Audit Practice II - Week 3: Ethics and Reports

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Questions and Answers

What is the primary purpose of analytical procedures in an audit?

To analyze plausible relationships among financial and nonfinancial data (correct)

To eliminate the need for tests of details

To prepare the financial statements

To directly verify all transactions

Which procedure is specifically intended to test for monetary misstatements in financial statement balances?

Test of details of balances (correct)

Risk assessment procedures

Test of controls

Substantive analytical procedures

What action may an auditor take related to accounts receivable to fulfill the accuracy audit objective?

Adjust financial statements based on projections

Communicate directly with the client’s customers (correct)

Conduct an internal risk assessment

Review sales journal entries for trends

What primarily influences the auditor's conclusion about the fairness of financial statements?

The auditor's professional judgment Signup and view all the answers

After completing the audit procedures, what is the next step the CPA must take?

Issue an audit report accompanying the client’s financial statements Signup and view all the answers

Which defense is NOT typically available for auditors in third-party lawsuits?

Contributory negligence Signup and view all the answers

What is a primary reason litigants prefer federal courts for actions against CPAs?

Higher likelihood of strict liability standards Signup and view all the answers

Which federal act is NOT relevant to criminal liability for accountants?

Sarbanes-Oxley Act Signup and view all the answers

What type of liability has seen the greatest growth in CPA litigation?

Federal securities law liability Signup and view all the answers

Which action can CPAs take to minimize their liability?

Working only with clients who possess integrity Signup and view all the answers

In the case of United States v. Simon, what were the auditors held liable for?

Filing false financial statements Signup and view all the answers

What feature of the federal securities laws makes CPA liability more severe?

Plaintiff-friendly nature of federal courts Signup and view all the answers

Which of the following is a criminal offense related to financial statements for CPAs?

Deliberately preparing misleading financial records Signup and view all the answers

What is misappropriation of assets commonly referred to as?

Defalcation Signup and view all the answers

Which of the following best describes fraudulent financial reporting?

Intentional overstatement of sales Signup and view all the answers

Which of the following is NOT a category of management assertions?

Assertions about cash flow dynamics Signup and view all the answers

What is a critical first step in planning an audit approach?

Studying the client’s business and environment Signup and view all the answers

What is the primary purpose of assessing the risk of material misstatement?

To inform the audit plan and the nature of procedures. Signup and view all the answers

How can an auditor reduce the risk of misstatement in financial statements?

By evaluating the effectiveness of internal controls Signup and view all the answers

Which of the following is true regarding the testing of controls?

It must be performed before considering reducing planned assessed control risk. Signup and view all the answers

What aspect must auditors understand to conduct adequate audits?

The management assertions used by the client Signup and view all the answers

How does client expansion with new customers impact the auditor's assessment?

It requires the auditor to assess a higher risk of misstatement. Signup and view all the answers

What is the process called when auditors verify the monetary amounts of transactions?

Substantive tests of transactions. Signup and view all the answers

What is important for auditors when auditing an insurance company?

Understanding how loss reserves are calculated Signup and view all the answers

What is the purpose of assessing control risk during an audit?

To identify weaknesses in financial systems Signup and view all the answers

What is the typical approach taken by auditors for efficiency?

Performing tests of controls and substantive tests concurrently. Signup and view all the answers

What is the primary reason that auditing standards do not require auditors to discover all material misstatements?

Complete assurance is unattainable in audits. Signup and view all the answers

Which factor does NOT typically influence the audit plan?

Personal preference of the auditor. Signup and view all the answers

In a scenario where an auditor failed to uncover fraud due to client's negligence in addressing internal control deficiencies, which defense can the auditor claim?

Contributory negligence. Signup and view all the answers

What phase do analytical procedures and tests of details of balances belong to?

Phase III Signup and view all the answers

What must a client demonstrate in order to succeed in a suit against an auditor based on negligence?

A close causal connection exists between the auditor’s actions and the damages. Signup and view all the answers

What aspect of internal controls is evaluated during tests of controls?

The effectiveness of controls in preventing misstatements. Signup and view all the answers

What occurs when a business cannot repay lenders due to economic conditions?

Business failure Signup and view all the answers

Which of the following is a potential liability of CPAs to third parties?

Providing misleading financial statements upon which the third party relied. Signup and view all the answers

Which of the following best describes audit failure?

Issuing an inaccurate audit opinion Signup and view all the answers

What does audit risk represent?

Possibility of concluding with misstatement Signup and view all the answers

Which scenario illustrates the defense of absence of causal connection?

A client claims damages due to a delayed audit affecting a loan renewal. Signup and view all the answers

What is an outcome of the auditor being sued by a third party?

The auditor could be held liable for negligence if misleading statements were provided. Signup and view all the answers

Why can audit risk be considered unavoidable?

Evidence is gathered only on a sample basis Signup and view all the answers

What is a primary cause of lawsuits against CPA firms?

Unqualified personnel performing audits Signup and view all the answers

Which of the following represents a misconception about the role of auditors?

Auditors can guarantee the absolute accuracy of financial statements. Signup and view all the answers

What key aspect differentiates the duty of auditors from that of insurers in terms of auditing?

Auditors do not provide guarantees about the accuracy of clients' financial positions. Signup and view all the answers

What should be questioned if an audit fails to discover material misstatements?

The auditor's due care Signup and view all the answers

What defines the difference between business failure and audit failure?

Economic conditions versus audit opinions Signup and view all the answers

Which of the following is NOT a factor that can lead to unethical behavior in people?

Strong moral values Signup and view all the answers

Study Notes

Audit Practice and Procedures II - Week Three

Topic: Legal Liability; Audit Responsibility and Objectives

Second Class Recap

Audit Report: Definition of an audit report
Types of Audit Reports: Four types of audit reports and the situations under which each one is issued
Materiality and Opinion: Relationship between materiality and the type of audit opinion
Ethics: Definition of ethics, code of professional conduct, six core values/principles
Unethical Behavior: Reasons behind unethical behavior
Ethical Dilemmas: Examples and analysis of ethical dilemmas

Fundamental Concepts

Business Failure: A business is unable to meet financial obligations due to economic conditions (recession), poor management, or unexpected competition.
Audit Failure: Auditors issue an incorrect audit opinion due to failure in complying with auditing standards, possibly resulting in assigning unqualified assistant(s) who fail to recognize material misstatements.
Audit Risk: The possibility that the financial statements may be materially misstated even after an adequate audit; unavoidable due to testing inherent limitations and concealing fraudulent activities.

Accounting and Legal Professionals Perspectives on CPA Firm Lawsuits

Understanding Business Failures and Audit Failures: Financial statement users often misunderstand the distinction between a business failure and an audit failure, leading to lawsuits against CPA firms.
Understanding Audit Failures and Audit Risk: The distinction between an audit failure and audit risk is essential for understanding the validity of legal claims against accounting firms.

Liability to Clients

Common Source of Lawsuits: The most frequent source of lawsuits against CPAs are from clients, including issues like failing to complete engagements on the agreed date, inappropriate withdrawal, failing to detect embezzlement, or violating confidentiality.
Relatively Small Amounts: These lawsuits usually involve smaller amounts, unlike third-party cases that can have significant publicity.
Audit Negligence: Typical cases against clients involves claims auditors failed to identify employee theft due to negligence in the audit process.
Contract Breach: Actions can be pursued for breaches of contracts, or audit negligence/breaches and professional misconduct.
Severity of Negligence: Tort actions (ordinary/gross negligence, fraud) are more common than contract actions since compensation amounts are typically higher, and can be determined based on negligence, gross negligence, or fraudulent behavior.

Legal Terms Affecting CPAs' Liability

Ordinary Negligence: Lack of reasonable care expected based on the circumstances of a situation.
Gross Negligence: A complete lack of care; significantly worse than ordinary negligence.
Constructive Fraud: Deliberate negligence, without intent to deceive, resulting in an inadequate audit.
Fraud: Making a false statement with the intent to deceive.

Auditor's Defenses Against Client Suits

Lack of Duty: Refuting an implied or expressed contract for audit services.
Nonnegligent Performance: Arguing that the audit was conducted in accordance with auditing standards despite misstatements.
Contributory Negligence: Client actions that resulted in losses or hindered the audit.
Absence of Causal Connection: Claims that there isn't a direct, clear connection between the alleged audit failure and reported damages.

Liability to Third Parties under Common Law

Third Parties: Include stockholders, vendors, bankers, creditors, employees, and customers.
Loss Incurred through Reliance: Third-party liability may arise if a loss is incurred due to relying on misleading financial statements.
Specific Legal Claims: (Example) Banks suing for not discovering that a borrower's financial statements are materially misstated.

Civil Liability Under Federal Securities Law

Growth in CPA Liability: Increased litigation against CPAs for issues related to financial statements under Federal Securities Laws.
Class-Action Litigation: This aspect facilitates the possibility of significant damages for the plaintiff.
Strict Liability Standards: Some sections of securities laws have strict liability standards, which courts often favor plaintiffs in lawsuits.
Recent Tort Reform: More recent attempts at tort reform may lessen negative outcomes for accounting firms within these particular courts.

Criminal Liability

Criminal Liability for Accountants: CPAs may face criminal charges under federal and state laws, including those similar to SEC rules (Uniform Securities Acts), fraudulent reporting (1933 & 1934 securities acts), federal mail fraud, and false statements.
Notable Criminal Case Examples: (Example) United States v. Simon, 1969, illustrating a case of criminal action against CPAs.

Minimizing Liability Factors for Practicing Auditors

Integrity-Focused Client Selection: Auditors should primarily focus on engaging with high integrity clients to mitigate legal risks.
Maintaining Independence: Auditor independence extends beyond financial and encompasses a commitment to maintaining an attitude and appropriate conduct separate from the client's interests.
Understanding Client Business: Possessing sufficient knowledge of the client's business operations and industry standards helps auditors identify potential misstatements.
Quality Audits: Encompasses obtaining necessary evidence, exercising adequate judgment and appropriately documenting audit activities.
Professional Skepticism: Demonstrating a cautious approach to assess misstatements within financial reporting.

Audit Report Objectives & Phases

Auditing Objective: Provide an opinion on whether the financial statements are fair, reflecting compliance with applicable financial accounting frameworks; notifying users if there are significant misstatements or uncertainty.
Developing Audit Objectives: Steps for developing audit objectives: Understanding objectives and responsibilities, dividing financial statements into cycles, knowing management assertions, and knowing specific audit objectives.
Phases of a Financial Statement Audit: Four sequential phases of the audit process--planning, tests of controls, substantive procedures and completing the audit and issuing the report.

Management's Responsibilities

Policy and Control: Management is responsible for implementing sound accounting principles, proper internal controls, and accurate representation in financial statements, since they have day-to-day management responsibility over the business.
Statements' Integrity and Accuracy: Management is in charge of financial statement integrity and determining required presentations/disclosures. If they insist on financial statements the auditor believes are unacceptable, the auditor can issue an adverse/qualified opinion, or withdraw from the engagement.

Auditor's Responsibilities

Reasonable Assurance: Auditors pursue "reasonable," but not absolute, assurance about material misstatements, recognizing limitations in their scope and the potential for undetected errors/fraud.
Material versus Immaterial Misstatements: Auditors focus on material misstatements, as those would likely change the decisions of a rational financial statement user, rather than immaterial errors.
Assurance for Several Reasons: Factors like sampling, making judgment calls (timing, scope, etc), and fraud inherent complexity make a complete assurance practically unachievable.

Management Assertions

Implied and Expressed: Management representations, implied or expressed, regarding transactions and disclosures, directly related to financial reporting standards.
Categories: Assertions grouped into three categories: Transactions and Events, Account Balances and Presentation & Disclosure.
Importance for Audit: Understanding these assertions is critical for auditors.

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Description

This quiz covers key topics from Week Three of the Audit Practice and Procedures II course. Focus areas include legal liability, types of audit reports, the relationship between materiality and audit opinions, and ethics in auditing. Test your understanding of these essential audit concepts and ethical dilemmas.