Audit Exam 3 Notes.pdf

Chapter 8: FASB Statement of Concepts: Recognize Expenses 1) When they can be matched with related revenues (COGS and sales), those revenues are recognized. 2) In the period in which they are incurred. 3) When they are allocated to the future periods by a “systematic and rational” p...

Chapter 8: FASB Statement of Concepts: Recognize Expenses 1) When they can be matched with related revenues (COGS and sales), those revenues are recognized. 2) In the period in which they are incurred. 3) When they are allocated to the future periods by a “systematic and rational” process (depreciation) Basic acquisition and expenditure activities: 1) Purchasing goods and services 2) Receiving the good or service 3) Recording the asset or expense and related liabilities 4) Paying the vendor Purchasing goods and services Purchase requisitions: An internal document initialed by a department or person within the entity asking the purchasing department to buy specific goods or services. It may also include a recommended vendor. Approved vendor list: Includes only vendors inspected by the organization and authorized for purchases. This control activity provides evidence of vendor existence to auditors. Purchase order: A formal contractual document issued by the buyer establishing the price, delivery point, delivery dates, and other information pertinent to the purchase. The purchasing department is an area of high fraud risk because employees who have the authority to purchase assets and services for the company are in a unique position to take advantage of their authority o An employee might have an ownership interest in a supplier o Might receive a kickback o Set up a shell company to provide fictitious invoices and receipt of payment o Misdirecting purchases for the employee’s benefit Receiving the goods or services Bill of lading: A contract between the shipper and the carrier; includes shipping information such as ship dates and origination, purchase order number, and signatures for receipt of merchandise.  Receiving report: The documentation completed by the receiving department that includes receiving date and time, purchase order number, condition of material received, and amount of material received; provides evidence regarding the receipt of materials by the entity. Blind purchase order: A type of purchase order issued without revealing the quantities of the items to be received. This ensures an unbiased and accurate count of the received items, promoting honesty and accuracy in inventory management. Recording the asset or expense and related liability Voucher/voucher package: A document used as a source for recording payables. It shows approvals, accounts, and amounts to be recorded, usually attached to the supporting purchase order, receiving report, and vendor invoice. Vendor’s invoice: A bill sent from the vendor to the entity purchasing the goods or services. Technology allows companies to automate large portions of the acquisition and expenditure cycle. This can lead to significantly reduced risk in the audit. An account or disclosure is significant if there is a reasonable chance that it could contain a material misstatement. Accounts Payable Inherent risk: o Manufacturers may need to cease production because of raw material shortages. o Retailers may have insufficient inventory for customer needs. o Needed services may not be obtained. Management may desire to present a more favorable financial condition by not recording an obligation in the correct period. Individuals may try to run personal expenses through the payable system. Completeness: Liabilities are not recorded. Cutoff: Liabilities are recorded in the incorrect period. Existence: Liabilities may not represent the actual obligations of the company. Presentation: Liabilities are not recorded in the proper accounts and properly disclosed in the footnotes. Valuation: Payables are recorded at an incorrect amount. Expenses  Completeness/cutoff: Not recording expenses in the current period or delaying the recognition of expenses to the subsequent period is often the method for financial statement fraud. Accuracy: Expenses are recorded as an incorrect amount. Classification: Many reasons to classify expenses o WorldCom Inc.: Placed ordinary expenses in capital accounts, thus lowering expenses and increasing assets by billions of dollars. o Cost-plus contracts: The construction submits bills for material and labor and is reimbursed for all expenses and paid a set percentage over the costs. Service expenses are used for recording fictitious expenses because services are intangible and harder to verify compared to tangible goods. Risk of Material Misstatement Three-way match: A process in accounting to ensure that a purchase order, the goods received, and the supplier’s invoice all match before making a payment. Short term effects: o Overstated assets o Understated expenses o Overstated equity Long term effects: o Depreciation/amortization issues o Overstated net income o Potential write-offs o Credibility and legal issues If an account payable is omitted from the end of the period of the balance, the following accounts may also be misstated: o Expenses o Net income o Retained earnings o Total liabilities o Total assets Internal Control Activities and Design Evaluation Primary functions that should be separated o Authorization o Custody o Recording o Reconciliation  Entity level controls: o Management should have a process for continually reviewing expenses and comparing them to budgets and forecasts. o Proper authorization for all expenditures o Corporate values and ethics o Security of items such as blank purchase orders and blank receiving reports Control considerations: o Proper separation of responsibilities o Internal controls should provide for detailed control-checking activities o A three-match control is a common automated control to ensure the proper recording of expenses. Custody: o Access to inventory and other physical assets must be restricted by placing them in locked areas when possible. o Access to blank documents such as purchase orders, receiving reports, and checks should be restricted. Testing of Operating Effectiveness of Internal Control Test of controls consists of identification of o The control that will be relied on to reduce assessed control risk. o The data population from which a sample of items will be selected for audit. Actions of test of controls: o Inspecting o Inquiry o Observing o Scanning o Matching o Recalculating How should an auditor test for proper authorization in the expenditure cycle? o Review policies and procedures o Sample transactions o Check for signatures o Matching with supporting documents o Review changes in authorization o Inquire with personnel o Evaluate segregation of duties Where would an auditor find the proper authorization that indicates it is okay to pay a vendor?  o Purchase order o Receiving report o Vendor invoice o Authorization signature or approval o Payment authorization form Substantive Procedures The audit approach in the purchasing cycle relies almost entirely on testing controls within the system, and far less on procedures. Much of the substantive evidence obtained in purchasing cycles is obtained through three-way match controls and system-generated exception reports. These procedures can sometimes result in testing 100% of purchase transactions. Evidence is much more difficult to obtain to support the completeness assertion rather than the existence assertion. Search for unrecorded liabilities: A substantive procedure to test the completeness assertion for liability accounts. o Open purchase orders: Auditors can find evidence of losses on purchase commitments in this file if market prices have fallen below the purchase price shown in purchase orders. o Unmatched receiving reports: Auditors can inspect the unmatched receiving report file to determine whether the company has material unrecorded liabilities on the financial statements date for goods that were received but not matched to invoices. o Unmatched vendor invoices: Auditors can inspect the unmatched invoice file and compare it with the unmatched receiving report file to determine whether liabilities that have been incurred are unrecorded. o Accounts (vouchers) payable trial balance: A list of payable amounts by vendor, and the total should agree with the accounts payable control account. o Purchases journal: Provides information for the analysis of purchasing patterns that can exhibit characteristics of errors and frauds and the sample of selections of transactions for tests of controls. o Fixed asset reports: Auditors should trace large purchases to the fixed asset reports and ensure that the details of fixed assets in control accounts are consistent with purchase orders. Where could an auditor look to find evidence of (a) losses on purchase commitments or (b) unrecorded liabilities to vendors? o Losses on purchase commitments  ▪ Purchase orders ▪ Vendor communications ▪ Market price analysis ▪ Subsequent events review o Unrecorded liabilities to vendors ▪ Vendor statements ▪ Subsequent payments ▪ Receiving reports ▪ Inquiry with management How would substantive procedures for accounts payable be affected by (a) a low risk of material misstatement or (b) a high risk of material misstatement? o Low risk of material misstatement ▪ Reduced extent of testing ▪ Less detailed testing ▪ Reliance on controls o High risk of material misstatement ▪ Increased extent of testing ▪ Detailed testing of transactions ▪ Greater emphasis on analytical procedures ▪ Independent confirmations Describe the purpose and give examples of audit procedures in the search for unrecorded liabilities. o The purpose of audit procedures for unrecorded liabilities is to find expenses or obligations that haven't been reflected in the financial statements. ▪ Review subsequent payments ▪ Vendor statement reconciliation ▪ Examine receiving reports ▪ Inquire with management ▪ Review contracts ▪ Analytical procedures In substantive procedures, why is the emphasis on the completeness assertion for liabilities instead of on the existence assertion as in the audit of assets? o Risk of understatement o Control environment o Impact on financial statements o Fraud risk Other Expenditure Cycle Accounts Prepaid expenses and accrued liabilities: Can be tested using analytical procedures, such as horizontal and vertical analyses. Accrued income taxes: Income taxes can sometimes lead to material misstatements and PCAOB inspection deficiencies. PPE and intangible assets: Gathering evidence to support management's assertions are physical inspection (existence and valuation). Vouching can help with existence, valuation, rights, and obligations. o Goodwill must be reviewed for impairment and if it is properly recorded. Other expenses: If the risk of material misstatement is high, expenses can be tested by testing details. o Test of details: The tests of a sample of transactions during the period for monetary errors. How do audit procedures for prepaid expenses and accrued liabilities also provide audit evidence about related expense accounts? o Verification of timing o Review of accrued liabilities o Cut-off testing o Supporting documentation o Trend analysis What assertions found in PP&E, investments, and intangibles accounts are of interest to an auditor during the examination of the expenditure and acquisition cycle? o Existence o Completeness o Valuation and allocation o Rights and obligations Audit Risk Model Applied What items could indicate a significant risk of fraud in the acquisition and expenditure cycle (red flags)? o Unusual vendor transactions o Round dollar amounts o Lack of supporting documentation o Frequent changes in vendor details o Segregation of duties issues o Unexplained increases in expenses  o Delayed or inconsistent approvals o Pressure from management o Frequent returns or adjustments Describe the purpose and give examples of specific fraud detection procedures in the acquisition and expenditure cycle. o The purpose of fraud detection procedures is to identify and prevent fraudulent activities related to purchases and payments. o Vendor verification o Data Analytics o Examine purchase orders o Inspect invoices o Review receiving reports o Segregation of duties assessment o Surprise audits o Confirmation of balances o Review journal entries Chapter 11: Audit Timeline Interim testing: Occurs between the beginning of the year and the year-end date under audit. o Test of controls o Substantive procedures Date of the financial statements: The year-end date of the latest period covered by the client’s financial statements. o Completing substantive procedures o Attorney letters o Written representations Date of the auditor's report (audit completion date): The date on which auditors have gathered evidence on which to base their opinions on financial statements and internal controls. o This date will be used for the auditor’s report on clients' financial statements and internal controls. o Subsequently discovered facts Audit report release date: The date on which auditors allow the client to use their reports in conjunction with the financial statements. o Also, the date on which the client’s statements are issued. o Subsequently discovered facts o Omitted audit procedures o Management letter o Communication with those in charge of governance Dual date report: Used to indicate that the auditor has performed additional audit procedures for a significant event that occurred after the date of the auditor’s report, but before the audit report release date. Completing Substantive Procedures Roll-forward procedures: The procedures performed by auditors to extend the conclusions from an interim date to the date of the financial statements. o Examining material transactions that occur between the interim testing date and the date of the financial statements. Analytical procedures: Procedures that allow auditors to evaluate financial information by studying relationships among both financial and non-financial data. o Use during planning to assist auditors in planning the nature, timing, and extent of other auditing procedures (required).  o Obtain audit evidence about particular assertions related to account balances or classes of transactions (optional). o Near the end of the audit, evaluate the overall financial statement representation (required). ▪ Evaluate the adequacy of evidence gathered. ▪ Identify unusual or unexpected account balances or relationships. o Earnings management: Items that reflect adjustments made to meet analyst’s earning expectations. ▪ Should be used to classify miscellaneous, other, and clearing accounts as deferred items, assets, liabilities, contra assets, or contra liabilities. o Estimates reflect uncertainty and future outcomes by nature. Auditors cannot audit, corroborate, or verify accounting estimates. ▪ Auditors should consider whether estimates are reasonable in the circumstances. ▪ Also consider how events occurring after the date of the financial statements may affect the reasonableness of accounting estimates. Attorney Letters Contingency: An existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. Contingent liabilities: o Potential payments related to warranties for products and services sold by the entity. o Income taxes in dispute with the IRS. o Guarantees of debt on behalf of another party. Auditors should: o Ensure that all contingencies have been appropriately identified. o Any client disclosure of contingencies reflects the most current information and all recent developments, both favorable and unfavorable to the client. o Inquire management and discuss potential litigation, claims, and assessments. Pending litigation, claims, and assessments should be: o Disclosed to auditors. o Are properly presented and disclosed in the client’s financial statements.  Attorney letter (letter of inquiry): A request from an auditor to a client’s lawyer asking for details about any ongoing or potential legal issues that could impact the client’s financial statements. Attorney Letter Flow of Correspondence: 1. Auditors request the client to prepare a letter to its attorneys. 2. The attorney receives the letter mailed by the auditor. 3. The letter asks the attorney to respond to the letter. o The attorney’s response should be provided directly to the auditors. Unasserted claim: A potential legal claim or lawsuit that has not yet been officially made or filed but may arise in the future based on current circumstances or events. Attorneys should encourage their clients to disclose this information to auditors when the assertion of a claim is at least probable. What is the typical content of attorney letters? o A list of pending or threatened litigations, claims, or assessments. o A description of each item. o An evaluation of the likelihood of an unfavorable outcome. o An estimate of the range of potential loss. Written Representations A written (management or client) representation is a signed letter from a company’s management to the auditor, confirming the accuracy and completeness of financial information. They are not substitutes for corroborating evidence obtained by applying other substantive procedures. They are the only available evidence about important matters of management intent. Management’s refusal to create representations constitutes a scope limitation, which typically results in a withdrawal from the engagement or a disclaimer of an opinion. What are the major categories of information contained in written representations? o The entity’s financial statements. o Types and completeness of information provided to the auditors. o Representations made related to internal control over financial reporting (for audits of issuers). What are written representations and attorney letters obtained ear the end of the evidence-gathering process and dated on the date of the auditor's report? o Timing: Ensure the auditor has the most current information.  o Purpose: Provides the auditor with assurance regarding the accuracy of the financial statements. o Significance: Helps address any last-minute concerns and support the auditor’s opinion. Ability to Continue as a Going Concern Auditors are not expected to design and perform procedures to identify conditions that indicate going concern uncertainties. Auditors must assess if any evidence they find raises “substantial doubt” about the client’s ability to keep operating normally for the foreseeable future. Auditors must ask management about any events or conditions that could impact the company’s ability to operate. If auditors find concerns about the company’s future, they should gather details on management’s plans to address these issues and evaluate how likely those plans are to succeed. Audit documentation should include: o Conditions or events that suggested going-concern uncertainties. o Management plans to address these issues and the audit steps taken to assess those plans. o The auditor’s conclusion on whether there is substantial doubt about the company’s ability to continue and if the audit report needs to be adjusted. Adjusting Entries and Financial Statement Disclosure Adjustments are proposed to indicate the responsibility of management for the financial statements. Uncorrected misstatements are errors found by the auditors that the client hasn’t fixed, usually due to materiality or cost considerations. o Roller-over method: Considers only the current period income effect(s) of the potential adjustment. o Iron curtain method: Considers the aggregate effect of current and prior misstatements in the entity’s balance sheet. Auditors are required to communicate all nontrivial misstatements detected during the audit to those in charge of governance. Audit Documentation Review The purpose of an audit documentation review is to check that the audit work is well-documented, supports the findings, meets standards, and is easy to understand.  GAAS requires the audit documentation to be reviewed by an additional person who has not been involved in the audit (engagement quality reviewer). o Formally known as second-partner review or concurring-partner review. Benefits of audit documentation review: o It serves as primary evidence of the audit procedures and conclusions, ensuring compliance with GAAS. o It helps the firm assess the overall quality of its audit practices for quality control. o It plays a key role in training and evaluating audit staff. o It ensures that auditors plan their work properly and supervise assistants effectively. Subsequent Events and Subsequently Discovered Facts Subsequent events: Events occurring between the date of the financial statements and the date of the auditor’s report. o Events that provide additional evidence of conditions that existed at the date of the financial statements. o Evidence that provides evidence that arose following the date of the financial statements. When significant subsequent events are found, auditors must ensure that the financial statements disclose these events accurately and comply with GAAP. Subsequently discovered facts: Information that becomes known to auditors after the date of their report that, had it been known at the time, may have caused the auditors to revise their report. o Sometimes, auditors can learn of these facts after the date of the auditor's report, but before the audit report release date. o The most common way to address this issue is to choose to dual date the report. Dual Dating functions: o It allows updates to the financial statements for information found after the auditor’s report date. o It limits the auditor’s liability for post-report events to those mentioned in the report. Unaudited events are when auditors may choose not to evaluate the effect of subsequently discovered facts on the financial statements. Clients should:  o Inform anyone (likely) relying on the financial statements that they shouldn’t be trusted and that revised statements and a new auditor’s report will be issued. o Issue revised financial statements promptly, including details about the newly discovered facts. Responsibilities Following the Audit Report Release Date Omitted procedures: The inadvertent failure of auditors to perform necessary audit procedures before the audit report release date. o Auditors should perform omitted procedures if: The omitted procedures are important in supporting the auditor’s opinion. Individuals are relying on the client's financial statements and auditors reports. Individuals charged with governance: These are those responsible for overseeing a company’s management and financial reporting, usually including the board of directors and audit committee. Professional standards require auditors to communicate in writing all significant internal control deficiencies and material weaknesses to the client and individuals charged with governance. o Issuers: Communication must be made before the audit report release date. o Nonissues: No later than 60 days following the audit report release date. Management Letter: A document from auditors to a company’s management that shares findings and suggestions for improving internal controls and financial processes after an audit.