TAP Ch.1: The Audit Framework

Question 1

1: What is an audit?

Answer 1

Answer:
An independent examination on financial statements,to an express an opinion on whether they give a true and fair value

Further breakdown:
- Someone independent
- Who checks the account
- To make sure they are not wrong in a serious way ( material)
- And gives an opinion

Question 2

1: What are the key points in the audit definition

Answer 2

1. Independent: not being influenced by management, unbiased
2. Examination: their job is to test, check and verify
3. Financial statements: income statement, statement of financial position, cash flows
4. Opinion: not guarantee; just assurance

Question 3

2: Why are audits needed?

Answer 3

Audits are needed because information risk and agency problem

Question 4

2.1: What is information asymmetry?

Answer 4

:When one party knows more information than the other
Management knows more about the business than shareholders
Shareholders rely on financial statements

Eg:
- Directors know the real inventory amount, Investors only see what directors

Question 5

2.2: What is the agency problem?

Answer 5

Agency theory:
- Shareholders = principals
- Managers = agents
Agents may act in their own interest, not the principals/owners’

Eg:
Managers msg overstate profits because bonuses depend on profit level

Question 6

2.3: What is information risk

Answer 6

Risk that financial statements are:
- Wrong
- Misleading
- Biased
- Incomplete
Auditors reduce the risk by checking the information

Question 7

3. What is assurance ?

Answer 7

The level of confidence the auditors provide?

Question 8

3.1: what is reasonable assurance? ( High)

Answer 8

A high but not absolute level of confidence that financial statements are free from material misstatement
- used in audits

Further explanation :
High confidence but not 100% certain. Due to:
- Sampling
- Complexity
- Judgement
- Fraud can be disguised
- Internal controls have limits
Eg: auditors tests 200 transactions out of thousands

Question 9

3.2: What is limited assurance?

Answer 9

Less testing = less confidence
- used in reviews

Eg: nothing has come to our attention that suggests the financial statements are wrong.

Question 10

3.3: What is no assurance

Answer 10

Accountant prepares info but does not check it,
Eg: bookkeeping services

Question 11

4: What is the concept of true and fair view

Answer 11

Financial statements should:
- Follow accounting standards
- Be honest
- Be complete
- Not misleading

Question 12

5: What is the audit expectation gap

Answer 12

The difference between what the public thinks auditors do and what auditors do

Question 13

5.1: what do the PUBLIC think auditors do?

Answer 13

• Check every transaction
• Find every fraud
• Guarantee accuracy
• Guarantee the company won’t fail
• Check management’s honest 100%

Question 14

5.2: What do auditors do?

Answer 14

1. Use sampling
2. Detect material fraud
3. Provide reasonable assurance
4. Do not guarantee anything

Question 15

6: what are the limitations of an audit?

Answer 15

Audits have built-in limits
1. Sampling: auditors only test some transactions
2. Judgement: materiality, risk assessment, estimates = judgement calls
3. Internal control limitations: people make mistakes, collusion, override.
4. Time and cost: can’t check everything
These limits explain why absolute assurance is impossible

Question 16

7.1: What is materiality?

Answer 16

Amount that would influence a user’s decisions if misstated

Question 17

7.2: What is audit risk ?

Answer 17

Risk auditors give wrong opinion

Question 18

7.3: What is inherent risk?

Answer 18

Risk something is wrong before controls
Eg: The natural risk in the transaction

Question 19

7.4: what is control risk?

Answer 19

Risk internal control fails

Question 20

7.5: What is detection risk?

Answer 20

Risk auditors don’t detect a misstatement

Question 21

7.6: What is an internal control?

Answer 21

Systems that help prevent errors/fraud

Question 22

7.7: what is professional scepticism

Answer 22

Auditor must question and not accept things at face value

Question 23

8: What is the audit process?

Answer 23

1. Accept client
2. Plan audit + assess risks
3. Test internal controls
4. Substantive testing
5. Review
6. Issue audit report

Question 24

9: what is the regulatory framework

Answer 24

Auditors must follow:
1. Law - Companies Act
2. Standards - ISAs ( International Standards on Auditing)
3. Ethical Rules : objectivity, professional competence, confidentiality, professional behaviour
This forms the audit environment

Question 25

10: common exam questions related to chapter 1

Answer 25

1. Explain why audits are necessary Prompt: information asymmetry, agency theory, information risk 2. Explain reasonable vs absolute assurance Prompt: sampling, judgement, limitations 3.Explain the audit expectation gap Prompt : public beliefs vs actual responsibilities 4. Define key terms: materiality, audit risk, independence, professional skepticism 5. Explain the role of an auditor Prompt: independence, assurance, testing