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Remaining Topics from Chapter 4 (Audit Planning)
• Risk Factors for Fraudulent Financial Reporting
• Related Party Transactions
• Using the Work of a Specialist
• Using the Work of Internal Auditors
• Preliminary Analytical Procedures
• Preparing the Audit Program
1. Factors Affecting the Risk of
Fraudulent Financial Reporting
1. Management’s attitude toward internal control &
2. Extent to which management’s compensation is tied
to earnings or stock price.
3. Excessive interest by management in maintaining or
increasing the firm’s stock price.
4. Commitments made by the firm’s management to
achieve aggressive or unrealistic forecasts.
5. New accounting or regulatory rules that could reduce
financial stability or earnings.
6. High degree of industry competition, resulting in
lower profit margins.
7. Extent of rapid change or general decline in the
8. Significant pressure to obtain additional capital to
9. Unusually rapid growth or profitability compared
with the rest of the industry.
10. Inability to generate cash flows despite
reported earnings and earnings growth.
11. Unusually high debt level.
2. Related Party Transactions
What are Related Parties? Entities that can:
• __________________ the management or operating
policies of one of the transacting parties, and can
• __________________ the other to an extent that one or
more of the transacting parties might be prevented
from fully pursuing its own separate interests.
• Your parents lend you money, and don’t charge you
• Sale of goods by Co. A to Co. B, when the same person
owns both companies.
Related Party Transactions (cont.)
The following are parties related to a company:
• its ________, ____________ or __________;
• entities the company has invested in, and accounts for
its investment using the equity method;
• immediate family members of _______________ or
______________ of the company.
What’s the auditor’s responsibility regarding the
client’s related party transactions?
1. Certain relationships with other companies must be
___________ (even if there were no transactions
between the two companies).
• These include two companies owned or controlled by
the same entity.
2. All related party transactions must be:
a. _________ in the footnotes to the financial
b. Recorded so as to reflect the
_________________ of the transaction, rather than
its legal form.
1. Example: the company makes an interest-free
loan to one of its officers (e.g., the CEO).
2. Economically, the company is providing
additional compensation to the officer. It should:
• recognize compensation expense.
• recognize interest earned.
Related Party Transactions (cont.)
What can the auditor do to identify related parties?
1. Inquire of appropriate management personnel;
2. Obtain written representations that all related
parties have been disclosed by management to the
3. Review filings with the SEC and other regulatory
4. Review stockholder listings to identify principal
5. Review prior years’ workpapers to identify
known related parties;
6. Inquire of predecessor auditors or auditors of
7. Review material investment transactions to
determine whether related party transactions were
3. Using the Work of a Specialist
Auditors may need to consult a specialist in order to:
• determine the value of specialized _________ (e.g.,
works of art, jewelry, antiques);
• determine quantities (e.g., mineral reserves);
• determine amounts derived by specialized _________
(e.g., obligations for future pension benefits based on
• interpret legal documents or regulations.
The auditor should make sure that any specialist used:
• has a strong ____________________;
• has appropriate ____________;
• has any applicable ___________ or __________.
The CPA should understand the methods and
assumptions used by the specialist.
Why are these important?
• The auditor will ___________________ the specialist in
forming an opinion on the client’s financial
Using the Work of a Specialist (cont.)
The specialist’s findings might support the information
in the client’s financial statements.
• In that case, the auditor ________________ the
special-ist or the specialist’s findings in the audit
The specialist’s findings might be inconsistent with
information in the client’s financial statements.
In that case, the auditor needs to decide whether the
specialist’s findings are reasonable.
a. If they’re reasonable, the auditor will
__________ the report, and refer to the specialist
and his/her findings.
b. If they’re not reasonable, the auditor will either:
• _____________ specialist, or
• perform additional ______________.
The opinion issued by the auditor will depend on the
results of these _______________.
4. Using the Work of Internal Auditors
a. Serve as an important element of internal control, by
b. providing the following to management regarding
the company’s operations:
• other information
The independent auditor (CPA) may wish to review the
internal auditor’s work, which might help the CPA:
a. Understand the client’s ________________
b. Plan ___________ testing procedures
c. Assess __________ risk and/or _________ risk
• the statements as a whole,
• a particular acct. balance or class of transactions, or
Using the Work of Internal Auditors (cont.)
The independent auditor (CPA) should not rely on the
work of the internal auditors if:
a. the internal auditors’ work is ________________
the independent auditor’s work, or
b. the _____ to the independent auditor of relying
on the internal auditors’ work _________ the
If the CPA believes that the internal auditor’s work is
______ and that using it would be ________,
the CPA should assess the ___________ and
_________ of the internal auditors (IAs).
The IA’s ___________ is a function of:
• his/her educational level;
• his/her professional experience;
• his/her certification, if any;
• the quality of his/her reports and recommendations.
The IA’s ___________ can be assessed by evaluating:
• his/her status in the organization, &
• any policies prohibiting IAs from studying particular
areas of operations.
The higher the level in the client the IA reports to, the
more ___________ he/she is generally considered to be
(other things equal).
Using the Work of Internal Auditors (cont.)
If the IA is considered by the CPA to be __________
the CPA may rely on the IA’s work if the CPA verifies
the quality of the work being relied on.
• For example, the IA may have tested the effectiveness
of certain internal controls.
• If the CPA wishes to rely on this work, the CPA should
test a sample of the IA’s work to ensure that it was
The responsibility to audit the financial statements
cannot be shared with, nor delegated to, the internal
What is “outsourced” internal auditing?
Why do some believe it is a threat to auditor
5. Preliminary Analytical Procedures
SAS No. 56 requires the auditor to perform analytical
procedures in the preliminary stages of the audit.
They are usually performed at the following stages as
• substantive testing stage;
• near the end of the audit.
What are analytical procedures?
• ____________ of unaudited financial information based
on the underlying ____________ ________ financial
and nonfinancial data.
For example, compare unaudited financial data with:
• prior period data (e.g., by what % did sales change?)
• anticipated results;
• other data for the same period (same company);
For example, accounts receivable vs. credit sales
• data from other companies in the same industry;
(accounts receivable/credit sales for this company vs.
the industry average)
• nonfinancial data (market share change, industry
Preliminary Analytical Procedures (cont.)
What’s the purpose of these procedures?
• They direct the ______________________ significant
changes over time, or balances that differ from
These differences could be due to:
• legitimate reasons (sales increased because a
competitor left the market); or
• misstatements contained in an account balance.
If a large difference exists between the recorded
balance and the expected balance in an account,
the auditor generally does more extensive substantive
tests related to that account.
6. Preparing the Audit Program
What is an audit program?
• a written set of audit ____________to be ___________
during the audit.
• it’s required for all GAAS audits.
The audit program is tailor-made for the particular audit
Standardized audit programs exist for most accounts; these
are modified by the auditor for the audit being conducted.