
- Perform preliminary analytical procedures
-Set materiality and assess acceptable audit risk and inherent risk
- Understand internal control and assess control risk
- Gather information to assess fraud risks
- Develop overall audit strategy and audit program

3

Two risks significantly affect conduct and costs of audits:

- Audit risk
- Inherent risk

4

Audit risk and inherent risk influence:

- The amount of evidence collected
- The experience level of staff

5

Four steps of initial audit planning

- Auditor decides whether to accept or continue client
- Auditor identifies reasons for audit
- Engagement letter
- Develop overall strategy

6

The ___________ auditor is required to communicate with the ______________ when the auditor decides to accept a new client.

Successor; predecessor

7

A lower acceptable audit risk means more or less money?

More

8

The risk that the client will fail to achieve its objectives

Client business risk

9

Ability to pay off current liabilities with cash

Cash ratio

10

Ability to pay off current liabilities very quickly

Quick ratio

11

Ability to pay off current liabilities within a year

Current ratio

12

Number of times accounts receivable turns over during the year

Accounts receivable turnover

13

Accounts receivable turnover expressed in number of days

Days to collect receivables

14

Number of times inventory turns over during the year

Inventory turnover

15

Inventory turnover expressed in number of days

Days to sell inventory

16

The extent of the use of debt in financing

Debt to equity

17

Shows whether a company can comfortably make its interest payments

Times interest earned

18

Shows profitability per share of common stock

Earnings per share

19

Shows the percentage of sales available to pay other expenses after deducting the cost of the product.

Gross profit percentage

20

Shows the percentage of sales available after deducting the cost of the product and operating expenses

Profit margin

21

Measure of overall profitability

Return on assets

22

The amount of net income returned as a percentage of shareholders equity. Measure of a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.

Return on equity

23

Principles underlying AICPA auditing standards indicate:

The auditor must plan the work and properly supervise any assistants

24

Three main reasons why the auditor should properly plan engagements:

- Enable the auditor to obtain sufficient appropriate evidence for the circumstances
- Keep audit costs reasonable
- Avoid misunderstandings with the client

25

A measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued

Acceptable audit risk

26

A measure of the auditor's assessment of the likelihood that there are material misstatements in an account balance before considering the effectiveness of internal control

Inherent risk

27

The burden of initiating the communication rests with the _____________ auditor, but the _____________ auditor is required to respond to the request for information.

Successor; predecessor

28

Reasons for not continuing to do an audit for existing clients:

- Previous conflicts over the appropriate scope of the audit
- Type of opinion to issue
- Unpaid fees
- Determining the client lacks integrity
- Excessive risk

29

Audits with a low acceptable audit risk will normally result in:

Higher audit costs, which should be reflected in higher audit fees

30

Auditing standards require that auditors document their understanding with the client, including the engagement's objectives, the responsibilities of the auditor and management, identification of the financial reporting framework used by management, reference to the expected form and content of the audit report, and the engagement's limitations.

Engagement letter

31

Sets the scope, timing, and direction of the audit and guides the development of the audit plan

Audit strategy

32

Strategic systems understanding of the client's business and industry:

- Industry and external environment
- Business operations and processes
- Management and governance
- Objectives and strategies
- Measurement and performance

33

Three primary reasons for obtaining a good understanding of the client's industry and external environment:

- Risk associated with specific industries may affect the auditor's assessment of client business risk and acceptable audit risk
- Many inherent risks are common to all clients in certain industries
- Many industries have unique accounting requirements that the auditor must understand to evaluate whether the client's financial statements are in accordance with accounting standards

34

An affiliated company, a principal owner of the client company, or any other party with which the client deals, where one of the parties can influence the management or operating policies of the other

Related party

35

Any transaction between the client and a related party

Related party transaction

36

Because material related party transactions must be disclosed, all related parties need to be:

Identified and included in the auditor's permanent files

37

In response to requirements in the Sarbanes-Oxley Act, the SEC requires each public company to:

Disclose whether it has adopted a code of ethics that applies to senior management, including the CEO, CFO, and principal accounting officer or controller

38

The official record of the meetings of the board of directors and stockholders

Corporate minutes

39

Auditors should understand client objectives related to:

- Reliability of financial reporting
- Effectiveness and efficiency of operations
- Compliance with laws and regulations

40

The risk that the client will fail to achieve its objectives

Client business risk

41

The auditor's primary concern is the risk of material misstatements in the financial statements due to:

Client business risk

42

Primary source for identifying client business risk

Management

43

Using the ratios to industry or competitor benchmarks to provide an indication of the company's performance are:

Preliminary analytical procedures

44

In identifying areas of specific risk, the auditor is likely to focus on the _________________ ratios

Liquidity activity

45

Evaluations of financial information through analysis of plausible relationships among financial and non-financial data

Analytical procedures

46

Analytical procedures may be performed at any of the three times during an engagement:

- Required in the planning phase
- During the testing phase
- Required during the completion phase

47

Five types of analytical procedures

- Industry data
- Similar prior-period data
- Client-determined expected results
- Auditor-determined expected results
- Expected results using non-financial data

48

Short-term debt-paying ability ratios:

- Cash ratio
- Quick ratio
- Current ratio

49

Liquidity Activity Ratios:

- Accounts receivable turnover
- Days to collect receivables
- Inventory turnover
- Days to sell inventory

50

Ability to meet long-term debt obligations ratios:

- Debt to equity
- Times interest earned

51

Profitability ratios:

- Earnings per share
- Gross profit percent
- Profit margin
- Return on assets
- Return on common equity

52

Written records of the client's expectations for the period

Budgets

53

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

Materiality

54

First the auditor determines materiality for:
Second, the auditor determines:

1) Financial statements as a whole
2) Performance materiality

55

Materiality for segments of the audit (classes of transactions, account balances, or disclosures)

Performance materiality

56

Steps in applying materiality:

1) Set materiality for the financial statements as a whole
2) Determine performance materiality
3) Estimate total misstatement in segment
4) Estimate the combined misstatement
5) Compare combined estimate with preliminary or revised judgment about materiality

57

The maximum amount by which the auditor believes that the statements could be misstated and still not affect the decisions of reasonable users; used in audit planning. One dollar less than the FASB definition of materiality.

Preliminary judgment about materiality

58

The lower the dollar amount of materiality,

The more evidence required

59

Factors affecting preliminary judgment about materiality:

- Relative rather than absolute concept
- Benchmarks are needed
- Qualitative factors influence

60

During the audit, auditors often change the preliminary judgment about materiality.

Revised judgment about materiality

61

What is often the primary benchmark for establishing whether misstatements are material?

Net income before taxes

62

Which is more important to materiality - amounts involving fraud or unintentional errors of equal dollar amounts?

Amounts involving fraud

63

Which is more important to materiality - misstatements that are otherwise minor or possible consequences arising from contractual obligations?

Contractual obligations

64

Performance materiality is less than:

Materiality for the financial statements taken as a whole

65

Determining performance materiality is necessary because:

Auditors accumulate evidence by segments rather than by the financial statements taken as a whole

66

Performance materiality is __________ related to the amount of evidence an auditor will accumulate.

Inversely

67

Why is it good enough for the auditor to focus on just the balance sheet accounts rather than both balance sheet and income statement?

If the balance sheet is right, then the income statement is right. The numbers of the income statement affect the balance sheet.

68

We determine ________ materiality by allocating _________ materiality to balance sheet accounts.

Performance; preliminary

69

Auditors face three major difficulties in allocating materiality to balance sheet accounts:

- Auditors expect certain accounts to have more misstatements than others
- Both overstatements and understatements must be considered
- Relative audit costs affect the allocation

70

The risk that audit evidence will fail to detect misstatements exceeding performance materiality

Planned detection risk

71

A measure of the auditor's assessment of the susceptibility of an assertion to material misstatement before considering the effectiveness of internal control

Inherent risk

72

A measure of the auditor's assessment of the risk that a material misstatements could occur in an assertion and not be prevented or detected on a timely basis by the client's internal controls

Control risk

73

A measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued

Acceptable audit risk

74

Audit risk model

PDR = (AAR)/(IR x CR)

75

Determines the amount of substantive evidence that the auditor plans to accumulate, inversely with the size of the planned detection risk

Planned detection risk

76

A higher PDR implies:

Less evidence needed

77

The risk that the auditor will suffer harm after the audit is finished, even though the audit report was correct

Engagement risk

78

Several factors are good indicators of the degree to which statements are relied on by external users:

- Client's size
- Distribution of ownership
- Nature and amount of liabilities

79

Factors that are good indicators of its increased profitability:

- Liquidity position
- Profits (losses) in previous years
- Method of financing growth
- Nature of the client's operations
- Competence of managment

80

Factors affecting engagement risk:

- External users' reliance on financial statements
- Likelihood of financial difficulties
- Management integrity

81

Methods used to assess acceptable audit risk based on external users' reliance on financial statements:

- Examine the financial statements, including footnotes, such as the Form 10K for a publicly held company
- Read minutes of board of directors meetings to determine future plans
- Read financial analysts' reports for a publicly held company
- Discuss financing plans with management

82

Methods used to assess acceptable audit risk based on the likelihood of financial difficulties:

- Analyze the financial statements for financial difficulties using ratios and other analytical procedures
- Examine historical and projected cash flow statements for the nature of cash inflows and outflows

83

The auditor considers several major factors when assessing inherent risk:

- Nature of the client's business
- Results of previous audits
- Initial vs. repeat engagement
- Related parties
- Complex or non-routine transactions
- Judgment required to correctly record account balances and transactions
- Makeup of the population
- Factors related to fraudulent financial reporting
- Factors related to misappropriation of assets

84

Management typically has three broad objectives in designing an effective internal control system:

- Reliability of financial reporting
- Efficiency and effectiveness of operations
- Compliance with laws and regulations

85

Section 404 of Sarbanes-Oxley requires management to assess and report on:

The effectiveness of internal control over financial reporting

86

Who must establish and maintain the entity's internal controls?

Management, not the auditor

87

Two key concepts underlie management's design and implementation of internal control:

- Reasonable assurance
- Inherent limitations

88

An act of two or more employees who conspire to steal assets or misstate records

Collusion

89

Section 404 of the Sarbanes-Oxley Act requires management of all public companies to issue an internal control report that includes the following:

- A statement that management is responsible for establishing and maintaining an adequate internal control structure and procedures for financial reporting
- An assessment of the effectiveness of the internal control structure and procedures for financial reporting as of the end of the company's fiscal year

90

Committee of Sponsoring Organizations of the Treadway Commission Integrated Framework

COSO

91

Management must identify the:

Framework used to evaluate the effectiveness of internal control

92

Management's assessment of internal control over financial reporting consists of two key aspects:

- Management must evaluate the design of internal control over financial reporting
- Management must test the operating effectiveness of those controls

93

The auditor's responsibilities for internal control:

Understanding, testing, issue audit report of internal control (for accelerated filers)

94

The auditor's primary concerns for internal controls:

- Controls over reliability of financial reporting
- Controls over classes of transactions

95

The COSO internal control components include the following:

- Control environment
- Risk assessment
- Control activities
- Information and communication
- Monitoring

96

What is the most widely accepted internal control framework in the United States?

COSO

97

Which component of internal control is the largest?

Control environment

98

Actions, policies, and procedures that reflect the overall attitude of top management, directors, and owners of an entity about internal control and its importance

Control environment

99

Types of specific control activities:

- Adequate separation of duties
- Proper authorization of transactions and activities
- Adequate documents and records
- Physical control over assets and records
- Independent checks on performance

100

Process for understanding internal control and assessing control risk

Phase 1: Obtain and document understanding of internal control design and operation
Phase 2: Assess control risk
Phase 3: Design, perform, and evaluate tests of controls
Phase 4: Decide planned detection risk and substantive tests

101

Methods to document internal control:

Narrative
Flowchart
Internal control questionnaire

102

A written description of a client's internal controls

Narrative

103

A proper narrative of an accounting system and related controls describes four things:

- The origin of every document and record in the system
- All processing that takes place
- The disposition of every document and record in the system
- An indication of the controls relevant to the assessment of control risk

104

A diagram of the client's documents and their sequential flow in the organization

Flowchart

105

Asks a series of questions about the controls in each audit area as a means of identifying internal control deficiencies

Internal control questionnaire

106

In a ______________, the auditor selects one or a few documents of a transaction type and traces them from initiation through the entire accounting process

Walkthrough

107

A deficiency in the design or operation of controls that does not permit company personnel to prevent or detect misstatements on a timely basis

Control deficiency

108

A significant deficiency that is less severe than a material weakness but important enough to merit attention by those responsible for oversight of the company's financial reporting

Significant deficiency

109

Exists if a significant deficiency, by itself or in combination with others, results in a reasonable possibility that internal control will not prevent or detect material financial misstatements on a timely basis

Material weakness

110

Five step approach to identify deficiencies and weaknesses:

- Identify existing controls
- Identify the absence of key controls
- Consider the possibility of compensating controls
- Decide whether there is a significant deficiency or material weakness
- Determine potential misstatements

111

The auditor _____ communicate significant deficiencies and material weaknesses ___________ to those charged with governance as soon as the auditor becomes aware of their existence. Usually addressed to the audit committee and management no later than 60 days following audit report release.

Must; in writing

112

A ______________ is one elsewhere in the system that offsets the absence of a key control

Compensating control

113

Letter identifying less significant internal control-related issues, as well as opportunities for the client to make operational improvements.

Management letter

114

The auditor is likely to use four types of procedures to support the operating effectiveness of internal controls:

- Inquiries of client personnel
- Examine documents, records, and reports
- Observe control-related activities
- Re-perform client procedures

115

Types of opinions an auditor can issue based on Section 404

- Unqualified
- Adverse
- Qualified/Disclaimer