3. Principals and Agents
Managers Stockholders
Agents Principals
A public company is a company that sells its stocks
or bonds to the public, giving the public a valid
interest in the proper use of the company’s
resources.
LO# 2
1-3
4. The Role of Auditing
Table 1-2 Summary of Management Assertions by Category
LO# 2
1-4
Assertions about classes of transactions and events for the period under audit:
Occurrence – transactions and events that have been recorded have occurred and pertain to the entity.
Completeness – all transactions and events that should have been recorded have been recorded.
Authorization – all transactions and events have been properly authorized.*
Accuracy – amounts and other data relating to recorded transactions and events have been recorded
appropriately.
Cutoff – transactions and events have been recorded in the correct accounting period.
Classification - transactions and events have been recorded in the proper accounts.
Assertions about account balances at the period end:
Existence – assets, liabilities, and equity interests exist.
Rights and obligations – the entity holds or controls the rights to assets, and liabilities are the obligations of the
entity.
Completeness – all assets, liabilities, and equity interests that should have been recorded have been recorded.
Valuation and allocation – assets, liabilities, and equity interests are included in the financial statements at
appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded.
Assertions about presentation and disclosure:
Occurrence and rights and obligations – disclosed events, transactions and other matters have occurred and
pertain to the entity.
Completeness – all disclosures that should be been included in the financial statements have been included.
Classification and understandability – financial information is appropriately presented and described and
disclosures are clearly expressed.
Accuracy and valuation – financial and other information are disclosed fairly and at appropriate amounts.
*International and AICPA auditing standards consider Authorization to be a subset of the Occurre nce assertion and th us do not
list it separately. We list Authorization as a separateassertion about classes of transactions and events for instructional clarity.
6. Auditing, Attest, and Assurance
Services Defined
Auditing
Assurance
Services
A systematic process of objectively
obtaining and evaluating evidence
regarding assertions about
economic actions and events to
ascertain the degree of
correspondence between those
assertions and established criteria
and communicating the results to
interested users.
Attestation
LO# 4
1-6
7. Auditing, Attest, and Assurance
Services Defined
Auditing Attestation
Assurance
Services
Attest services occur when a
practitioner is engaged to issue ... a
report on subject matter, or an
assertion about subject matter, that
is the responsibility of another party.
LO# 4
1-7
8. Auditing, Attest, and Assurance
Services Defined
Auditing Attestation
Assurance
Services
Independent professional services
that improve the quality of
information, or its context, for
decision makers.
LO# 4
1-8
10. Materiality
Information is material if
omitting it or misstating it
could influence decisions
that users make on the
basis of the financial
information of a specific
reporting entity.
LO# 5
1-10
11. Audit Risk
Audit risk is the risk that the auditor expresses an
inappropriate audit opinion when the financial
statements are materially misstated.
The auditor’s standard
report states that the
audit provides only
reasonable assurance
that the financial
statements do not
contain material
misstatements.
Reasonable assurance implies
some risk that a material
misstatement could be present in
the financial statements and the
auditor will fail to
detect it.
LO# 5
1-11
12. Audit Evidence Regarding
Management Assertions
Relevance – Is the
information related to
the specific assertion
being tested?
Reliability – Can the
information be relied
upon to signal the true
state of the specific
assertion being
tested?
Evidence that assists the auditor in evaluating
management’s financial statement assertions
consists of the underlying accounting data and any
additional information available to the auditor,
whether originating from the client or externally.
LO# 5
1-12
13. Sampling: Inferences Based on
Limited Observations
Auditors use a sampling approach to examine a
subset of the transactions based on previous audits,
an understanding of the company’s internal control
system, or knowledge of the company’s industry.
It would be too costly for the
auditor to examine every
transaction.
LO# 6
1-13
14. Issue the Audit Report
LO# 8
The title line of the audit report includes the word
“Independent,” and usually, the report is addressed
to the stockholders of the company.
The audit report includes an introductory paragraph,
a scope paragraph, an opinion paragraph, an
explanatory paragraph referring to the audit of
internal control, the name of the auditor or audit
firm, and the date of the audit report.
Adverse
Qualified
Unqualified
1-14
15. Issue the Audit Report
LO# 8
The auditor may issue an unqualified opinion.
The auditor’s report (audit opinion) is the main
product or output of the audit. The standard
unqualified (clean) audit report is the most common
type of report issued. In this context, unqualified
means that because the financial statements are free
of material misstatements, the auditor does not find
it necessary to qualify his or her opinion about the
fairness of the financial statements.
1-15
16. Issue the Audit Report
LO# 8
The auditor may issue a qualified opinion.
Suppose an auditee’s financial statements contain a
misstatement that the auditor considers material
and management refuses to correct the
misstatement. The auditor will likely qualify the
report, explaining that the financial statements are
fairly stated except for the misstatement identified
by the auditor.
1-16
17. Issue the Audit Report
LO# 8
The auditor may issue an adverse opinion.
Suppose an auditee’s financial statements contain a
misstatement that the auditor considers so material
that it pervasively affects the interpretation of the
financial statements. Given such a situation, the
auditor will issue an adverse opinion, indicating that
the financial statements are not fairly stated and
should not be relied upon.
1-17
19. Types of Audit, Attest, and
Assurance Services
LO# 2
Audit Services:
Attest Services:
Assurance Services:
Nonaudit Services:
Internal Control Audits, Compliance Audits, Operational
Audits, Forensic Audits
Reporting on nature and quantity of inventory stored in
a company’s warehouse so that the company can obtain
a bank loan
Auditing is a specialized form of assurance service
Tax Preparation and Planning Services, Management
Advisory Services, Compilation and Review Services
2-19
20. Society’s Expectations and the
Auditor’s Responsibilities
The auditor has a responsibility to plan and
perform the audit to obtain reasonable
assurance about whether the financial
statements are free of material
misstatement, whether caused by error or
fraud.
Because of the nature of audit evidence and the
characteristics of fraud, the auditor is able to
obtain reasonable, but not absolute, assurance
that material misstatements are detected.
LO# 5
2-20
21. Context of Financial Statement
Auditing
The primary context with which an auditor is concerned is the industry or
business of his or her auditee. In other words, the context provided by the
entity’s business impacts the auditor and the audit, and is thus a primary
component of the environment in which financial statement auditing is
conducted.
LO# 6
Thought Question:
How would your concerns about the
inventory account differ for a Computer
Hardware Manufacturer versus a
Jewelry Store?
2-21
22. Auditing Standards
Auditing standards serve as
guidelines for and measures of
the quality of the auditor’s
performance.
Public
Companies
PCAOB
Nonpublic
Companies
Auditing
Standards
Board
> 100
Countries
IAASB
LO# 10,11
2-22
23. The 10 Generally Accepted
Auditing Standards (PCAOB)
GAAS
General Field Work Reporting
LO# 10,11
2-23
27. Statements on Auditing Standards
(SAS)—Interpretations of GAAS
GAAS and SAS are considered to be minimum
standards of performance for auditors.
PCAOB adopted, on an
interim basis, GAAS and
SAS existing in 2003.
Standards issued by
PCAOB are called
Auditing Standards (AS).
LO# 12
2-27
28. Ethics, Independence, and the
Code of Professional Conduct
Ethics refers to a system or code of conduct
based on moral duties and obligations that
indicate how we should behave.
Professionalism refers to the conduct, aims,
or qualities that characterize a profession or
professional person. All professions operate
under some type of code of ethics or code of
conduct.
LO# 13
2-28
30. Establish an Understanding with
the Entity
The terms of the engagement, which are documented in
the engagement letter, should include the objectives of
the engagement, management’s responsibilities, the
auditor’s responsibilities, and the limitations of the
engagement.
Who signs the engagement letter?
In establishing the terms of the engagement,
three topics must be discussed:
1.The engagement letter;
2.Using the work of the internal audit function;
and
3.The role of the audit committee.
LO# 3
31. Planning the Audit
• The auditor will develop an overall audit strategy for
conducting the audit. This will help the auditor to
determine what resources are needed to perform
the engagement.
• An audit plan is more detailed than the audit
strategy.
• Basically, the audit plan should consider how to
conduct the engagement in an effective and
efficient manner.
LO# 7
32. Assess Business Risks
To understand the
entity’s business
and transactions
To identify
financial statement
accounts likely to
contain errors
By understanding the entity’s business and
identifying where errors are likely to occur, the
auditor can allocate more resources to investigate
more risky accounts.
LO# 7
33. Establish overall
materiality
(more on this later!)
Establish tolerable
misstatement for
accounts
Establish tolerable
misstatement for
disclosures
LO# 7
Establish Materiality
34. Types of Audit Tests
Risk Assessment
Procedures
Used to obtain an understanding of
the entity and its environment,
including its internal control.
Tests of Controls
Directed toward the evaluation of the
effectiveness of the design and
operation of internal controls.
Substantive
Procedures
Detect material misstatements in a
transaction class, account balance,
and disclosure component of the
financial statements.
LO# 9
36. Substantive Procedures
Analytical
Procedures
Evaluations of
financial information
through analysis of
plausible
relationships among
financial and non-
financial data
Tests of
Details
Tests for errors or
fraud in individual
transactions,
account balances,
and disclosures
LO# 9
37. Materiality
The United States Supreme Court
interpretation of materiality is that a fact is
material if there is “a substantial likelihood
that the…fact would have been viewed by the
reasonable investor as having significantly
altered the ‘total mix’ of information made
available.”
Materiality is not an absolute and
it is not a black or white issue!
The determination of materiality
requires professional judgment.
LO# 10
39. Audit Risk
The risk that an auditor expresses
an inappropriate audit opinion
when the financial statements are
materially misstated.
Financial statement
level
Individual account
balance or disclosure
level
LO# 1
4-39
Assertion
level
40. The Audit Risk Model
Audit Risk = IR × CR × DR
Inherent risk and control risk:
Risk of material misstatement
Nonsampling
risk
Sampling
risk
Detection risk:
Risk that auditor will not detect misstatements
Inappropriate audit procedure
Improper or incomplete use
of an audit procedure
Misinterpreting audit results
LO# 2
4-40
41. Using the Audit Risk Model
Case AR RMM DR
1 Very low High Low
2 Low Moderate Moderate
3 Low Low High
LO# 3
Qualitative terms may also be used in the audit risk model.
4-41
42. The Auditor’s Risk
Assessment Process
Auditors need to
identify business risks and
understand the potential
misstatements that
may result.
Business risks
are risks that result from
significant conditions, events,
circumstances or actions that
impair management’s ability
to execute strategies.
LO# 4
4-42
43. Auditor’s Risk Assessment Procedures
(How do we gather this evidence?)
Inquiries of Management,
Other Entity Personnel, and
Others Outside the Entity
Analytical
Procedures
Observation
and Inspection
LO# 4
4-43
44. Errors are unintentional misstatements of amounts
or disclosures in the financial statements.
Fraud refers to an intentional act by one or more
among management, those charged with
governance, employees, or third parties,
involving the use of deception that results in a
misstatement in the financial statements.
LO# 5
Assessing the Risk of Material
Misstatement
4-44
45. Fraud involves intentional
misstatements. The fraud risk
identification process includes:
Sources of information about possible
fraud―
Communications among the audit team
Inquires of management and others
Analytical procedures
Investigation of unexpected period-end
adjustments
LO# 6
The Fraud Risk Assessment
Process
4-45
46. Three conditions usually
exist when fraud occurs.
Incentive or
pressure to
perpetrate fraud
Opportunity
to carry out
the fraud
Attitude or
rationalization
to justify fraud
LO# 6
Conditions Indicative of Fraud and Fraud Risk
Factors
4-46
52. Audit Evidence
All the information, from
whatever source, used
by the auditor in arriving at
the conclusions on which the
audit opinion is based.
LO# 3
5-52
53. The Concepts of Audit
Evidence
Nature of audit evidence
Sufficiency and appropriateness
of audit evidence
Evaluation of audit evidence
LO# 3
5-53
54. Nature of Audit Evidence
Records of
initial entries and
supporting records
Invoices Contracts
General
and subsidiary
ledgers
Adjustments
to financial
statements Worksheets
Spreadsheets
supporting cost
allocations
Other
computations,
reconciliations, and
disclosures
LO# 3
5-54
55. Sufficiency of
Audit Evidence
Sufficiency is the measure of
the quantity of audit evidence.
Greater risk of
misstatement requires
a higher quantity
of audit evidence.
Higher quality
audit evidence results
in a lower quantity
of audit evidence.
LO# 3
5-55
56. Appropriateness of
Audit Evidence
Relevance
Reliability
Independent source outside the entity
Effectiveness of internal control
Auditor’s direct personal knowledge
Documentary evidence
Original documents
LO# 3
Appropriateness is a measure
of the quality of audit evidence.
5-56
57. Evaluation of
Audit Evidence
Proper evaluation of evidence
requires an understanding of the:
Types of evidence available.
Relative reliability of available evidence.
An auditor should be thorough in searching
for evidence and unbiased in its evaluation.
LO# 3
5-57
59. Internal Control
Management has the responsibility to maintain controls that
provides reasonable assurance that adequate control exists over
the entity’s assets and records.
The Internal Control System should:
-ensure that assets and records are safeguarded
-generate reliable information for decision making
The auditor needs assurance about the reliability of the data
generated by the information system.
LO# 1
6-59
60. Internal Control
The auditor uses risk assessment procedures to
-obtain an understanding of the entity’s internal control
-identify key controls
-identify the types of potential misstatements
-design tests of controls and substantive procedures
The auditor’s understanding of the internal control is a
major factor in determining the overall audit strategy. The
auditor has a responsibility to:
(1) obtain an understanding of internal control and
(2) assess control risk.
LO# 1
6-60
61. COSO’s Internal Control –
Integrated Framework
Reliability of
Financial
Reporting
Effectiveness
and Efficiency
of Operations
Compliance
with Laws and
Regulations
Objectives
LO# 2
6-61
62. Components of Internal Control
Control
Environment
Entity’s Risk
Assessment
Process
Information and
Communication
Control
Activities
Monitoring of
Controls
LO# 5
6-62
63. Components of Internal Control
Figure 6-1 The Relationship of the Objectives of Internal Control to the Five Components
of Internal Control
LO# 5
6-63
64. Planning an Audit Strategy
Audit Risk Model
AR = IR × CR × DR
In applying the audit risk model, the auditor
must assess control risk. The figure on the
next slide presents a flowchart of the auditor’s
decision process when considering internal
control in planning an audit.
LO# 6
6-64
65. LO# 6
Planning an Audit Strategy
Figure 6-2 Flowchart of the Auditor’s Consideration of Internal Control and Its Relation to
Substantive Procedures
6-65
66. Substantive Strategy
After obtaining an understanding of internal control, an
auditor may choose to follow a substantive strategy and set
control risk at high for some or all assertions because of one
or all of the following factors:
Controls do
not pertain to
an assertion.
Controls are
assessed as
ineffective.
Testing the
effectiveness
of controls is
inefficient.
LO# 6
6-66
68. Communication of Internal
Control-Related Matters
Significant
Deficiency
Material
Weakness
A significant deficiency is a deficiency, or a
combination of deficiencies, in internal control
that is less severe than a material weakness yet
important enough to merit attention by those
charged with governance.
A material weakness is a deficiency, or
combination of deficiencies, in internal control,
such that there is a reasonable possibility that a
material misstatement of the entity’s financial
statements will not be prevented, or detected
and corrected, on a timely basis.
LO# 14
6-68
70. Management Responsibilities
under Section 404
Section 404 of the Sarbanes-Oxley Act requires
managements of publicly traded companies to
issue a report that accepts responsibility for
establishing and maintaining “adequate” internal
control over financial reporting (ICFR) and assert
whether ICFR is effective as of the end of the
fiscal year.
LO# 1
7-70
71. Management Responsibilities
under Section 404
Management must comply with the following requirements in
order for the external auditor to complete an audit of ICFR.
1. Accept responsibility for the effectiveness of
the entity’s ICFR.
2. Evaluate the effectiveness of the entity’s
ICFR using suitable control criteria.
3. Support the evaluation with sufficient
evidence, including documentation.
4. Present a written assessment regarding the
effectiveness of the entity’s ICFR as of the
end of the entity’s most recent fiscal year.
LO# 1
7-71
72. Auditor Responsibilities under
Section 404 and AS5
The entity’s independent auditor must audit and
report on the effectiveness of ICFR. The auditor is
required to conduct an integrated audit of the
entity’s ICFR and its financial statements.
LO# 2
7-72
73. ICFR Defined
ICFR is defined as a process designed to provide
reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements in
accordance with GAAP. Controls include procedures that:
1. Pertain to the maintenance of records that accurately
and fairly reflect the transactions and dispositions of
the assets of the company.
2. Provide reasonable assurance that transactions are
properly authorized and recorded in accordance with
GAAP.
3. Provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or
disposition of the company’s assets.
LO# 3
7-73
74. Internal Control Deficiencies
Defined
A control deficiency exists when the design or
operation of a control does not allow management or
employees, in the normal course of performing their
assigned functions, to prevent or detect
misstatements on a timely basis.
A significant deficiency is a control deficiency, or a
combination of control deficiencies, in internal
control over financial reporting that is less severe
than a material weakness, yet important enough to
merit attention by those responsible for oversight of
the company's financial reporting.
LO# 4
7-74
75. Internal Control Deficiencies
Defined
A control deficiency may be serious enough that it is
to be considered not only a significant deficiency but
also a material weakness in the system of internal
control. A material weakness is a deficiency, or a
combination of deficiencies, in ICFR, such that there
is a reasonable possibility that a material
misstatement of the annual or interim financial
statements will not be prevented or detected on a
timely basis.
As illustrated on the next slide, the auditor must
consider two dimensions of the control deficiency:
likelihood (reasonably possible), and
magnitude (material, significant, or insignificant)
LO# 4
7-75
76. Internal Control Deficiencies
Defined
Material
Not material
but significant
Not material
or significant
Remote Reasonably possible or
probable
Material
weakness
Significant
deficiency
Control
deficiency
L I K E L I H O O D
M
A
G
N
I
T
U
D
E
LO# 4
Report externally to audit
committee and to
management
Report to audit
committee and to
management
Report to
management
7-76
77. Types of Reports Relating to the
Audit of ICFR
An unqualified opinion signifies that the
entity’s internal control is designed and
operating effectively (no material
weaknesses).
A serious (more than minor) scope limitation
requires the auditor to disclaim an opinion.
An adverse opinion is required if a material
weakness is identified.
LO# 14
7-77
78. Types of Reports Relating to the
Audit of ICFR
Report Modification Based on Control Deficiencies
Likelihood/Magnitude
of Misstatement
Type of
Audit Report
Control
deficiency
Significant
deficiency
Material
weakness
Unqualified
opinion
Adverse
opinion
LO# 14
7-78
79. Types of Reports Relating to the
Audit of Internal Control
Report Modification Based on Scope Limitation
Seriousness of
Scope Limitation
Type of
Audit Report
Minor
effect
More than
minor effect
Unqualified
opinion
Disclaim
opinion or
withdraw
LO# 14
7-79
81. Introduction
Auditing standards recognize and permit both statistical and
nonstatistical methods of audit sampling.
Two technological advances have reduced the
number of times auditors need to apply sampling
techniques to gather audit evidence:
1
Development of
well-controlled,
automated
accounting
systems.
2
Advent of powerful
PC audit software to
download and
examine entity
data.
LO# 1
8-81
82. Definitions and Key Concepts
On the following slides we will
define:
1. Audit Sampling.
2. Sampling Risk.
3. Confidence Level.
4. Tolerable and Expected Error.
LO# 1
and 2
8-82
83. Audit Sampling
The selection and evaluation of less than 100
percent of the items in a population of audit
relevance selected in such a way that the
auditor expects the sample to be
representative of the population and thus
likely to provide a reasonable basis for
conclusions about the population.
LO# 1
8-83
84. Sampling Risk
Sampling risk is the possibility that the sample
drawn is not representative of the population.
There are two types of sampling risk.
Risk of incorrect rejection (Type I) – in a test of internal
controls, it is the risk that the sample supports a conclusion that the
control is not operating effectively when, in fact, it is operating
effectively. In substantive testing, it is the risk that the sample
indicates that the recorded balance is materially misstated when, in
fact, it is not.
Risk of incorrect acceptance (Type II) – in a test of
internal controls, it is the risk that the sample supports a conclusion
that the control is operating effectively when, in fact, it is not
operating effectively. In substantive testing, it is the risk that the
sample supports the recorded balance when it is, in fact, materially
misstated.
LO# 2
8-84
85. Sampling Risk
Three Important Factors in Determining Sample Size
1.The desired level of assurance in the results
(or confidence level),
2.Acceptable defect rate (or tolerable error), and
3.The historical defect rate (or expected error).
LO# 2
8-85
86. Confidence Level
Confidence level is the
complement of sampling risk.
The auditor may set
sampling risk for a
particular sampling
application at
5 percent, which
results in a
confidence level of
95 percent.
LO# 2
8-86
87. Tolerable and Expected Error
Once the desired confidence level is established, the
sample size is determined largely by how much the
tolerable error exceeds expected error.
Precision, at the
planning stage of
audit sampling, is
the difference
between the
expected and
tolerable deviation
rates.
Auditing Standards
refer to Precision
as the “Allowance for
sampling risk.”
LO# 2
8-87
88. Types of Audit Sampling
Auditing standards recognize and permit both statistical and
nonstatistical methods of audit sampling.
In nonstatistical (or judgmental)
sampling, the auditor does not
use statistical techniques to
determine sample size, select
the sample items, or measure
sampling risk.
Statistical sampling uses the
laws of probability to compute
sample size and evaluate results.
The auditor is able to use the
most efficient sample size and
quantify sampling risk.
LO# 4
8-88
89. Types of Audit Sampling
Advantages of statistical sampling:
1. Design an efficient sample.
2. Measure the sufficiency of evidence
obtained.
3. Quantify sampling risk.
Disadvantages of statistical sampling:
1. Training auditors in proper use.
2. Cost to design and conduct sampling
application.
3. Lack of consistent application across
audit teams.
LO# 4
8-89
91. Attribute Sampling
Used to estimate the proportion of a
population that possess a specified
characteristic. The most common use of
attribute sampling is for tests of controls.
The entity’s controls
require that all checks
have two independent
signatures.
Yes, I know. We are
planning a test of that
control using
attribute sampling.
LO# 4
8-91
92. Monetary-Unit Sampling
Monetary-unit sampling uses attribute sampling theory to estimate
the dollar amount of misstatement for a class of transactions or
an account balance.
This technique is used
extensively because it has
a number of advantages
over classical variables
sampling.
LO# 4
8-92
93. Classical Variables Sampling
Auditors sometimes use classical variables sampling
to estimate the dollar value of a class of transactions
or account balance. It is more frequently used to
determine whether an account is materially
misstated.
LO# 4
8-93
95. Revenue Recognition
Revenue is defined as inflows or other
enhancements of assets of an entity or
settlements of its liabilities (or a combination of
both) from delivery or producing goods, rendering
services, or other activities that constitute the
entity’s major or central operations.
LO# 1
10-95
96. Revenue Recognition Criteria
SAB 101
1. Persuasive evidence of an arrangement exists.
2. Delivery has occurred or services have been
rendered.
3. The seller’s price to the buyer is fixed or
determinable.
4. Collectibility is reasonably assured.
LO# 1
10-96
97. Types of Transactions and
Financial Statement Accounts
Affected
Three types of transactions are typically processed through the
revenue process:
1. The sale of goods or rendering of a service for cash or credit.
2. The receipt of cash from the customer in payment for goods
or services.
3. The return of goods by the customer for credit or cash.
LO# 3
10-97
98. The Major Functions
Functions of the Revenue Process
Order entry Acceptance of customer orders for goods and services into
the system in accordance with management criteria.
Credit authorization
Appropriate approval of customer orders for
creditworthiness.
Shipping Shipping of goods that has been authorized.
Billing
Issuanace of sales invoices to customers for goods
shipped or services provided; also, processing of billing
adjustments for allowances, discounts, and returns.
Cash receipts Processing of the receipt of cash from customers.
Accounts receivable
Recording of all sales invoices, collections, and credit
memoranda in individual customer accounts.
General ledger
Proper accumulation, classification, and summarization of
revenues, collections, and recivables in the financial
statement accounts.
LO# 5
10-98
99. Major Functions
LO# 5
Order Entry
The initial function in the revenue
process is the entry of a new
sales order into the system.
10-99
100. Major Functions
Shipping
Goods should not be
shipped, nor should
services be provided
without proper
authorization. The main
control is payment or
proper credit
authorization.
Billing
The objective of proper billing is to ensure that all goods
shipped and all services rendered are billed to the
customer.
Credit Authorization
The credit authorization
process must determine
that the customer is able
to pay for the goods or
services purchased.
Failure to properly
authorize credit can lead
to extensive bad debts
for the entity.
LO# 5
10-100
101. Cash Receipts
All cash collected
must be properly
identified and
promptly deposited
intact at the bank.
Accounts Receivable
All billings,
adjustments, and
cash collections must
be properly recorded
in the customers’
accounts receivable
records.
General Ledger
As related to the revenue process, the general ledger
function must ensure that all revenues, collections, and
receivables are properly recorded and classified.
Major Functions
LO# 5
10-101
102. Inherent Risk Assessment
The four inherent risk factors that may affect
the revenue process are:
1. Industry-related factors.
2. The complexity and contentiousness of revenue recognition
issues.
3. The difficulty of auditing transactions and account balances.
4. Misstatements detected in prior audits.
LO# 7
10-102
103. Control Risk Assessment
Understand and document the revenue process based
on a reliance strategy.
Plan and perform tests of controls on revenue
transactions.
Set and document the control risk for the revenue
process.
LO# 8
10-103
104. Occurrence of Revenue
Transactions
The auditor is concerned about two major
types of material misstatements:
1. Sales to fictitious customers.
2. Recording revenue when goods have not been shipped or
services have not been performed.
The auditor needs assurance that all recorded
revenue transactions are valid.
LO# 9
10-104
105. Completeness of Revenue
Transactions
The major misstatement that concerns both
management and the auditor is that goods are
shipped or services are performed and no
revenue is recognized.
Controls concerning completeness
include: (1) accounting for
numerical sequence of shipping
documents and sales invoices, (2)
matching shipping documents with
sales invoices, (3) reconciling
sales invoices to daily sales
reports, and (4) maintaining and
reviewing the open-order file.
LO# 9
10-105
106. Authorization and Accuracy of
Revenue Transactions
Possible misstatements due to improper authorization include
shipping goods to, or performing services for, customers who are
bad credit risks and making sales at unauthorized prices or
terms.
LO# 9
The presence of an authorized price list
and terms of trade reduces the risk of
inaccuracies. The sales invoice should
also be verified for mathematical accuracy
before being sent to the customer.
10-106
107. Cutoff and Classification of
Revenue Transactions
Sales may be recorded in the wrong
accounting period unless proper controls are
in place. All shipping documents should be
forwarded to the billing department daily.
LO# 9
The use of a chart of accounts and proper
codes for recording transactions should
provide adequate assurance about the proper
classification of revenue transactions.
10-107
108. Occurrence of Cash Receipts
Transactions
The possible misstatement that concerns
the auditor when considering the
occurrence assertion is that cash receipts
are recorded but not deposited in the
entity’s bank account.
LO# 9
10-108
109. Completeness of Cash Receipts
and Authorization of Discounts
A major misstatement is that cash or checks
are stolen or lost before being recorded in the
cash receipts records. Proper segregation of
duties and a lockbox system are strong
controls relating to completeness.
LO# 9
2/10,n/30
Terms of trade generally include discounts for
payment within a specified period as a way of
encouraging customers to pay on time.
10-109
110. Accuracy of Cash Transactions
The wrong amount of cash could be recorded
from the remittance advice, or the receipt
could be incorrectly processed during data
entry. To minimize these types of errors, daily
remittance reports should be reconciled to a
control listing of remittance advices. All bank
statements should be reconciled monthly.
LO# 9
10-110
111. Cutoff and Classification of
Cash Receipts Transactions
If the entity uses a lockbox system or if
cash is deposited daily in the bank, there is
a small possibility of cash being recorded
in the wrong accounting period.
LO# 9
The auditor seldom has major concerns
about cash receipts being recorded in the
wrong financial statement account.
10-111
112. The Confirmation Process –
Accounts Receivable
Confirmation is audit evidence that is a direct
written response from third parties about the
account receivable balance. Confirmation is a
good source of evidence about the existence
of the accounts receivable. The confirmation
process should be controlled by the auditor.
LO# 13
10-112
113. Omitting Confirmations
Accounts receivable balance is
immaterial.
External confirmations would be
ineffective.
The auditor’s assessed level of risk of
material misstatement at the
relevant assertion level is low, and
the other planned substantive
procedures address the assessed risk.
LO# 13
10-113
114. Factors Affecting the Reliability of A/R
Confirmations
Type of confirmation request (positive
versus negative).
Prior experience with the client or
similar engagements (e.g., response
rate, accuracy of returned
confirmations, misstatements
identified).
The intended respondent (competence,
knowledge, ability, and objectivity).
LO# 13
10-114
115. Types of Confirmations
Positive
Confirmation
Requests that
customers indicate
whether they agree
with the amount due
to the client. A
response is expected
whether the customer
agrees or disagrees
with the balance
indicated.
Negative
Confirmation
Requests that the
customer respond only
when they disagree
with the amount due
to the client. Negative
confirmations are used
when the client has
many small account
balances and control
risk is assessed as low.
LO# 13
10-115
116. Evaluating the Audit Findings
When the auditor has completed the planned
substantive procedures, the likely misstatement
(projected misstatement plus an allowance for
sampling risk) for accounts receivable is
determined.
Aggregate misstatement
less than tolerable
misstatement
Aggregate misstatement
greater than tolerable
misstatement
Accept the account
as fairly presented.
Account is not fairly
presented.
LO# 15
10-116
118. Overview of the Human Resource
Management Process
The human resource process starts with the
establishment of sound policies for hiring,
training, evaluating, counseling, promoting,
compensating, and taking remedial actions for
employees.
The main concern of the auditor involves payroll
transactions once an employee has been hired.
LO# 1
12-118
119. Two types of transactions are typically processed
through the human resource management
process:
1. Payments to employees for services rendered.
2. Accrual and payment of payroll-related liabilities
arising from employees’ services, including
liabilities for Social Security and unemployment
taxes.
LO# 2
Types of Transactions and
Financial Statement Accounts
Affected
12-119
121. Inherent Risk Assessment
In assessing inherent risk, the auditor may want
to consider the effect of economic conditions on
payroll costs, the supply of skilled workers, and
the frequency of employee turnover. The auditor
should be familiar with any existing labor
contracts and the impact of regulation on the
company.
The inherent risk
associated with non-officers
of the company is
generally considered low.
The inherent risk associated with
officers of the company may not
be considered low because of the
ability to take advantage of their
high position.
LO# 6
12-121
122. Control Risk Assessment
Understand and document the human
resource management process based on a
reliance strategy.
Set and document the control risk for the
human resource management process.
Plan and perform tests of controls on
payroll transactions.
LO# 7
12-122
124. Types of Documents and Records
1. Production Schedule – Based on the expected demand for
the entity’s products.
2. Receiving Report – Records the receipt of goods from
vendors.
3. Materials Requisition – Used to track materials during the
production process.
4. Inventory Master File – Contains all the important
information related to the entity’s inventory, including the
perpetual inventory records.
Production
Schedule
LO# 2
Inventory
Master
File
13-124
125. 5. Production Data Information – Contains information about
the transfer of goods and related cost accumulation at
each stage of production.
6. Cost Accumulation and Variance Report – Material, labor,
and overhead costs are charged to inventory as part of the
manufacturing process. The variance report compares
actual costs to standard or budgeted costs.
7. Inventory Status Report – Shows the type and amount of
products on hand.
8. Shipping Order – Used to remove goods from the perpetual
inventory records.
Types of Documents and Records
Shipping
Order
LO# 2
13-125
126. The Major Functions
Inventory management
Authorization of production activity and maintenance of
inventory at appropriate levels; issuance of purchase
requisitions to the purchasing department.
Raw materials stores
Custody of raw materials and issuance of raw materials to
manufacturing departments.
Manufacturing Production of goods.
Finished goods stores
Custody of finished goods and issuance of goods to the
shipping department.
Cost accounting Maintenance of the costs of manufacturing and inventory in
cost records.
General ledger
Proper accumulation, classification, and summarization of
inventory and related costs in the general ledger.
Functions in the Inventory Management Process
LO# 3
13-126
127. Inherent Risk Assessment
The auditor should consider industry-related factors and
operating and engagement characteristics when assessing the
possibility of a material misstatement.
If industry competition is intense,
there may be problems with the
proper valuation of inventory.
Technology changes in certain
industries may also promote
material misstatement due to
obsolescence.
Products that are small and of
high value are more susceptible
to theft. The auditor must be
alert to related-party transactions
for acquiring raw materials and
selling finished products. Prior-year
misstatements are good indicators
of potential misstatements in the
current year.
LO# 5
13-127
128. Control Risk Assessment
Major steps in setting the control risk in the
inventory management process.
Understand and document the inventory
management process based on a reliance
strategy.
Set and document the control risk for the
inventory management process.
Plan and perform tests of controls on inventory
transactions.
LO# 6
13-128
129. Control Activities and Tests of
Controls – Inventory Transactions
Cutoff of Inventory Transactions
Inventory transactions recorded in the improper period could
affect a number of accounts, including inventory, purchases, and
cost of goods sold.
LO# 7
13-129
130. Auditing Inventory
Assertions about Classes of Transactions and Events:
Occurrence. Inventory transactions and events are valid.
Completeness. All inventory transactions and events have been
recorded.
Authorization. All inventory transactions and events are properly
authorized.
Accuracy. Inventory transactions have been properly computed and
recorded.
Cutoff. Inventory receipts and shipments are recorded in the correct
accounting period.
Classification. Inventory is recorded in the proper accounts.
LO# 8
13-130
131. Assertions about Account Balances at the Period End:
Existence. Inventory recorded on the books and records
actually exists.
Rights and obligations. The entity has the legal right to the
recorded inventory.
Completeness. All inventory is recorded.
Valuation and allocation. Inventory is properly recorded in
accordance with GAAP (e.g., lower of cost or market).
LO# 8
Auditing Inventory
13-131
132. Assertions about Presentation and Disclosure:
Occurrence and rights and obligations. All disclosed events,
transactions, and other matters relating to inventory have occurred and pertain
to the entity.
Completeness. All disclosures relating to inventory that should have been
included in the financial statements have been included.
Classification and understandability. Financial information relating to
inventory is appropriately presented and described, and disclosures are clearly
expressed.
Accuracy and valuation. Financial and other information relating to
inventory are disclosed fairly and in appropriate amounts.
LO# 8
Auditing Inventory
13-132
133. Observing Physical Inventory
During the observation of the physical inventory count, the auditor
should do the following:
1. Ensure that no production is scheduled. If production is
scheduled proper controls must be established for movement
between departments in order to prevent double counting.
2. Ensure that there is no movement of goods during the inventory
count.
3. Make sure that the entity’s count teams are following the
inventory count instructions.
4. Ensure that inventory tags are issued sequentially to individual
departments.
LO# 11
13-133
134. 5. Perform test counts and record a sample of counts in the
working papers.
6. Obtain tag control information for testing the entity’s inventory
compilation.
7. Obtain cutoff information, including the number of the last
shipping and receiving documents issued.
8. Observe the condition of the inventory for items that may be
obsolete, slow moving, or carried in excess quantities.
9. Inquire about goods held on consignment for others or held on a
“bill-and-hold” basis.
LO# 11
Observing Physical Inventory
13-134
135. Evaluating the Audit Findings -
Inventory
At the conclusion of testing, the auditor should aggregate all
identified misstatements. The likely misstatement is compared to
the tolerable misstatement allocated to the inventory account.
Likely misstatement < Tolerable misstatement
The auditor may accept the inventory account as fairly
presented.
Likely misstatement > Tolerable misstatement
The auditor must conclude the inventory is not fairly
presented.
LO# 13
13-135
137. Auditing Prepaid Expenses
LO# 1
14-137
Other assets that provide economic benefit
for less than a year are classified as current
assets.
Prepaid expenses are a common other
asset. Examples include:
1. Prepaid insurance.
2. Prepaid rent.
3. Prepaid interest.
138. Inherent Risk Assessment –
Prepaid Expenses
The inherent risk associated with prepaid expenses is generally
assessed as low because the accounts do not involve any
complex or contentious accounting issues.
LO# 1
14-138
139. Control Risk Assessment – Prepaid
Expenses
Because prepaid expenses are normally processed through the
purchasing process, control procedures in purchasing should
ensure that each item is properly authorized and recorded.
LO# 1
14-139
140. Auditing Intangible Assets
Intangible assets are assets that provide
economic benefit for longer than a year, but
lack physical substance. The following list
includes examples of five general categories of
intangible assets:
1. Marketing – trademark, brand name, and Internet
domain names.
2. Customer – customer lists, order backlogs, and
customer relationships.
3. Artistic – items protected by copyright.
4. Contract – licenses, franchises, and broadcast
rights.
5. Technology – patented and unpatented technology.
LO# 1 & 2
14-140
141. Inherent Risk Assessment –
Intangible Assets
The inherent risk associated with intangible assets
raises serious risk considerations.
The accounting rules are complex and the
transactions are difficult to audit.
Accounting standards require different asset
impairment tests for different classes of intangible
assets (FASB ASC Topic 350).
With the judgment and complexity associated with
valuation and estimation of intangible assets, the
auditor would likely assess the inherent risk as high.
LO#
1 & 2
14-141
142. Control Risk Assessment –
Intangible Assets
In assessing control risk, the auditor considers factors such as:
1. The expertise and experience of those determining the fair value of
the assets.
2. Controls over the process used to determine fair value
measurements, including controls over data and segregation of
duties between those committing the entity to the purchase and
those undertaking the valuation.
3. The extent to which the entity engages or employs valuation
specialists.
4. The significant management assumptions used in determining fair
value.
5. The integrity of change controls and security procedures for
valuation models and relevant information systems, including
approval processes.
LO#
1 & 2
14-142
143. Auditing the Property Management
Process
Property, plant, and equipment usually represents a material amount
in the financial statements.
Recurring Engagement
The auditor is able to focus
on additions and retirements
in the current period because
amounts from prior periods have
been subject to audit procedures.
New Engagement
The auditor has to verify the
assets that make up the
beginning balance in
property, plant, and
equipment.
LO# 3
14-143
144. Types of Transactions
Four types of PP&E transactions may occur:
1. Acquisition of capital assets for cash or nonmonetary
considerations.
2. Disposition of capital assets through sale, exchange, retirement,
or abandonment.
3. Depreciation of capital assets over their useful economic life.
4. Leasing of capital assets.
LO# 4
14-144
145. Inherent Risk Assessment –
Property Management Process
There are three inherent risk factors that must be considered by
the auditor.
Complex
accounting
issues.
Difficult-to-audit
transactions.
Misstatements
detected in
prior audits.
LO# 5
14-145
146. Inherent Risk Assessment –
Property Management Process
Complex Accounting Issues
Lease accounting, self-constructed assets, and interest
capitalization are examples of some of the complex accounting
issues faced by auditors.
LO# 5
14-146
147. Inherent Risk Assessment –
Property Management Process
Difficult-to-Audit Transactions
When assets are purchased directly from a vendor, the
transaction is relatively easy to audit. However, transactions
involving donated assets, nonmonetary exchanges, and self-
constructed assets are more difficult to audit.
LO# 5
14-147
148. Inherent Risk Assessment –
Property Management Process
Misstatements Detected in Prior Audits
If misstatements in prior audits have been detected, the
auditor should set inherent risk higher than if few or no
misstatements have been found in the past.
LO# 5
14-148
149. Evaluating the Audit Findings
Property, Plant, and Equipment
The auditor aggregates the likely misstatements and compares this
amount to the tolerable misstatement.
If the aggregate misstatement is less than
the tolerable misstatement, the evidence indicates
that the PP&E accounts are not materially misstated.
If the aggregate misstatement is greater than the
tolerable misstatement, the auditor would either require
adjustment of the accounts or issue a qualified audit
report.
LO# 10
14-149
151. Auditing Long-Term Debt
The auditor must be assured that the amounts
shown on the balance sheet for the various types
of long-term debt are not materially misstated. This
assurance extends to the recognition of interest
expense. For the vast majority of entities, it is more
efficient to follow a strategy of conducting
substantive testing.
LO# 1
15-151
152. Inherent Risk Assessment –
Long-Term Debt
The inherent risk for notes and bonds would
normally be assessed as low to moderate because
the volume of transactions are low, the accounting
is not complex, and the entity often receives third-
party statements or amortization tables.
However, the amounts are usually large and the
financial markets have developed sophisticated
instruments that have characteristics of both debt
and equity. The inherent risk associated with these
instruments is normally high.
LO# 1
15-152
153. Control Risk Assessment –
Long-Term Debt
When a substantive strategy is followed, the
auditor still needs a sufficient understanding
of the entity’s internal control system over debt.
LO# 2
15-153
154. Auditing Stockholders’ Equity
The following three types of transactions
are of importance to the auditor:
1. Issuance of stock including transactions such
as sale of stock for cash; the exchange of stock
for assets, services, or convertible debt; and
issuance of stock for stock splits.
2. Repurchase of stock including both the
reacquisition of stock and retirement of stock.
3. Payment of dividends including cash and stock
dividends.
LO# 5
15-154
155. Control Risk Assessment –
Stockholders’ Equity
A substantive strategy is often used to audit
stockholders’ equity because the number of
transactions is usually small. The auditor must
still understand the types of controls that are in
place to prevent the misstatement of equity
transactions.
Large, publicly traded companies use an
independent registrar, transfer agent, and
dividend-disbursing agent to process and
record equity transaction. Relevant
information about equity transactions may be
confirmed with those parties.
LO# 6
15-155
156. Auditing Income Statement
Accounts
The audit of revenue and expense accounts
depends on the extent of work conducted on
the entity’s control system and balance sheet
accounts. Substantive procedures on selected
income statement accounts include:
• The results of testing controls for the various business
processes.
• The results of the detailed tests of balance sheet
accounts and the related income statement accounts.
• Performance of substantive analytical procedures on
income statement accounts.
• Detailed tests of selected income statement accounts.
LO# 12
15-156
157. Direct Tests of Balance
Sheet Accounts
Income statement accounts are normally audited in the course of
auditing the related balance sheet accounts.
Balance Sheet Account Audited Related Income Statement Account
Accounts receivable/allowance for
uncollectible accounts
Bad-debt expense
Notes receivable/ investments/
accrued interest receivable
Interest income
PP&E/accumulated depreciation
Depreciation expense, gain/losses on sales
or retirement of assets
Prepaid insurance Insurance expense
Long-term debt/accrued interest
payable
Interest expense
LO# 12
15-157
158. Substantive Analytical
Procedures
Extensive use may be made of analytical procedures in the audit
of revenue and expense accounts.
Common size
income statement
for current and
previous years.
Percentage
income statement
for current and
previous years.
Trend and ratio
analysis.
LO# 12
15-158
159. Tests of Selected Account
Balances
The auditor may wish to examine key revenue
and expense accounts in some detail. Usually,
the auditor verifies the transactions in the
account by examining the supporting
documentation. Accounts audited in this manner
may be related to income tax reporting and
include legal and audit expense, travel and
entertainment, charitable contributions, and
other income and expense.
LO# 12
15-159
161. Cash and Cash Equivalents
“Cash” reported in the financial statements
represents currency on hand and cash on deposit
in bank accounts, including certificates of deposit,
time deposits, and savings accounts.
“Cash equivalents” are frequently combined with
cash for presentation in the financial statements.
Definition: Short-term, highly liquid investments
that are readily convertible to cash or so near their
maturity that there is little risk of change in their
value.
Examples: Treasury bills and money market funds.
LO# 1
16-161
162. Types of Bank Accounts
In order to optimize its cash flow, an entity implements
procedures for accelerating the collection of cash
receipts and delaying the payment of cash
disbursements, to the extent delay is appropriate.
General Cash
Account
Imprest Cash
Accounts
Branch
Accounts
Types of Bank
Accounts
LO# 2
16-162
163. The Effects of Controls
The reliability of the entity’s
controls over cash affects
the nature and extent of the
auditor’s tests of details.
Controls for
Cash Receipts
Controls for
Cash
Disbursements
Completion of
Monthly Bank
Reconciliation
LO# 2
16-163
164. Auditing the General Cash
Account
Copy of Bank
Reconciliation
Standard Bank
Confirmation
Cutoff Bank
Statement
To audit a cash
account, the auditor
should obtain these
items.
LO# 5
16-164
165. Cutoff Bank Statement
Date of Last
Bank
Reconciliatio
n
7 to 10
Days
A cutoff bank statement normally covers the 7- to 10-day
period after the date on which the bank account is
reconciled.
For reconciliation purposes, any item should have cleared
the entity’s bank account during the 7- to 10-day period.
LO# 5
16-165
166. Tests of the Bank Reconciliation
The auditor typically uses the following audit procedures to
test the bank reconciliation:
1. Verify the mathematical accuracy and agree the balance per the books
to the general ledger.
2. Agree the bank balance on the reconciliation with the balance shown
on the standard bank confirmation.
3. Trace the deposits in transit on the bank reconciliation to the cutoff
bank statement.
4. Compare the outstanding checks on the bank reconciliation with the
canceled checks contained in the cutoff bank statement for proper
payee, amount, and endorsement.
5. Agree any charges included on the bank statement to the bank
reconciliation.
6. Agree the adjusted book balance to the cash account lead schedule.
LO# 5
16-166
168. Extended Bank Reconciliation Procedures
In some instances, the year-end bank reconciliation can
be used to cover cash defalcations. This is usually
accomplished by manipulating the reconciling items in
the bank reconciliation. For example, suppose an
employee was able to steal $5,000 from the entity. The
entity’s cash balance at the bank would then be $5,000
less than reported on the entity’s books. The employee
could “hide” the $5,000 shortage in the bank
reconciliation by including a fictitious deposit in transit.
LO# 6
16-168
169. Auditing a Payroll or Branch
Imprest Account
The audit of any imprest cash account
such as payroll or a branch account
follows the same basic audit steps
discussed under the audit of the general
cash account.
LO# 6
16-169
170. Auditing Petty Cash
Usually not
material.
Potential for
defalcation.
Seldom perform
substantive
tests.
Document
controls.
LO# 6
16-170
172. Review for Contingent Liabilities
A contingent liability is defined as an existing
condition or set of circumstances involving
uncertainty as to possible loss that will ultimately be
resolved when some future event occurs or fails to
occur.
Probable: The future event is likely to
occur.
Reasonably Possible: The chances of the
future event occurring is more than
remote but less than likely.
Remote: The chance of the future event
occurring is slight.
Examples
• Pending or threatened litigation
• Actual or possible claims and
assessments
• Income tax disputes
• Product warranties or defects
• Guarantees of obligations to
others
• Agreements to repurchase
receivables that have been sold
LO# 1
17-172
173. Audit Procedures for Identifying
Contingent Liabilities
Read minutes of
meetings of the board of
directors, committees of
the board, and
stockholders.
Review contracts, loan
agreements, leases, and
correspondence from
government agencies.
Confirm or otherwise
document guarantees
and letters of credit.
Inspect other documents
for possible guarantees
or other similar
arrangements.
Review tax returns, IRS
reports, and schedules
supporting the entity’s
income tax liability.
LO# 2
17-173
174. Audit Procedures for Identifying
Contingent Liabilities
Inquire and discuss with
management about its policies
and procedures for identifying,
evaluating, and accounting for
contingent liabilities.
Examine documents in the
entity’s records such as
correspondence and invoices
from attorneys for pending or
threatened lawsuits.
Obtain a legal letter that
describes and evaluates any
litigation, claims, or
assessments.
Obtain written representation
from management that all
litigation, asserted and
unasserted claims, and
assessments have been
disclosed in accordance with
FASB ASC Topic 450.
Specific Audit Procedures Conducted Near
Completion of Audit
LO# 2
17-174
175. Review for Subsequent Events for
Audit of Financial Statements
Balance
Sheet Date
Type I Event
Conditions existed
before the balance
sheet date and affect
estimates that are part
of financial statements
Type II Event
Conditions did not
exist at the balance
sheet date and do not
affect the accuracy of
the financial statements
Requires adjustment of
the financial
statements
Requires disclosure
and possibly pro forma
financial statements
LO# 5
17-175
176. Review of Subsequent Events
for Audit of Financial Statements
Figure 17-1
LO# 5
17-176
177. Dual Dating
When a subsequent event is recorded or disclosed
in the financial statements after sufficient,
appropriate audit evidence has been obtained
but before the issuance of the financial
statements, the auditor considers the following
options for dating of the auditor’s report:
(1) “Dual date” the report (original date of report
plus date of subsequent event—limits liability)
(2) Change the date of the auditor’s report to the
date of the subsequent event—extends liability
LO# 6
17-177
179. Reporting on the Financial
Statement Audit: The Standard
Unqualified Report
The standard unqualified
report is issued when the
auditor has gathered sufficient
evidence, the audit has been
performed in accordance with
PCAOB standards, and the
financial statements conform
to GAAP.
Eight Elements
1. Report title
2. Addressee
3. Introductory paragraph
4. Scope paragraph
5. Opinion paragraph
6. Explanatory paragraph
referring to the audit of
ICFR
7. Name of auditor
8. Audit report date
LO# 1
18-179
180. Reporting on the Financial
Statement Audit: The Standard
Unmodified Report
The standard unmodified
report is issued when the
auditor has gathered sufficient
evidence, the audit has been
performed in accordance with
GAAS, and the financial
statements conform to GAAP.
Nine Elements
1. Report title
2. Addressee
3. Introductory paragraph
4. Management’s
responsibility
5. Auditor’s responsibility
6. Scope paragraph
7. Opinion paragraph
8. Name of auditor
9. Audit report date
LO# 1
18-180
181. Lack of Consistency
Change in
accountin
g principle
Change in
reporting
entity
Correction
of a mis-
statement
in F/S
Changes Affecting Consistency
Change in
accounting
estimate
Changes Not Affecting Consistency
Change in
classification
and
reclassification
Change expected
to have a material
future effect
LO# 2
18-181
182. Conditions for Departure from
Unqualified/Unmodified Report
Scope
Limitation
Departure
from GAAP
Lack of Auditor
Independence
LO# 3
18-182
184. Discussion of Conditions Requiring
Other Types of Financial Statement
Audit Reports
Scope
Limitation
Not in
Conformity
with GAAP
Auditor Not
Independent
Results from an inability to obtain
sufficient appropriate evidence
about some component of the
financial statements.
Results when auditor has some
form of prohibited relationship with
the entity (see Ch. 19).
LO# 5
18-184
185. Scope
Limitation
Not in
Conformity
with GAAP
Auditor Not
Independent
Issue a qualified opinion or a
disclaimer.
Issue a qualified opinion or
adverse opinion.
Issue a disclaimer.
LO# 5
Discussion of Conditions Requiring
Other Types of Financial Statement
Audit Reports
18-185
187. Ethics and Professional Conduct
Ethics
Professionalism
Refers to the conduct, aims, or
qualities that characterize or mark a
profession or professional person
LO# 1
19-187
188. The AICPA Code
of Professional Conduct:
A Comprehensive Framework for Auditors
Principles of
Professional Conduct
Rules of Conduct
Interpretations of
Rules of Conduct
Rulings by the
Professional
Ethics Executive
Committee
(PEEC)
LO# 4
19-188
190. Covered Members
1. An individual on the attest engagement team
2. An individual in a position to influence the
attest engagement
3. A partner or manager who provides nonattest
services to the attest entity beginning once he
or she provides 10 hours of nonattest services
4. A partner in the office in which the lead attest
engagement partner primarily practices in
connection with the attest engagement
5. The firm, including the firm’s employee benefits
plan
6. An entity whose operating, financial, or
accounting policies can be controlled by any of
the individuals or entities described above or
by two or more such individuals or entities if
they act together
LO# 5
19-190
191. Prohibited Financial
Relationships
A financial interest that is owned
directly by an individual or entity, or is
under the control of an individual or
entity
Results when a covered member has a
financial interest in an entity that is
associated with an attest entity, for
example an investment in a mutual fund
that owns the entity’s stock
Direct
Exception: Certain types of
personal loans from financial
institutions who are audited by a
covered member
Material
Indirect
LO# 5
19-191
192. Prohibited Business
Relationships
Rule 101 and relevant interpretations
essentially indicate that the independence of a
CPA is impaired if the CPA performs a
managerial or other significant role for an
entity’s organization during the time period
covered by an attest engagement.
Interpretation 101-2 indicates that a firm’s
independence will be considered to be
impaired with respect to an entity if a
partner or professional employee leaves the
firm and is subsequently employed by or
associated with that entity in a key position
unless a number of conditions are met.
LO# 5
19-192
193. Effect of Family Relationships
A covered member’s immediate family (spouse,
spousal equivalent, or dependent) is subject to
Rule 101 and its interpretations and rulings.
LO# 5
19-193
194. Effect of Family Relationships
Two major situations with close relatives that can impair
independence:
1. A close relative has a financial interest in the entity
that is material to the close relative, and the CPA
participating in the engagement is aware of the
interest.
2. An individual participating in the engagement has a
close relative who could exercise significant influence
over the financial or accounting policies of the entity.
Close relatives include nondependent children, brothers, sisters,
parents, grandparents, parents-in-law, and their respective
spouses.
LO# 5
19-194
195. Effect of Actual or
Threatened Litigation
The commencement of litigation by management
alleging deficiencies in audit work for the entity would
be considered to impair independence.
An expressed intention by management to commence
litigation against the CPA alleging deficiencies in audit
work would also impair independence if the auditor
concluded that it is probable that such a claim will be
filed.
The commencement of litigation by the CPA against
management alleging management fraud or deceit
would be considered to impair independence.
LO# 5
19-195
196. Provision of Nonattest Services
The AICPA Code of Professional Conduct
restricts the types of nonaudit services that can
be provided to attest entities.
The SEC has even more restrictive
independence rules for audits of public
companies.
LO# 5
19-196
197. SEC and PCAOB Independence
Requirements for Audits of
Public Companies
The SEC’s rules are predicated on three basic
principles of auditor objectivity and
independence:
1.An auditor should not audit his or her own
work.
2.An auditor should not function in the role of
management.
3.An auditor should not serve in an advocacy
role for the entity.
LO# 6
19-197
198. SEC and PCAOB
Independence Requirements for Audits
of Public Companies
Bookkeeping
Financial
Information
Systems Design
and
Implementation
Appraisal or
Valuation
Services
Actuarial
Services
Internal
Auditing
Outsourcing
Services
Management
Functions or
Human
Resources
Broker or
Dealer
Legal
Services
Expert
Services
Nine Categories of Prohibited Nonaudit Services
LO# 6
19-198
199. SEC Independence Requirements
for Audits of Public Companies
Partners are limited to five
consecutive years.
A one year “cooling
off” period is required
for employees in a
“financial reporting
oversight role” who
previously worked
with the CPA firm
performing the audit.
A firm is not independent
if an audit partner’s
compensation is based
on selling engagements
to that client for services
other than audit, review,
and attest services.
LO# 6
19-199
200. Integrity and Objectivity
Rule 102
In the performance of any professional service, a
member shall maintain objectivity and integrity, shall be
free of conflicts of interest, and shall not knowingly
misrepresent facts or subordinate his or her judgment to
others.
LO# 6
19-200
201. General Standards and
Compliance with Standards
Rule 201
A member shall comply with the following standards and
with any interpretations thereof by bodies designated by
Council.
Due
Professional
Care
Professional
Competence
Planning and
Supervision
Sufficient
Relevant
Data
LO# 7
19-201
202. Confidential Client Information
Rule 301
A member in public practice shall not disclose any
confidential client information without the specific
consent of the client.
To comply
with a valid
subpoena
To meet GAAP
or GAAS
disclosure
requirements
As required
by an
authorized
peer review
body
As part of an
investigative
or disciplinary
proceeding
Five Situations Where CPAs Can Disclose Confidential
Information
LO# 7
In connection
with a purchase,
sale, or merger
of the practice
19-202
203. Contingent Fees
Rule 302
A member shall not
(1) Perform for a contingent fee any professional service for,
or receive such a fee from, a client for whom the member
or the member’s firm performs (a) an audit or review of a
financial statement, (b) a compilation of a financial
statement expected to be used by a third party if the
compilation report does not disclose a lack of
independence, or (c) an examination of prospective
financial information, or
(2) Prepare an original or amended tax return or claim for a
tax refund for a contingent fee for any client.
LO# 7
19-203
205. Acts Discreditable
Inappropriate response to requests by current and former audit entities for
certain records (501-1).
Discrimination and harassment in employment practices (501-2).
Failure to follow standards and/or procedures or other requirements in
government audits (501-3).
Negligence in the preparation of financial statements or records (501-4).
Failure to follow the requirements of government bodies, commissions, or
other regulatory agencies in performing attest or similar services (501-5).
Solicitation or disclosure of CPA examination questions and answers (501-
6).
Failure to file tax return or pay tax liability (501-7).
Including certain types of indemnification and limitation of liability
provisions in agreements for the performance of audit or other attest
services in jurisdictions where such provisions are prohibited (501-8).
Confidential information obtained from employment (501-9).
Financial interests (501-10).
False, misleading, or deceptive acts in promoting or marketing
professional services (501-11).
LO# 7
19-205
