Auditing ACC0048 Review Assignment

The following audit review assignment is intended to help you study for the next mid-term test on April 26th, 2011. I will provide you with class time in order to complete much of the assignment. You will need to bring your textbook to class (yes you will actually have to open it once more!) in order to answer the following questions: Chapter 6: 1. What procedures would an audit firm undertake to determine whether or not to accept a client or not? What are some reasons that an auditor may not continue audit engagements? Answer: Before beginning an audit, auditors undertake two types of activity. a. Risk Management: Auditors try to reduce the risk (Probability of something going wrong) by carefully managing the engagement. b. Quality Management: Auditor Manage audit in accordance with quality control standard. Client acceptance or retention procedure should include. i. Make sure you are independent ii. Get knowledge of the client iii. Obtaining and reviewing of financial information about client iv. Evaluation of competency and resources Reasons for not continuing: - When the auditor finds himself not independent from the client - When the client sue the auditor for any reason - When the auditor found mistake in the financial statement and is not able to correct it. 2. The engagement letter forms the basis of a contract between the auditor and its client. What are the basic elements of an engagement letter? Answer: An engagement letter is a contract between the auditor and client; written about the deadline, auditors responsibility and the clients responsibility. The basic element of the engagement letter is: - Standard require the auditor and management to agree on the terms of the audit engagement and the auditors fee - An engagement letter can head off claims that the auditors did not perform the work promised. - A new engagement letter should be obtained every year of a continuing audit 3. Why does the auditor attempt to understand the clients business? Answer: a. To know the risk of the company, and help the audit plan, the type of audit risk we are facing b. In order to design an effective audit, auditors must understand the business and the economic environment of the business including factors such as: i. National economic condition and policies ii. Geographic location

iii. iv.

Development in taxation and regulation Specific industry characteristics

4. Why does the auditor use preliminary analytical procedures at the planning phase of an audit? Answer: a. To compare the current Years account balances to the years before, and the companys anticipated results b. Compare the current years account balances and financial relationship with similar information for the auditees industry c. Evaluate the relationships of current year balances to other current year balances for conformity to predictable patterns d. Study the relationships of current year balances to relevant nonfinancial information 5. What are five different types of analytical procedures that an auditor will perform on the financial statements? Briefly describe each one. Answer: a. Horizontal: Compare the numbers and ratios of 1 year to other years b. Vertical: compare 1 year financial statement balance to another balance, sales vs assets or Inventory vs. COGS for same year c. Ratios: current ratio, gross margin ratio, Debt Ratio, Page 214 on the book. d. Current to budget or industry. Actual to Budget. e. Current to non-financial. Non- financial information to financial information. 6. What are some examples of distress ratios? Answer: a. Working capital over total asset, Current ratio, Gross Margin Ratio, Acid Test Ratio, retained earnings over 7. Define the term materiality. Answer: a. Lowest dollar of amount that affects the decision making on the financial statement and that the users can tolerate it. b. Materiality is the largest amount of uncorrected misstatement that might exist in financial statements that still fairly present the companys financial position and results of operation 8. What are the quantitative benchmarks used by auditors to determine an auditees materiality? Answer: a. 5-10% of income from continuing operations (should be normalized or averaged before using) b. 5-10% of net income before bonus c. to 2% of revenues or expenses for non-for profit entities d. to 1% of net asset value for the mutual fund industry, or e. 1% of revenue for the real estate industry. 9. What other factors should be considered after quantitative calculations when determining materiality? Answer: a. User related factors

b. c. d.

Nature of the item or issue Other circumstances Effect on share price

10. What are the five main financial statement assertions made by management? Briefly describe each one in your own words. Answer: a. Existence/Occurred: it means that assets, liability, and equity actually exist. Revenue and expenses transactions actually occurred as of a proper date. b. Ownership: Establish with the evidence that the amounts reported as assets of the company represent property rights and the amounts reported as liabilities represent obligations c. Completeness: Establish with evidence that all transactions and accounts that should be presented in the financial reports are actually included d. Valuation: Determine whether proper values have been assigned to assets, liabilities, equities, revenues and expenses. e. Presentation/ Disclosure: Determine whether the accounting principles are properly selected and applied and whether disclosures are adequate. Chapter 7: 1. What is audit risk and what are the components of audit risk? Describe each one briefly. Answer: a. Audit risk is related to information risk that financial statements are materially misstated. b. Audit risk is the probability that an auditor will fail to express a reservation that financial statements are materially misstated. Components of audit risk: - Inherent Risk: The probability of material misstatement occurring in transactions entering the accounting system or being in the account balances is inherent risk. - Control Risk: Control risk assessment provides only an indirect assessment of monetary misstatements in the financial statements. - Detection Risk: The risk that any material misstatement that has not been corrected by the clients internal control will not be detected by the auditor is detection risk. We have to lower the materiality to detect the risk. 2. How are materiality and audit risk related? If the IR and CR are too high how would an auditor control this? Answer: a. Materiality refers to the magnitude of a misstatement; audit risk refers to the level of assurance that material misstatement does not exist. b. Auditor cannot control IR and CR, these are the responsibility of managements 3. What is the purpose of managements controls? Answer: a. To asses adherence to management policy b. Promote operational efficiencies c. Address strategic risks These are called the Company-level controls and permeate the organization and can have a big impact on whether its financial reporting and disclosures objectives are met.

4. Why are a clients internal controls important to an auditor? Answer: a. Do they exist? If they do 5. What are the components of an internal control? Answer: a. Control environment b. Managements risk assessment process c. Information system, included the related business processes, relevant to financial reporting and communication d. Control activities e. Monitoring of controls f. Policy and procedure is documented Components (a) (b) (c) and (e) operate at the company level, and are referred to as management controls. Control activities are controls over processes, applications, and transactions. These controls are more closely related to accounting information, and will be referred to as accounting controls. 6. Think of a typical financial statement account with high inherent risk and one with a low inherent risk. Answer: a. Inherent risk is high in counting the revenue (revenue recognition) and is low in Tax calculation and accruals, accounts payable approvals, expense reimbursements, and some others. 7. What is a general control and give an example? Answer: a. General controls include organizational features such as capable personal, segregation of responsibilities, controlled access, and periodic comparison. Like environmental controls, general controls are primarily preventive and have a pervasive impact on the various accounting processes. For these reasons, auditors preliminary evaluation of internal controls tends to focus on environmental and general controls. b. Segregation of duty 8. What is an application control and give an example? Answer: a. Application controls are viewed in terms of whether they relate to input, processing, or output of the accounting system. They help ensure that all recorded transactions really occurred, are authorized, and are completely and accurately entered and processed through the system. Examples: - authorization checks prior to data input - arithmetical checks of the accuracy of records - maintenance and review of accounts and trial balances 9. What is the difference between a compliance test and a substantive test? Answer: a. In compliance testing you gather evidence with the objective of testing an organization's compliance with control procedures, e.g. when you run a report to verify

that certain controls had been applied over a database table. In substantive testing, you gather evidence to evaluate the integrity of data, a transaction or other information. E.g. you run a report to verify if the amount paid to vendors is accurate. Chapter 8: 1. Auditors use six basic audit evidence gathering techniques describe each one and give an example. Page 289 Answer: a. Recalculation/Reperformance: recomputed amortization expense using declining balance method. Recomputed the tax as percentage of total sale amount on invoices. b. Observation: observe data entry procedure, petty cash control, auditees inventory counting procedure. c. Confirmation: obtain written confirmation of A/R balance and detail from customer. d. Enquiry: enquire about frequency of bank reconciliation procedure, which employee totals cash receipts and deposit them to the bank. e. Inspection: read term of lease agreement for lessee, review inventory variance analysis report. f. Analysis: Analyze monthly gross margin by product line. 2. On page 282 there is a list of potholes in audit gathering techniques read each one and suggest how you would have avoided these issues. Answer: a. Recalculation: Auditor didnt count the inventory properly b. Inspection of Assets: Mark the Assets, take the VIN number on the car if any c. Confirmation: do a research about the company and find out if any mistake d. Enquiry: check the record, check if some of the receivable are received or not. e. Inspection by Examination of Documents: re-add up all the deposits, cheque received and anything related to the situation. Also, check if the amount is correct or not. f. Inspection by the scanning procedure: Disclose this problem on the financial statement. 3. Discuss how effective analysis is in discovering fraud and errors. Answer: a. Analysis is the method of study and comparison of evidence about financial statement accounts. Also, analysis is an evidence-gathering procedure during the audit. Through analysis an auditor can detect any misstatement on the financial statement. For example, when the company reports heavy weight inventory on their financial statement and the company has the forklift to carry only light weighted inventory, then the auditor can find this fraud through analysis. 4. An auditor must determine what is sufficient (amount) and appropriate (Quality) audit evidence when referring to appropriate an auditor must determine what is relevant and reliable information. There is a hierarchy of the quality or reliability of audit evidence provide what procedures provide the auditor with the highest level of reliability. (Slide) Answer: a. Auditors direct, personal knowledge:

Gained though observation and recalculation, this is the most reliable evidence. b. External evidence: Documentary evidence that is obtained directly from independent sources, Very reliable evidence c. External-internal evidence: Documentary evidence that originates outside the clients system, but that has been received and processed by the client. This is reliable evidence (although circumstances of internal control are important). d. Internal evidence: Evidence that is produced within the clients system, Low reliability, but used extensively under satisfactory internal control conditions, Plentiful and easy to obtain, less costly than other evidence e. Analysis: Broad analytical procedures of general nature are not considered highly reliable. Used for preliminary risk identification and attention directing early in the audit. Analysis using specific data the auditor has verified produces evidence that is fairly reliable. f. Spoken and written representations: Evidence that comes from the clients officers, directors, management, and employees in response to enquiry, generally considered the weakest form of evidence, Representations should be corroborated with other types of evidence. 5. What procedures provide auditors with the lowest amount of assurance? Answer: a. Explained on 4 above 6. Listing the six general audit procedures determine what is (are) the primary management assertion(s) that each one is testing. Answer: a. 7. How does an auditor gage sufficiency of audit evidence? Answer: a. Although, there no official standard on auditing profession, but the auditor must use his/her professional judgment to find efficient and appropriate evidence to make a decision on the financial statement. The decision must be based on enough evidence to be acceptable by other auditors and outsiders (Judges, critics, CPAB inspectors) Chapter 5: 1. What must a plaintiff prove in a common law action when seeking damages from an auditor? Answer: a. Must prove that he/she was damaged or suffered a loss b. That there was a beneficiary relationship with the defendant c. That the financial statements were materially misleading, or that the accountants advice was faulty d. That he/she relied on the statements advice e. That they were the direct cause of the loss

f. 2.

That the accountant was grossly negligent, deceitful, or otherwise responsible for damages.

What are the main defences used by an auditor to defend him/herself in a common law suit? Answer: a. The primary defense against negligence claim is to offer evidence that the audit had been conducted in accordance with GAAS with due professional care. b. The auditors defense is to demonstrate that at least one of the Elements of Negligence (P.140) is missing. The auditor may also argue that the plaintiff contributed to his own loss by, for example, not correcting internal control weaknesses. Define and explain the meaning of privity, primary beneficiary and foreseeable beneficiaries. In terms of negligence. What must each prove to be successful against an auditor? Answer: a. Privity: the relationship of direct involvement between parties to a contract. In this case the plaintiff need only to prove that the accountant was negligent and showed lack of reasonable care in the performance of professional accounting tasks. b. Primary Beneficiary: Is the third parties the audit or other accounting service is primarily performed for. In many cases proof of ordinary negligence is sufficient to make accountants liable for damages to primary beneficiaries. c. Foreseeable Beneficiary: these are external users such as Creditors, Investors who rely on accountants work. If they are able to show that a public auditor was grossly negligent and perpetrated a constructive fraud. What are the main sources of Statutory Law concerning auditors? Answer: a. Class action law suit: Under this law suit if the auditor found liable, he/she will have to pay percentage of their responsibility to the investors and if the company fail to pay to the investor the portion of auditor will go up to 50% of the liability. b. Do EP3 and EP5 case studies on pages 162 and 163. a.

3.

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