Responding to Risk Assessment: Evidence Accumulation and Evaluation

Question 1

1. The Statement on Attestation Standards suggests 2 basic types of evidence collection procedures: 1) search and verification and 2) internal inquiries and comparisons. Search and verification procedures include procedures such as inspecting assets, confirming receivables, and observing the counting of inventory. Internal inquiry and comparison procedures include discussions with firm representatives and analytical procedures such as ratio analysis.

Answer 1

1. Evidence - General

Question 2

1. Auditors should obtain sufficient appropriate audit evidence to reduce audit risk to a low level.
2. Section AU-C 500 points out that sufficiency is the measure of the quantity of audit evidence that should be obtained. Appropriateness is the measure of the quality of that audit evidence - both its relevance and reliability in providing support for, or detecting misstatements. Relevance relates to the assertion being addressed.
3. The auditor should be able to form an opinion within a reasonable length of time, at a reasonable cost. However, the difficulty or expense involved in testing a particular item is not in itself a valid reason for omitting a test.

Answer 2

2. Sufficient Appropriate Audit Evidence

Question 3

4. Obtaining sufficient appropriate evidence is particularly difficult when auditing client accounting estimates ( allowance for doubtful accounts, loss reserves, pension expenses). AU-C 540 suggests that the auditor’s objectives relating to estimates are to determine that all estimates 1) have been developed, 2) are reasonable, and 3) follow GAAP
5. Know that the three basic approaches for evaluating the reasonableness of these estimates are to 1) review and test management’s process of deriving the estimate (consider the reasonableness and accuracy of management’s approach), 2) develop one’s own expectation of the accounting estimate and compare it to management’s and 3) review subsequent events or transactions occurring prior to the completion of fieldwork which bear on the estimate.

Answer 3

2. Sufficient Appropriate Audit Evidence

Question 4

1.Recall from Module 2 that at the account level audit risk is composed of the risk of material misstatement (inherent risk and control risk) and the risk that the auditor’s procedures do not detect a material misstatement

Answer 4

3. Types of Audit Evidence

Question 5

1. When evaluating evidence, auditors estimate the amount of misstatements within the financial statements, and determine whether it exceeds a material amount. The auditor estimates the likely misstatement in the financial statements and attempts to determine whether an unacceptably high audit risk exists.

Answer 5

4. Evidence - Specific

Question 6

1. Substantive procedures are of two types: 1) substantive analytical procedures, 2) tests of details of transactions, account balances, and disclosures.
2. Analytical procedures consist of evaluations of financial information made by a study of plausible relationships among financial and nonfinancial data.
3. Perhaps the most familiar example of analytical procedures used in auditing is the calculation of ratios. However, analytical procedures range from simple comparisons of information through the use of complex models such as regression and time series analysis.

Answer 6

5. Types of Substantive Procedures

Question 7

1. An audit program is a detailed list of the audit procedures to be performed in the course of an audit. It is helpful to understand the nature of audit programs for various accounts to help reply to a variety of multiple choice questions and, possibly, to a simulation.

Answer 7

6. Substantive Procedure Audit Programs

Question 8

1. Make certain that you are familiar with the information in the outline of AU-C 230.
2. Audit documentation should be prepared so as to enable an experienced auditor, with no previous connection to the audit, to understand procedures performed, audit evidence obtained, and conclusions reached.
3. While it is not necessary to document every matter considered during the audit, oral explanations alone (absent working paper documentation) are not sufficient to support the work of the auditor.

Answer 8

7. Documentation

Question 9

4. The documentation completion period is 60 days following the report release date. That means that changes resulting from the process of assembling and completing the audit file may be made within 60 days following the date the audit report was released to the client.
5. The retention period (how long audit documentation should be kept) should not be less than five years from the report release date (longer if legal and regulatory requirements so require).
6. Audit documentation is the property of the auditor and is confidential.

Answer 9

7. Documentation

Question 10

1. Kiting is a form of fraud that overstates cash by causing it to be simultaneously included in two or more bank accounts.
2. A bank transfer schedule shows the dates of all transfers of cash among the client’s various bank accounts.
3. A cutoff statement is a bank statement for the first 8-10 business days after year-end. Know that its primary purpose is to help auditors to verify reconciling items on the year-end bank reconciliation

Answer 10

8. Cash

Question 11

1. Lapping is an embezzlement scheme in which cash collections from customers are stolen and the shortage is concealed by delaying the recording of subsequent cash receipts.
2. Confirmation of accounts receivable is a generally accepted auditing procedure. Auditors are to confirm receivables unless 1) accounts receivable are immaterial, 2) confirmations would be ineffective as an audit procedure, or 3) the combined assessment of inherent risk and control risk is low, and that assessment, with other substantive evidence, is sufficient to reduce audit risk to an acceptably low level.

Answer 11

9. Receivables

Question 12

1. Observation by the auditor of the client’s counting of inventory is a generally accepted auditing procedure and departure from it should be justified.

Answer 12

10. Inventory

Question 13

1. Recall the criteria for deciding whether the cost adjusted for fair value, equity, or consolidated basis should be used for the investments (see outlines of APB 18 and SFAS 94). Also recall the distinction in accounting treatment under SFAS 115 for debt securities and equity securities where significant influence does not exist. Accounting for derivative instruments is presented in SFAS 133.
2. Because of the liquid nature of securities, the auditor’s inspection is generally performed at year-end simultaneously with the audit of cash, bank loans (e.g. a revolving credit agreement) and other related items.

Answer 13

11. Investment Securities

Question 14

1. Many PP&E acquisitions involve trades of used assets. Module 11, Section C, points out that under SFAS 153 most nonmonetary exchanges of these assets are recorded using the fair value of the asset exchanged.
2. Assets constructed by a company for its own use should be recorded at the cost of direct material, direct labor, and applicable overhead. Recall that interest may be capitalized.
3. PP&E should be tested for impairment when facts and circumstances indicate that the asset’s value may be impaired.

Answer 14

12. Property, Plant, and Equipment

Question 15

1. Confirmations may be sent to vendors. However, such confirmation procedures are sometimes omitted due to the availability of externally generated evidence (e.g. both purchase agreements and vendors’ invoices) and due to the inability of confirmations to adequately address the completeness assertion.
2. Accounts payable confirmations are most frequently used in circumstances involving 1) bad internal control, 2) bad financial position, and 3) situations when vendors do not send month-end statements.

Answer 15

13. Payables (Current)

Question 16

1. Despite the fact that this account’s turnover rate is low, considerable analysis is performed on its ending balance. Confirmations are frequently used; recall that when the debt is owed to banks, confirmation is obtained with the standard bank confirmation.

Answer 16

14. Long-Term Debt

Question 17

1. Clients use one of two approaches for capital stock transactions. First, a stock certificate book may be used which summarizes shares issued through use of “stubs” which remain after a certificate has been removed. The certificates for outstanding shares are held by the stockholders; canceled certificates (for repurchased stock or received when a change in stock ownership occurs) are held by the client.
2. The second approach, typically used by large clients, is to engage a registrar and a stock transfer agent to manage the company’s stock transactions. The primary responsibility of the registrar is to verify that stock which is issued is properly authorized. Stock transfer agents maintain detailed stockholder records and carry out transfers of stock ownership. The number of shares authorized, issued, and outstanding will usually be confirmed to the auditor directly by the registrar and stock transfer agent.

Answer 17

15. Owners’ Equity

Question 18

1. Transactions in which a customer agrees to purchase goods but the seller retains physical possession until the customer requests shipment to designated locations. Because delivery has not yet occurred, such transactions do not ordinarily qualify. The primary requirements to qualify for revenue recognition are that the buyer make an absolute commitment to purchase, has assumed the risks and rewards of the product, and is unable to accept delivery because of some compelling reason.

Answer 18

16. Revenue

Question 19

1. Read the outline of this standard. Auditors increasingly are finding it necessary to use the work of specialists in areas such as postemployment and postretirement benefits,environmental cleanup obligations, fair value disclosures and derivatives, as well as in more traditional areas such as the valuation of inventory (e.g. diamonds/jewelry). A specialist is an individual or organization possessing expertise in a field other than accounting and auditing. A specialist may be hired by the client (the “client’s specialist”) or by the auditors (“the auditors’ specialist”).

Answer 19

17. Using the Work of a Specialist (AU-C 620; AU 336)

Question 20

1. Accounting standards (e.g. FAS 5) require disclosures relating to loss contingencies, as well as adjusting journal entries for those which are probable and estimable. Los contingencies are due to occurrences such as litigation, income tax disputes, various guarantees made by the client, accounts receivable sold or assigned with recourse, and environmental issues.
2. While auditors obtain information on many of these issues through inquiry of management, reading related correspondence, and various analyses of transactions, the client’s laywer is the primary source for corroboration of information obtained from the client concerning loss contingencies. If the auditor assesses a risk of material misstatement regarding litigation, claims, or assessments, the auditor should seek direct communication with the entity’s external legal counsel who have devoted substantive attention to the matter.

Answer 20

18. Loss Contingencies and Inquiry if a Client’s Lawyer (AU-C 501; AU 337)

Question 21

1. Generally accepted accounting principles require companies to use “fair value” for measuring, presenting, and disclosing various accounts (e.g. investments, intangible assets, impaired assets, derivatives). Fair value is generally considered to be the amount at which an asset or liability could be bought or sold in a current transaction between willing parties.
2. The determination of fair value is easiest when there are published price quotations in an active market (e.g. a stock exchange). Determining fair value is more difficult when an active market does not exist for items such as various investment properties or complex derivative financial instruments.

Answer 21

19. Fair Values (AU-C 501; AU 328)

Question 22

1. Review the outline of AU-C 550. The main issue with related-party transactions concerns the price at which a transaction occurs. This price may not be the one that would have resulted from an “arms-length bargaining”

Answer 22

20. Related-Party Transactions (AU-C 550; AU-C 334)

Question 23

1. This section deals with accounting issues (e.g. how to measure and disclose certain events) as well as audit responsibility with respect to certain events. Section 560 classifies subsequent events into 2 types.
2. Those events that provide additional evidence with respect to conditions that existed at the date of the balance sheet (for which the financial statements are to be adjusted for any changes in estimates).
3. Those events that provide evidence with respect to conditions that did not exist at the date of the balance sheet but arose subsequent to that date (for which these is to be footnote disclosure)

Answer 23

21. Subsequent Events and Subsequent Discovery of Facts Existing at the Date of the Audit Report (AU-C 560; AU 560, 561)

Question 24

4. The auditor should perform audit procedures to obtain appropriate audit evidence that subsequent events that require adjustment or disclosure have been identified.
5. While the auditor is not required to perform audit procedures after the date of the auditor’s report, if a subsequently discovered fact becomes known before the report release date, the auditor should discuss it with management (and those charged with governance) and determine whether the financial statements should be amended.
6. The auditor should discuss the matter with management and determine whether the financial statements need to be amended

Answer 24

21. Subsequent Events and Subsequent Discovery of Facts Existing at the Date of the Audit Report (AU-C 560; AU 560, 561)

Question 25

1. Throughout the course of the audit, the auditors will propose adjusting entries for all material misstatements (whether caused by error or fraud) that are discovered in the client’s financial statements. Any material misstatement that the auditors find should be corrected; otherwise, they cannot issue an unqualified opinion on the financial statements.

Answer 25

22. Evaluate Audit Findings

Question 26

1. PCAOB Auditing Standard No. 7 requires that an engagement quality reviewer perform a review of the audit and the related conclusions reached in forming the audit’s overall conclusions and in preparing the audit report. In essence, this is a final review of the audit, performed by a competent reviewer who isn’t a member of the audit team and who should maintain objectivity when performing the review.
2. The AICPA Quality Control Standards for nonpublic company engagements require that a CPA firm establish criteria to determine which of its engagements should undergo a quality control review. Thus, the audit of a nonpublic client that meets the firm’s criteria will have a quality review prior to audit report issuance.

Answer 26

23. Engagement Quality Review