1
Q
The accounting system diagram? (1.2)
A
- Transaction goes into accounting information system. From accounting information system, info goes to stakeholders of the firm and managements, however, auditor also checks accounting information system and the info which goes from accounting information system to the stakeholders
2
Q
Layman definition of auditing (1.16/17)
A
- Auditing is a process in which a business requests an audit firm to examine its accounting records and certify whether the numbers reported in financial statements are accurate
3
Q
Parties involved in organization (1.22) 4 parties
A
- Management
Prepares and presents F$
Designs, implements & maintains internal control over financial reporting o Provides info to auditors - Internal audit function
Gives assurance on internal control (IC) to managers and audit committee - External auditor
Provides independent audit of internal control and financial statement (FS) - Audit committee
Subcommittee of board of directors (BoD)
Oversees managers and internal audit
Hire external auditor
4
Q
Formal definition of audit / A statement of basic audit concepts (1971). (1.23)
A
- An audit is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of corresponderice between these assertions and established criteria, and communicating the results to interested users
5
Q
With what 2 things does credible information help with? (1.25)
A
- Reduces risk (risk-return trade off)
- Improves decision making process
6
Q
What does “Pittman and Fortin (2004) say about: Which companies young/old with a high quality auditor pay significantly lower interest rates (1.25)
A
young companies
7
Q
How can an auditor solve info problems? Regarding lending bank and debtholders (Jensen and Meckling (1976) (1.25)
A
- By providing valuable information about a borrowing firm to a lending bank, potentially lowering the monitoring costs of debtholders
8
Q
5 points of insurance role of auditing? (1.26) weirdly asked question, he would ask differently.
A
- Auditors provide reasonable assurance about the accuracy of the financial statements of a company
- Users rely on these audited financial statements to make their decisions
- Users can sue auditors to recover their losses.
- Identification of material misstatement in financial statements
- Proven that auditors have worked negligently (In a way that is not careful enough)
9
Q
2 points of signaling role of auditing? (1.27)
A
- Audit is indication of transparency
- Enhances the perception of a company (low risk company
10
Q
When is the audit mandatory in the US? (1.30)
A
- Only required for public companies and certain other regulated entities. PCAOB oversees audits of public companies.
11
Q
What does PCAOB mean? (Google filled the knowledge gap)
A
- Pubic Company Accounting Oversight Board. Created by the Sarbanes-Oxley Act of 2002. A nonprofit corporation established by Congress to oversee accounting professionals who provide independent audit reports for publicly traded companies.
- Registering public accounting firms. Establishing audit, quality control, ethics, independence, other standards relating to audits of public company audits. Enforcing compliance with the Sarbanes-Oxey Act
12
Q
What was the Sarbanes-Oxley Act about? (Knowledge gap). It’s two points?
A
-Is a federal law that established broad auditing and financial regulations (record keeping and reporting) for public companies.
13
Q
When is the audit necessary in the Netherlands? (1.30]
A
- If the company meets 2 of the 3 criteria in 2 successive years
o Total assets > 6mln euros
o Net sales > 12mln euros
o Average number of employees > 50
14
Q
What does AFM stand for? And what does it do? (1.30)
A
- The Dutch Authority for the Financial Markets.
- Responsible for supervising the operations of the financial markets since 1 March 2002 (Savings, investment, insurance, loans, pensions, capital markets, asset management, accountancy and financial reporting)
15
Q
The history of audit? (Video in the slides)
A
- The first references of audit came around 2000BC in Roman Empire. The emperor’s appointed bright and ambitious men that they considered trustworthy as Cuesta’s. They were sent to the far lands of Roman empire to ensure that the governors who rules the provinces was spending the money (that Rome has sent) correctly. The assets that money had bought were protected and looked after and existed. And taxes which governors had to collect and sent to Rome were being collected and sent to Rome, without governors taking a persentage off to themselves.
o In short: governor appoins a person who he trusts to verify financial expenditure, assets and that no fraud is being commited. - 1068-1100 AD Henry the first of England, was first that used the word audit. From latin ‘audre’ meaning: to hear. He sent auditors to the corners of England to confirmt that the barons who ruled on his behalf were spending the money as it should be sent, assets were protected, taxes collected and sent to the king.
- The key to the audit, which we see today, was invented due to Industrial Revolution in 1760-1840. For the first time, investors became part of the business process. But investors would only invest their money in something they believe is safe, and understandable, so they appointed people they considered trustworthy (often business associates and friends) to verify that the provided information by the management, the people behind the potential business was true and fair.
- After the stock market crash in 1929 regulations became harsher. Now auditors needed to be qualified professionals, not your friends. Technologies involved, so people turned to that, and we had to adapt techniques to that as well.
- Auditing scandals in 1980s – 1990s brought futher improvements in regulations. Enron scandal. Enron were audited by Arthur Andersen (the largest and most successful audit firm of that time). Because of the scandal, they lost reputation and they had to close.
16
Q
How does the graph look like when there is a divergence of interest effect? In terms of management ownership and agency cost (1.38)
A
- Straight line from high agency cost to low agancy cost by the increase in management ownership.
17
Q
What does entrenchement effect mean? How does the graph look like? (1.39)
A
- Managers have more scope for behaving opportunistically when they have greater control.
18
Q
How does the graph look like when we combine entrenchment effect and divergence of interest? (1.40)
A
Answer it. graph is in the slides if needed.
19
Q
What could be 4 solutions to the agency problem? (1.41)
A
- Board of directors
o Have skills
o Willing to spend time
o Monitor performance through financial statements - Managerial compensation
o Link managerial compensation with shareholder wealth
o Managerial performance is measured through financial statements - Managerial ownership
- Audit
20
Q
A firm is more likely to purchase voluntary audits if…? Dedman, Kausar, Lennox (2014) (1.45)
A
- Agency cost higher (size, complex, ownership dispersion)
- Riskier (performance, age, inventory or receivable)
- Raise capital
- Purchase non-audit services from auditor (knowledge spillover?)
- Exhibit greater demand for audit under mandatory regime (fee, B4?)
21
Q
A high-quality audit is when….? (2.6)
A
- An audit performed in accordanve with GAAS (Generally Accepted Auditing Standards) to provide reasonable assurance that the audited financial statement and related disclosures are
1. Presented in accordance with GAAP and
2. Are not materially misstated whether due to error or fraud.
22
Q
According to DeAngelo (1981) audit quality equals to what? (2.7)
A
- Audit quality = competence + independence
- Joint probability that a given auditor will both detect material misstatements in the client’s financial statements (technical capabilities = competence) and report the material misstatements (auditor independence)
23
Q
Drivers of audit quality? 5 of them. (2.10)
A
- Effectiveness of the audit process +
- Reliability and usefulness of audit reporting +
- Factors outside the control of auditors +
- Audit firm culture +
- Skills and qualities of the audit partner and the engagement team +
24
Q
Structure of AEG (Audit expectation gap) (was asked in the exam and I struggled to explain) (2.11) (Porter 1993)
A
The audit expectation gap is a term used to describe the difference between what the general public expects from the audit, and what a financial audit actually involves.
- There are 2 parts: performance gap and reasonableness gap.
- Reasonableness gap (what the public expects auditors to achieve and what they can reasonably be expected to accomplish).
- In performance gap there are deficient performance (the expected standard of performance of auditors 16%) and deficient standards (expectations defined by the law and profession standards 50%).
25
What is not ethics? (2.14)
- Being ethical is not a matter of following one’s feelings. In fact, feelings frequently deviate from what is ‘ethical’
- Ethics cannot be confined to religion nor is the same as religion
- Ethics are not necessarily determined by law
- Being ethical is not the same as doing “whatever society accepts”
26
What is ethics? (2.14)!
- Ethics = standards of behavior (set of moral principles and values) that suggest how human beings should act
27
A few ethical dilemmas to auditors: (2.16)
- Dealing with a client who threatens to seek a new auditor unless an unqualified opinion is issued.
- Deciding whether to confront a supervisor who has materially overstated departmental revenues as a means of receiving a larger bonus
- Continuing to be part of management of a company that harasses and mistreats employess or treats customers dishonestly (if you have a family to support and the job market is tight)
- Cheating for your final CPA exam (to safeguard your future career prospects)
- Dealing with budget pressure (decision to shift audit hours from a client with tight budget to the one with a loser one)
28
Professional conduct (behavior)? (2.17)
- GAAS
- CPA examination
- Code of prefessional conduct
- Peer review
- Continuing education req.
- Legal liabilities
- Quality control.
- AFM, PCAOB, SEC
29
What are the ethical principles of code of professional conduct (behavior)? (2.18)
I name it: IOS RC
1. Integrity = fairness, truthfulness
2. Objectivity = be free of conflicts of interest
3. Secrecy
4. Responsibilites = commitment to professionalism
5. Competence and due care = competence is up-to-date
30
What are the threats of code of professional conduct (behavior)? (2.19)
I name it: SASI FIA
- self-interest = financial or other interest of an auditor
- Self-assesment = threat coming from the idea that auditor itself assesses his or her own performance
- Advocacy = not being objective
- Intimidation = factual or alleged threats
- Familiarity = close connections between the auditor and the client
31
What is the difference between independence in fact vs appearance? (2.20)
- In fact = whether the auditor is actually able to maintain an unbiased attitude throughout the audit. He is objective, no conflict of interest
- In appearance = is the result of others’ interpretation of this ‘independence’
o A third-party view
- Important: if auditors are independent in fact, yet users believe them to be advocates (supporter) for the client, most of the value of the audit function is lost
32
Lennox (one of the auditors) showed “employment affiliation”. What does it mean?
- An employment affiliation occurs when an individual leaves and audit firm and joins one of the audit firm’s clients.
33
Alma mater affiliation? (2.22)
- An alma mater affiliation occurs when an executive persuades her company to appoint her former CPA (accounting firm) firm as the company’s auditor. An affiliated executive may have a preference for her former audit firm.
- Lennox argues that audit quality can be impaired when executives previously worked for their companies’ audit firms.
o Audit team members might be overly friendly with their former colleague and are unwilling to challenge her assertions
o The former auditor might be sufficiently familiar with the audit firm’s testing methodology that she can circumvent (find a way around it/overcome) its design. (2.25)
34
High audit fees => important client in portfolio
facts
35
What are 4 rules to avoid impairment of independence? (2.30)
- Prohibit non-audit services
- Cooling down period (don’t really understand)
- Firm/partner rotation
- Monitoring mechanism
36
Who rely on audited FS? (2.31) Around 10 are named below
- The client, actual and potential investors, vendors, banks, employees, customers, supervisory boards, unions, the government, …
37
What are the 2 types of audit quality safeguards? (2.31)
- Legal (via civil and criminal liability)
- Market (through reputational concerns)
38
What is the max duration period of audit engagements with possible derogations?
10
39
For sole audits, MS may provide that the first 10-year period be extended by another __ years
10
40
MS may privilege joint audits, for which maximum duration period would be ___ years.
24
41
Rotation after a maximum of how many years (key audit partners)? Followed by a how long cooling-off period?
7 and 3
42
For statutory PIE audits: the maximum duration for an audit firm is __ years and ___ be extended
- 10 / cannot
43
Does long audit partner increase or decrease audit quality?
Decrease
44
What is materiality? (4.18)
- Materiality defines the treshold point after which misstatements are relevant to decision making needs of users.
45
The quantitative amount may be adjusted lower for materiality for qualitative factors such as? 5 things
- Owners of entity (large group)
- Changes of ownership
- Public interest in financial statements
- Established client
- Volatile business results/environment
46
What is a general rule for percentage or revenue for materiality? (4.21)
- 0.5% to 3%.
47
3 steps of interim audit process? (4.28) (Was in last exam…)
- Understanding the desing of internal control
- Test existence of internal control (walkthrough)
- Test whether internal congrol operates effectively
So, you have to first understand what is their internal control, secondly you have to check it actually exist, and lastly you have to check if it is efficient.
48
What is the main control risk in purchase process? (4.29)
- Unauthorized payments
49
Name a few level controls for purchase process. (4.29) 5
- Segragetion of duties
- Three-way match
- Authorization of invoices
- Authorizations within the bank application
- Creditor master data
50
2 ways to test the effectiveness of payment authorization? (4.31)
- Test the formality
o Receive documentation that the supervisor and the CFO authorized the payment list
- Reperformances
o For a number of payments on the payment list, we check the bank account number.
51
Types of audit evidence? (4.34)
- Obtaining written or oral info from client
- Inspection of the client’s records and documents (internal and external)
- Recalculation (rechecking sample of calculations, checking mathematical accuracy, often done by software)
- Reperformance (execution of procedures and control by the auditor
- Observation (looking at process or procedure)
- Physical examination of assets (inspection of tangible assets)
- Scanning (review acc. data to identify significant or unusual items)
- Analytical procedures
- External confirmation (receipt)
52
A misstatement in the financial statements can be considered material if knowledge of the misstatement would affect _____. (5.6)
- Decision of a reasonable user of the statements
53
The extent of auditor effort varies ____ with the level of planning materiality (planning materiality = PM) (5.11)
- inversely
54
Commonly used rule-of-thumb: (5.11) (income before taxes and total assets = percentages)
>10% of net income before taxes (NIBT) or > 1.5% of total assets
55
What is the effect of firm size on planning materiality?
- Larger clients => +
56
What is the effect of firm controls on planning materiality?
- Better control systems => +
57
What is the effect of firm complexity on planning materiality?
- More complex clients => -
58
What is the effect of firm big 5 on planning materiality?
- (negative)
59
What is the effect of ROA 5 on planning materiality?
- +
o Small ROA = close to zero = possible risk of earnings management = lower PM
o Large ROA – less likely to manipulate earnings = high PM
60
Auditing standards state that planning materiality should reflect ____ as well as ____ factors.
- Quantitative (of which size of the client is a first-order consideration) / qualitative (internal errors, small losses)
61
Engagement risk? (5.15)
- Represents the overall risk associated with an audit engagement
62
Engagenement risk consists of what 3 components? (5.15)
Clients’ business risk (also referred to as entity’s business risk)
Auditor’s business risk
Audit risk
63
What is client business risk? (5.16) and then what are the sources of business risk? 5 things
- A threat to an organization that reduces the likelihood that the orgnaization will achieve one or more of its objectives
o Sources of business risk?
Competitive environment (inventory valuation)
Employees or management (incentives)
Process breakdowns (relation between input-output)
Inaccurate processing of information (noise, errors)
Ineffective responses to risks (going concern)
3-2
64
What is auditor’s business risk? (5.17)
- Refers to the risk the audit firm is exposed to due to loss or injury from litigation (settling a dispute in a court of law), adverse publicity, or other events arising in connection with the audited FS
65
What is audit risk? (5.18)
- Likelihood that auditor will issue an incorrect opinion on the financial statement
66
What is type 1 error? (5.18)
- FS are actually free from material misstatement but auditor wrongly concludes that there are material misstatements in the FS (less likely)
67
What is type 2 error? (5.18)
- FS actually contain material misstatements but auditor wrongly concludes that there are no material misstatements in the FS (issues clean report)
68
What is audit failure? (5.18)
- Likelihood that auditor will conclude that all material assertions made by the management are true when, in fact, at least one material assertion is incorrect.
69
2 ways which each will go more in deth, which helps assess acceptable audit risk? (5.19)
- Degree to which external users rely on FS (heavy reliance, decrease acceptable audit risk)
o Client size
o Distribution of ownership
o Nature and amount of liabilities
- Likelihood that client will have financial difficulties after audit report is issued
o Liquidity position
o Profits/losses in the previous year
o Nature of the client’s operations
o Competence of management
70
What are the names of 4 components of audit risk? When do they arise? (5.20)
One: erros likely to occur in client’s FS <-inherent risk
Two: errors that bypass controls <- control risk
Three: errors caught by the auditor <-detection risk
Four: errors undetected by the auditor <- audit risk
71
Audit risk model (ARM)? The formula? (5.21)
- AR = RMM (IR, CR) x DR
72
Why is there the risk that an auditor fails to discover an existing misstatement? (5.22) 2 things
- Because of sampling (do not examine all transactions) and non-sampling risk (inadequate planning, procedural errors, improper corrective actions
73
What is inadequate planning? (5.22)
- An auditor may not plan or perfom audit procedures necessary to detect an existing misstatement
74
What are procedural errors? (5.22)
- An auditor may apply procedures ineffectively or may incorrectly evaluate the results of procedures (does not recognize an error even when an erroneous transcation is selected for testing)
75
Improper corrective actions? (5.22)
- An audit team member identifies an erroneous transaction but his response is inappropriate (intentionally or unintentionally)
76
What is the meaning of erroneous? (Knowledge gap)
- Wrong
77
What is audit evidence? (5.26)
- The information used by the auditor in arriving at conclusions on which the audit opinion is based.
78
Because of the nature of audit evidence and cost considerations of doing an audit, it is ______ that the auditor will be completely convinced that the opinion is correct. (5.27)
- Unlikely
79
What are the two determinants of the persuasiveness of audit evidence? (5.27)
- Appropriateness of evidence
o Degree of objectivity
o Auditor’s direct inspection/observation
o Effectiveness of client’s internal control
o Qualification of individual providing the information
o Independence of provider
- Sufficiency of evidence (expectation of misstatements, effectiveness of IC)
80
What are 4 audit evidence decisions? (5.29)
- Which audit procedures to use?
- What sample size to select for a given procedure?
- Which items to select from the population?
- When to perform the procedures?
81
Types of audit evidence? = audit procedures :9
- Physical examination of assets
- Insperction of the client’s records and documents (internal & external)
- External confirmation (receipt)
- Inquires of the client (written or oral info from client)
- Observation (looking at process or procedure)
- Recalculation (rechecking sample of calculation, checking mathematical accuracy)
- Reperformance (execution of procedures and control by the auditor)
- Analytical procedures (analysis of relationships between financial and non-financial info)
- Scanning (review and accounting data to identify significant or unusual items)
82
What are the 3 core audit concepts? (5.31)
- Materiality
- Evidence
- risk
83
Once again, what is the definiton of an audit? (6.2)
- an audit is a systematic process of objectively obtaining and evaluating evidence regarding assertations about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria, and communicating the results to interested users.
84
New and revised international standards on the audit report are mandatory from ____
- dec 15. 2016.
85
Name 4 benefits of extended audit report (6.9)
- Increased transparency & enhanced informational value
- Enhanced communications between investors and the auditor, as well as the auditor and those charged with governance.
- Increased attention by management and those charged with governance to the disclosures in the financial statements to which reference is made in the auditor’s report (basically attention increased in being more precise for the management, since auditor will comment more regarding the numbers and etc.)
- Renewed focus of the auditor on matter to be communicated in the auditor’s report, which could indirectly result in an increase in professional skepticism (a bit more skepticism towards auditors, because their work will be more detailed, so its possible to judge them more)
86
If all the information in the financial statement is materially correct, the opinion of the auditors will be _______ opinion. (6.11)
unmodified
87
If there are the chances that the information in the FS is having some material errors, the auditors give a _____ opinion. (6.11)
modified
88
Unmodified opinion consists of…...? (6.13) 4 points
- Auditor was able to perform the audit in accordance with auditing standards.
- FS are presented according to appropriate accounting framework (GAAP)
- Sufficient and appropriate evidence has been accumulated
- No circumstances that require explanatory paragraph or modification of the report.
89
When would you issue an unmodified opinion with emphasis-of-matter paragraph? (6.15)
- Complete audit took place, with satisfactory results and FS are fairly presented, but the auditor believes that it is important or required to provide additional information.
o Justified departure from GAAP to avoid misleading info
o Change in accounting principles
o Uncertainty of future outcome or exeptional litigation
o Substantial doubt on going concern
90
What does ‘going concern’ mean? (6.16) Name a few examples?
- Indicated the doubt about the continuation of the company
o Significant recurring operating losses
o Inability to pay obligations in time
o Loss of major customers
o Legal proceedings
o Etc.
91
Purpose of audit is not ______ but _____. (6.16)
- To evaluate financial health / auditor is responsible to evaluate whether company is likely to continue as a going concern.
92
What is self-fulfilling prophecy effect? (6.17)
- Self-fulfilling prophecy is a prediction that directly or indirectly causes it to become true, byt the very terms of the prophecy. Example: the auditor’s early warning could itself be the proixmate cause of bankruptcy. However…Weber and Willenborg (2003) study auditors issuing going concern opinion for Microcap IPOs and find NO-support for self-fulfilling prophecy effect
93
When do we issue modified opinion? (6.20) Examples?
- The scope of the audit has been restricted (scope limitation). Auditor inable to obtain sufficient appropriate evidence. Client specific reasons or the ones beyond the powers of client or auditor.
o Client did not allow auditors to count inventory or to contact clients.
o Auditor was appointed after year end (previous auditor left)
This could mean that it is material, qualified, except for…
94
What does disclaimer mean? (6.21)
- Scope limitations exist / auditor lack independence. That’s why disclaimer of opinion: auditor does not issue any opinion, because he couldn’t obtain enough information to say anything about it. (Client might have put restrictions on audit in order to hide something)
95
When would you issue adverse opinion? (6.24)
- More pervasive GAAP departures, affecting more than 1 item
- Auditor believes that overall FS are so materially misstated or misleading they they cannot fairly present the financial position
Auditing
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