The Audit Process Flashcards

Question

The 4 Steps in Evaluating an Internal Control Syste,

Answer 1

Understand design & implementation Assess ability to prevent/detect material misstatements Determine appropriate audit approach * Strong IC → More reliance → Less substantive testing * Weak IC → Less reliance → More substantive testing Evaluation includes documentation review, interviews, and testing.

Answer 2

They may look in the client’s procedures manual if one exists. They talk to client staff to gain an understanding of how the controls operate in practice. They may make use of an Internal Control Questionnaire (ICQ), which is a set of questions designed to gather information about the client's control environment and specific control activities. They may perform a ‘walk through’ test, which involves tracing a transaction from its initiation through the accounting system to its eventual recording in the financial statements. This helps the auditor understand the flow of transactions and the controls in place at each stag

Answer 3

System Descriptions: Detailed narratives of processes Control objectives for each process Key control activities Visual Representations: Flowcharts showing process flows Decision trees for control points Swimlane diagrams for responsibility assignment Control Matrices: Mapping controls to risks Identifying control owners Documenting frequency of controls Supporting Evidence: Copies of key forms and reports Samples of authorization signatures System screenshots for automated controls

Answer 4

Two-stage process: Design evaluation: Assess if controls are theoretically strong If weak: No compliance testing needed If strong: Proceed to stage 2 Compliance testing: Verify if controls operate as designed

Answer 5

The auditor's judgment about whether ICs will fail to prevent/detect material misstatements: Based on design evaluation + compliance testing Higher CR → More substantive testing required

Answer 6

Historically: Professional judgment + informal guidelines Currently: Statistical techniques (more scientific/defensible) Outcome determines: Detection risk (DR) level Extent of substantive procedures

Answer 7

1️⃣ Direct confirmation (external+independent) 2️⃣ Physical examination (auditor's direct verification) 3️⃣ Re-performance (auditor's independent execution) 4️⃣ External documentation (third-party prepared) 5️⃣ Observation (time-sensitive verification) 6️⃣ Analytical procedures (requires corroboration) 7️⃣ Internal documentation (client-prepared) 8️⃣ Client enquiries (inherently biased)

Answer 8

Objectivity: External > internal evidence Provider qualifications: Expert sources preferred Independence: Third-party > client-provided Auditor's direct knowledge: Observation > inquiry

Answer 9

Objectivity: High (written third-party response) Independence: High (external to client) Key factor: Provider qualifications (must be knowledgeable) Risk: Non-response or client interference

Answer 10

External docs (more persuasive): Invoices from suppliers Bank statements Internal docs (less persuasive): Client-prepared spreadsheets Internal memos

Answer 11

Objectivity: Low (self-reported information) Independence: None (client is provider) Mitigation: Corroborate with other evidence Example: Management representations

Answer 12

High persuasiveness when: Using reliable external data (e.g., industry benchmarks) Showing predictable relationships (e.g., cost of sales vs. revenue) Low persuasiveness when: Standalone (requires other evidence) Using client-prepared estimates

Answer 13

"Evaluations of financial information through analysis of plausible relationships among financial/non-financial data" (SAS No.56)

Answer 14

1️⃣ Planning: Understand business risks/areas of focus 2️⃣ Substantive Testing: Gather evidence on account balances 3️⃣ Final Review: "Smell test" before opinion issuance (Salad Oil Swindle example) 4️⃣ Risk Assessment: Links to Audit Risk Model components

Answer 15

Simple → Complex: Ratio Analysis (e.g., current ratio) Trend Analysis (3-5 year comparisons

Answer 16

It's easy to do and saves in costs whilst maintaining high audit quality Highlights problems in the areas at the planning stage Fits into a version of the Audit Risk Model

Answer 17

The probability that audited financial statements contain material misstatements even after receiving an unqualified ("clean") opinion Occurs when auditors fail to detect significant errors or fraud Represented by the formula: AR = IR × CR × DR Example: Auditor approves financials that overstate revenue by 10%

Answer 18

Auditor's decision: Issues clean opinion Reality: Financial statements are materially misstated Consequences: Most serious error - can lead to investor losses and legal liability Called "false positive" because system appears fine when it's not Example: Approving financials with undiscovered fraudulent revenue recognition

Answer 19

Auditor's decision: Issues modified/adverse opinion Reality: Financial statements are actually correct Consequences: Unnecessary audit work and client dissatisfaction Called "false negative" because finds problems where none exist Example: Flagging legitimate transactions as suspicious

Answer 20

IR (Inherent Risk): Natural risk of material misstatement due to account nature (e.g., complex estimates) CR (Control Risk): Risk client's controls fail to prevent/detect misstatements DR (Detection Risk): Risk audit procedures fail to catch misstatements Relationship: Multiplicative - high IR/CR requires lower DR Application: Used to plan audit procedures

Answer 21

ARR × TD Model: ARR (Analytical Review Risk): Risk analytical procedures miss errors TD (Tests of Detail Risk): Risk detailed testing misses errors Used when relying heavily on analytics IR × CR × DR × SR Model: Adds SR (Sampling Risk): Risk sample isn't representative Used for audits with extensive sampling

Answer 22

Nature: Use more reliable procedures (e.g., confirmation vs inquiry) Timing: Perform tests closer to year-end Extent: Increase sample sizes Trade-off: Lower DR requires more work = higher costs Example: For high risk areas, use 100% testing instead of sampling

Answer 23

Transaction complexity: Derivatives, M&A accounting Subjectivity: Bad debt allowances, asset impairments External factors: Rapid industry changes, new regulations Historical issues: Past restatements or errors Example: Tech company with complex revenue recognition policies

Answer 24

A financial reporting concept adopted by auditors The threshold where misstatements could influence users' economic decisions Two key aspects: Quantitative: Size of error (e.g., 5% of profit) Qualitative: Nature of error (e.g., fraud vs. mistake) Example: A 1Merrorina100M revenue company may be immaterial, but the same $1M in executive bonuses would be material

Answer 25

User-focused: Based on needs of financial statement users (investors, creditors) Context-dependent: Considers: Company size Industry Economic conditions Judgment-based: No fixed rules - requires professional scepticism Dynamic: Can change year-to-year (e.g., during crises)

Answer 26

Quantitatively: Exceeds calculated thresholds (e.g., >5% of net income) Qualitatively: * Involves fraud/illegal acts * Affects debt covenant compliance * Changes loss to profit (or vice versa) * Impacts executive compensation * Concerns related-party transactions Example: A $50k fraud is material even if <1% of revenue

Answer 27

Maximum error in an account balance auditors will accept Typically 50-75% of overall materiality Used to: Determine sample sizes Evaluate audit findings Decide if adjustments are needed Formula: TER = Materiality × Risk Factor

Answer 28

Intent: Fraud > unintentional errors Masking: Hiding poor performance Regulatory: Non-compliance consequences User impact: Affects key ratios/trends Psychological: Rounding thresholds (9.9Mvs10M) Case Example: WorldCom capitalized $3.8B in expenses - quantitatively large but also qualitatively material due to intentional deception

Answer 29

Planning: Set preliminary materiality (often 5% of normalized profit) Testing: Use TER for individual accounts Evaluation: Aggregate uncorrected misstatements Reporting: Determine if aggregate errors exceed materiality Professional Judgment Required: Must consider both numbers and context

Answer 30

Errors in small items may indicate: Control weaknesses Potential for larger undetected errors "Iceberg" risk (small visible errors hint at bigger problems) Audit Approach: Investigate patterns of small errors that could be symptomatic

Answer 31

A mathematically-based sampling method that: Provides measurable conclusions about populations Quantifies sampling risk Uses probability theory Contrasts with judgmental sampling Key feature: Every item has known selection probability Example: Randomly selecting 100 invoices from 10,000 using computer-generated numbers

Answer 32

Detection limitation: Measures how sampling reduces error detection capability Efficiency dilemma: Mathematically determines optimal sample size Defensibility: Provides objective basis for audit conclusions Example: Justifying why testing 200 items is sufficient for 50,000 transactions

Answer 33

Objectivity: Removes auditor bias in sample selection Precision: Quantifies sampling risk (e.g., 95% confidence) Efficiency: Calculates minimum required sample size Defensibility: Provides audit evidence that can withstand scrutiny Regulatory benefit: Meets PCAOB/SEC requirements

Answer 34

Cost: Requires specialized training/software Constraints: Needs clearly defined population Rigidity: May exclude professional judgment MUS limitation: Works best with near-zero error expectations Practical reality: Often modified for real-world conditions

Answer 35

Must reflect population characteristics through: Random selection: Equal chance for all items Stratification: Grouping similar items Adequate size: Mathematically determined Failure example: Only testing Q4 transactions would be non-representative

Answer 36

Homogeneous populations: * Single sampling approach sufficient * Example: All cash disbursements under $10k Heterogeneous populations: * Requires stratification * Example: Separating capital vs. expense transactions Audit impact: Affects sample size calculations

Answer 37

Confidence level (e.g., 90% vs 95%) Tolerable Error Rate (TER): Max acceptable error Expected Error Rate: Auditor's pre-test estimate Formula: n = (Confidence factor × Population value) / TER Practice tip: Higher risk = larger sample

The Audit Process Flashcards

(62 cards)