Chapters 8 - 10 Flashcards Preview

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Flashcards in Chapters 8 - 10 Deck (115):

Three main reasons for audit planning

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


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


Two risks significantly affect conduct and costs of audits:

- Audit risk
- Inherent risk


Audit risk and inherent risk influence:

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


Four steps of initial audit planning

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


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

Successor; predecessor


A lower acceptable audit risk means more or less money?



The risk that the client will fail to achieve its objectives

Client business risk


Ability to pay off current liabilities with cash

Cash ratio


Ability to pay off current liabilities very quickly

Quick ratio


Ability to pay off current liabilities within a year

Current ratio


Number of times accounts receivable turns over during the year

Accounts receivable turnover


Accounts receivable turnover expressed in number of days

Days to collect receivables


Number of times inventory turns over during the year

Inventory turnover


Inventory turnover expressed in number of days

Days to sell inventory


The extent of the use of debt in financing

Debt to equity


Shows whether a company can comfortably make its interest payments

Times interest earned


Shows profitability per share of common stock

Earnings per share


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

Gross profit percentage


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

Profit margin


Measure of overall profitability

Return on assets


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


Principles underlying AICPA auditing standards indicate:

The auditor must plan the work and properly supervise any assistants


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


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


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


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

Successor; predecessor


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


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

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


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


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

Audit strategy


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


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


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


Any transaction between the client and a related party

Related party transaction


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

Identified and included in the auditor's permanent files


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


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

Corporate minutes


Auditors should understand client objectives related to:

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


The risk that the client will fail to achieve its objectives

Client business risk


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

Client business risk


Primary source for identifying client business risk



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

Preliminary analytical procedures


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

Liquidity activity


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

Analytical procedures


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


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


Short-term debt-paying ability ratios:

- Cash ratio
- Quick ratio
- Current ratio


Liquidity Activity Ratios:

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


Ability to meet long-term debt obligations ratios:

- Debt to equity
- Times interest earned


Profitability ratios:

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


Written records of the client's expectations for the period



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



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

1) Financial statements as a whole
2) Performance materiality


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

Performance materiality


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


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


The lower the dollar amount of materiality,

The more evidence required


Factors affecting preliminary judgment about materiality:

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


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

Revised judgment about materiality


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

Net income before taxes


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

Amounts involving fraud


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

Contractual obligations


Performance materiality is less than:

Materiality for the financial statements taken as a whole


Determining performance materiality is necessary because:

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


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



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.


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

Performance; preliminary


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


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

Planned detection risk


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


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


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


Audit risk model

PDR = (AAR)/(IR x CR)


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

Planned detection risk


A higher PDR implies:

Less evidence needed


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

Engagement risk


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


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


Factors affecting engagement risk:

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


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


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


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


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


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

The effectiveness of internal control over financial reporting


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

Management, not the auditor


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

- Reasonable assurance
- Inherent limitations


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



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


Committee of Sponsoring Organizations of the Treadway Commission Integrated Framework



Management must identify the:

Framework used to evaluate the effectiveness of internal control


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


The auditor's responsibilities for internal control:

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


The auditor's primary concerns for internal controls:

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


The COSO internal control components include the following:

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


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



Which component of internal control is the largest?

Control environment


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


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


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


Methods to document internal control:

Internal control questionnaire


A written description of a client's internal controls



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


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



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

Internal control questionnaire


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



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


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


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


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


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


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

Compensating control


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

Management letter


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


Types of opinions an auditor can issue based on Section 404

- Unqualified
- Adverse
- Qualified/Disclaimer