AUD CPA Exam Review Course

Hello and welcome to the Bisk CPA review course and our coverage of the auditing and attestation section of the CPA exam. My name is Bob Monette, and I'll be your instructor for these classes. And in this class, we're going to be talking about a very heavily tested part of the auditing CPA Exam. And that is reporting issues.
Before we get into reporting issues. I just want to say a word. About the auditing CPA Review course and the auditing CPA Exam itself. I think, that the auditing CPA Exam itself is a four-hour monster. It's a tough CPA Exam. And I think that we should start with what I think is the hardest part of the CPA Exam. Why not let's get right to it.
You know what the hardest part of the CPA Exam is, make sure you don't fall behind. That's the hardest part. That's the hardest part of the whole thing. I think when you look back on. You're studying for the AUD CPA Exam. I think you'll agree with me. That's the hardest thing. Make sure you don't fall behind. What I'm getting at is it's important.
It's essential that you set up a regular study schedule. When I was studying for the CPA Exam, I was auditing during the day. And what I did was lunch hours all the time I studied for the CPA Exam. I Brown bagged it to work. And when it got to be lunch hour, I'd find an empty office, close myself off. And I did an hour of.
Questions every day. It's very powerful. It doesn't sound it, but that's in my mind, a relatively painless way of putting in about five hours a week, five lunch hours a week, and then a few hours maybe on Saturday, make sure you're all caught up. And if you're all caught up, you reward yourself by taking Sunday off.
I really believe that because you need a break, you have to get away from it. So that's the deal you make with yourself. If you're all caught up as of Saturday, you're allowed to take Sunday off. If you're not caught up, you have to actually study on Sunday to let that be an incentive to you to get caught up by Saturday.
So you can get that day off. So to me that's our game plan. You have to watch all these classes, but you have to get the problems done on the software and the way that you're going to get the problems done on the software an hour a day. Try lunch hours. It doesn't have to be lunch hours. I've had students set their alarm clock an hour early in the morning, get up an hour early, do an hour of problems and then have their normal day.
That's great. I know I couldn't do that. I throw the alarm clock across the room. I just know I would, you've got to be honest with yourself. What are you really going to do? But choose an hour, try to do an hour a day. And you'll find that the cumulative effect from that effort really starts to pay off.
You'll really get this work done and you have to get this work done. Now, as I said in this class, we're going to be talking about reporting issues, always a very heavily tested part of the auditing and attestation exam, but I want to start with the basic steps in the audit process, just to warm us up, get us in the mood.
Let's go over the basic steps in the audit process. There are six essential steps. In the audit process. Step one, we have to establish an understanding with our client. That step one, you must establish an understanding with the client about the objectives of the engagement, any limitations on the engagement, the services that are going to be performed.
Space requirements, staffing requirements, audit fees, always very important. What are the fees and lay out clearly the auditor's responsibility, the client's responsibility. And always remember that we are required. We are required under generally accepted auditing standards. We are required to document our understanding with the client in what is called the engagement letter.
Then step two in step two, we're into the planning phase. And in the planning phase, we have to obtain an understanding of the entity, the client and its environment, including internal control. Okay. In the planning phase, we use risk assessment procedures to obtain an understanding of the client, its environment, internal control.
And of course the risk assessment procedures that we perform depend on the size of the client, the size of the entity, its complexity, our previous experience with the entity with air every year. And of course in the planning phase we discussed with the audit team, how susceptible the financial statements are to material misstatements.
How susceptible the financial statements are to errors and fraud, then step three and step three, we evaluate the risk of material misstatement related to specific assertions cash investments. Liabilities. Now we're going to in step three, evaluate the risk of material misstatement in relation to particular assertions.
And we evaluate the probability of material misstatement related to. Particular assertions, always considering materiality in step four, we design and perform our audit procedures. That's step four, we designed and we perform our audit procedures. Remember we're going to have tests of controls, compliance testing.
We're going to have substantive tests of details, but in step four, we designed and perform our audit procedures to address. The risk of material misstatement in particular assertions in step five, we evaluate all the audit evidence that we obtained. That's step five. We simply evaluate all the audit evidence we've obtained.
And in step six, we form an audit opinion and issue our audit report. That's the sixth and final step in the audit process where we form our opinion and issue the audit report in this class. We're really going to be talking about step six. Where we form our opinion and issue our audit report and what the client wants, that what the client wants out of any audit is a clean opinion, an unmodified opinion.
That's the client wants a clean opinion, an unmodified opinion. So I think that's a good place for us to start. How does your client deserve an unmodified opinion? How does your client earn. An unmodified opinion. How was it earned? To get an unmodified opinion, it's really very simple. The client has to meet six requirements to get an unmodified opinion, six requirements.
Number one, there can't be any significant departures from us GAAP. No significant departures from us, generally accepted accounting principles or whatever financial framework we're testing. It could be but in this class, We'll assume it's us generally accepted accounting principles, but that is the first requirement.
They can't be any significant departures from us. GAAP. Number two, us GAAP must have been consistently applied between accounting periods. Step three, there must be adequate and disk and complete disclosures, adequate and complete disclosures. And I want you to notice something if your bracket.
Those first three requirements together. Once you write this in your notes next to those three requirements, what are we saying? In a nutshell, they can't be any problem with the financial statements. When we say there can't be any significant departures from us GAAP must have been consistently applied between accounting periods, adequate and complete disclosures.
What we're saying bottom line, there can't be any problem with the financial statements. Now four, five, and six number four. There can't be any significant uncertainties. Number five, no significant scope, limitations. And number six, no significant going concern problems. Now bracket four, five, and six together.
What are we saying in four, five and six. When we say there can't be any significant uncertainties, no significant scope, limitations, no significant going on. No, no significant going concern problems. Aren't we saying in those last three, no problems with the audit. Isn't that really the bottom line. What we're saying to our client is if you want to deserve an unmodified opinion, if you think you've earned an unmodified opinion, then there can't be any problem with the financial statements, the first three, and there can't be any problem with the audit.
The last three. Now, if you look in the viewer's guide, you'll see an example of the standard unmodified opinion. And this is really the foundation. Of all your studying in the area of reporting, you must memorize. This memorize word for word, the standard unmodified opinion. You'll find if you do that, you're much stronger than reporting in the reporting area, because if you memorize the standard unmodified opinion and you really know it cold now later, you just have to make sure, what modifications are made.
To the standard unmodified opinion in certain situations, then you can focus on modifications, but let's look at the standard unmodified opinion. Notice the heading independent auditor's report. They'll just write in the heading independent auditor's report. Remember if an accountant, if an auditor is going to provide any type of assurance on financial information, any kind of assurance on financial information.
The auditor must be independent, in fact, independent in appearance. If the auditor is going to provide any type of assurance on financial information, and remember the goal of an audit is to provide what reasonably positive assurance that the financial statements are free of any material misstatement we're providing reasonably positive assurance that the financial statements are free of any material errors and fraud.
But we are provided reasonable assurance. So the auditor must be independent. So that's right. That's right upfront independent auditor's report. Now it's addressed to the company, the board of directors, the shareholders, but never management, not management. Now this report starts with the introductory paragraph.
Introductory paragraph says we have audited notice. We make our level of service. Obvious. We state our level of Serbia service immediately. We're not doing our review. We're not doing a compilation. The level of service is laid out. We have audited the accompanying financial statements of XYZ company, which comprised the balance sheet as of December 31 year one.
And the related statements of income changes in stockholders' equity and cash flows for the year then ended and the related notes to the financial statements. That's the introductory paragraph. Now what the standard unmodified opinion does is lay out very clearly management's responsibility and the auditor's responsibility.
So notice the next paragraph has a title management's responsibility for the financial statements. What we're going to call on these classes, the management responsibility paragraph, but the actual title is management's responsibility for the financial statements. Let's take a look at it. Management is responsible.
For the preparation and fair presentation of these financial statements in accordance with accounting principles generally accepted in the United States of America. This
includes the design implementation and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error, that is the management responsibility paragraph. And now. The most involved paragraph, the auditor's responsibility paragraph, it says our responsibility to express an audit opinion on these financial statements.
Based on our audit, very clear, we conducted our audit in accordance with auditing standards, generally accepted in the United States of America. Now there might be more than one set of standards. You could say. We conducted our audit in accordance with auditing standards, generally accepted in the United States of America and in accordance.
With standards of the public company, accounting oversight board, if it's an issuer, or we could say we conducted our audit in accordance with auditing standards, generally accepted in the United States of America and in accordance with international standards of auditing to just keep in mind that there might be more than one set of standards that we follow.
Those standards require that we plan and perform the audit to obtain reasonable assurance. About whether the financial statements are free from material misstatement on audit, involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor's judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error.
In making those risk assessments, the auditor considers internal control relevant to the entity's preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an audit opinion on the effectiveness of the entities, internal control accordingly, we express no such opinion.
An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness. Have significant accounting estimates made by management as well as evaluating the overall presentation of the financial statements. And now the bottom line, the last sentence, we believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.
And then finally, of course, the opinion paragraph in our opinion, The financial statements referred to above present fairly. This is clear and opinion. This is an unmodified opinion. That's what the client wanted. Its client hope for present fairly in all material respects the financial position of XYZ company as of December 31 year one, and the results of its operations and it's cash flows for the year then ended in accordance with accounting principles, generally accepted in the United States of America.
It is signed. Either manually or by the printed signature of the firm. When is it dated? It's dated? No. Earlier member of the audit report is dated no earlier than the date on which the auditor obtained sufficient appropriate audit evidence on which to base the opinion. A member of the audit report is always dated no earlier than the date on which the auditor has obtained sufficient, appropriate audit evidence.
On which the base, the opinion that it's a standard unmodified opinion. Now I said, memorize it. And I meant memorize it word for word. You want to get to the point where you could sit down at your laptop and just print that out. Just type it out. Not word for word. Believe me, they test it. Word for word.
Multiple choice can get very picky about the wording. They could have a simulation. Where they give you a version of the report with all kinds of mistakes in it and ask you to sort out what's wrong with it. You can only do that if you know the report cold. I also want to mention international standards.
There are a couple of major differences when you do an, a standard unmodified opinion under international standards of auditing. For example, in international standards of auditing. In the introductory paragraph, they also refer to the summary of significant accounting policies and other explanatory information.
So remember that if it's international standards of auditing in the introductory paragraph, they would also refer to a summary of significant accounting policies and other explanatory information in the auditor's responsibility paragraph. They would also state that auditing standards require that the auditor must comply with ethical requirements.
They include that too. And in international standards, you can refer to the fair presentation of the financial statements, or you can refer to financial statements that give a true and fair view. Welcome back in our last class, we went over the standard unmodified opinion word for word, and as I said, it's essential.
That you memorize the unmodified opinion word for word. That is really how you begin your study of reporting issues, because you'll find you come back to it time. And again, because when you study, what modifications have you made to the unmodified opinion? It is so helpful if you know it cold and you can just zero in on the modifications, you'll find it helps you time.
And again, Now, what we want to get into in this class is something that we might add to the unmodified opinion. For example, we might add to the unmodified opinion, an emphasis of matter paragraph, an emphasis of matter paragraph would come in after the opinion paragraph it's not modifying the opinion.
Let me say that again. When there's an emphasis of matter paragraph. It comes after the opinion paragraph because we're not modifying the opinion. It's an unmodified opinion. Now an emphasis of matter paragraph could be required or at the auditor's discretion. Now, when is it used an emphasis of matter paragraph is used for information that is recorded in the financial statement, it's properly recorded.
It's fully disclosed, but emphasis is going to be added because it's essential. To the user's understanding of the financial statements. That's when you need an emphasis of matter paragraph it's for information that's recorded properly in the financial statements, it's fully disclosed, but emphasis is added because it's fundamental.
It's essential to the user's understanding of the financial statements. Now, if you look in the viewer's guide, you'll see the four situations were an emphasis of matter. Paragraph is required. Number one, an emphasis of matter paragraph is required when there's a substantial doubt about the entities ability to continue as a going concern.
And we'll talk about going concern issues later in these classes, but when there's a substantial doubt about the entities ability to continue as a going concern, that is a required emphasis of matter. Paragraph number two, an emphasis of matter paragraph is required when there's a justified. Change in accounting principle that has a material effect on the financial statements.
I think, you know what we're talking about? Let's say a company changes from an old generally accepted accounting principle to a new generally accepted accounting principle. For the same transactions for the same set of circumstances, they changed their inventory costing method from five photo light bulb, light photo FIFO, five photo weighted, average, something like that.
They changed their method of accounting for long-term contracts, from percentage of completion to completed contract or from completed contract to percentage of completion. These situations come up. If there's a justified notice, it's justified change in principle that has a material effect on the statements that is a required emphasis of matter.
Paragraph. Notice this includes a change in entity that would be included in this emphasis of matter. Paragraph, a change in entity, a parent sub have always issued separate statements this year. They want to consolidate their statements. That's a change in the reporting entity, a change in entity.
That would be included in this section. This would also include correcting an error that involves a principle. In other words, you miss applied a principle or you go from an unacceptable principle to an acceptable principle. If it involves an accounting principle, correcting an error, not mathematical mistakes, but if you correct an error that involves an accounting principle, that would be in this section also.
A change in estimate inseparable from a change in principal. And the classic example of that, a change in depreciation methods, a change in depreciation methods is a change in estimate that's affected by a change in principle that would be included in this emphasis of matter paragraph, by the way, not a change in estimate we use to estimate the machine would last for six years.
Now, we think it will last for eight. Just a simple change in estimate is not in this section, but a justified change in principle that has a material effect on the statements. That's a required emphasis of matter. Paragraph number three, if the financial statements are prepared with an applicable, special purpose framework, other than regulatory basis, that's intended for general use, that's an emphasis of matter.
Paragraph. An emphasis of matter paragraph is required. Number four, when subsequently discovered facts lead to a change in opinion. And we'll talk about that later in these classes. But any time subsequently discovered facts have led to a change in audit opinion. That's going to be required a required emphasis of matter paragraph.
Now, an emphasis of matter paragraph
May be used for an uncertainty. It may be used if there's a major catastrophe, it may be used. If there were a significant related party transactions and it may be used if there are significant subsequent events. Now, after the emphasis of matter paragraphs, then there are other matter paragraphs.
So remember it's the opinion. Paragraph followed by emphasis of matter paragraphs. And then after the emphasis of matter paragraphs. There would be other matter paragraphs. Now, when do we use an other matter paragraph? We use an other matter paragraph, and again, it could be required or at the auditor's discretion, we're going to use an other matter paragraph to describe a matter that is relevant to the user's understanding of the audit report or the auditor's responsibility.
When do we use an emphasis of matter paragraph? When do we use that? When we want to emphasize a matter that's. Essential to the user's understanding of the financial statements, but we're going to use an other matter paragraph two, for a matter that's relevant to the user's understanding of the audit opinion or the auditor's responsibility.
Now, again, if you look in your viewers guide, you'll see the nine situations where an other matter paragraph is required. Number one, if the auditor has to restrict use of the audit report, That's a required other matter paragraph number two, if there are subsequently discovered facts that lead to with change and audit opinion.
Now notice that was one of our required emphasis of matter paragraphs. See here, the auditor has a choice if there are subsequently, and we will talk about this later in the class in the classes, but if there were subsequently discovered facts that lead to a change in audit opinion, that will either be a required emphasis of matter paragraph.
Or an other matter paragraph based on the auditor's judgment of its importance, obviously the auditor thinks it's extremely important. It's audit or judgment. It would be more likely to be an emphasis of matter. Paragraph. The auditor thinks it has less importance. It would be an other matter paragraph, but it has to be one of the other.
It's required to be one of the other, but it could be one of the other. Number three, if the financial statements of prior periods are audited by a predecessor auditor and the predecessor auditor's report is not going to be, re-issued not going to be reissued. And again, we'll talk about that later in these classes, but that would be a required of the matter paragraph number four, if the current period financial statements are audited and presented in comparison with compiled statements or reviewed statements.
For prior periods or presented in comparison with prior periods that were not compiled, not reviewed that's required on the matter paragraph number five, if there's a material inconsistency and other information and management refuses to revise the other information presented alongside audited financial statements, that number six, that'd be a required other matter paragraph.
If the auditor chooses to report on supplemental. Supplementary information in the audit report rather than a separate report. Number seven, there'll be another matter paragraph required. If the auditor wants to refer to supplementary information, that's required, it's required supplementary information, and we'll talk about other information and supplementary information later in these classes.
Number eight, there'll be another matter paragraph required. If the auditor has to restrict use of the report, when a special purpose. Financial statements, special purpose financial statements are presented in accordance with contractual or regulatory basis. But again, I'm not talking about a regulatory basis intended for general use.
And then finally, number nine, another matter paragraph would be required to if a report on compliance is included with the audit report, those are the nine situation. Where an other matter paragraph is required. Now, an other matter paragraph may be necessary. Notice first to explain why the auditor cannot withdraw when there's a management imposed scope limitation.
And we will be talking about that. But if the auditor is unable to withdraw from an engagement, when there's an management imposed scope limitation that may require it's up to the auditor's judgment may require an other matter paragraph and other matter paragraph may be necessary when. The auditor is either required or permitted to provide further explanation of their audit responsibility.
And then finally, an other matter, paragraph may be necessary if the auditor is engaged to report on more than one set of financial statements with a different general purpose framework. Now it's important that you study. When an emphasis of matter paragraph is required. And when it may be used, when an other matter paragraph is required or may be used, it is the sort of thing.
The CPA Exam is likely to ask questions, time. And again about these issues, emphasis of matter paragraphs other matter paragraphs, when are they used? Why are they used? Make sure you focus in now, before I see you in the next class. You'll see, at the beginning of the next class, there are six multiple choice questions that have to be done, and it is essential that you answer those six questions before you start that class.
And we talk about the questions together. It's very important that you're an active participant in these classes. Don't just watch the classes passively, take good notes. When there are questions assigned, you get your answers and then we'll discuss them together. You'll find. You get much more out of the classes, if you do those simple things, and this is what we both want.
We both want you to get a lot out of these classes. So before I see you in that next class, I want you to do those six multiple choice questions and get your answers, and then we'll discuss them together. And in the next class, we'll continue our discussion on reporting issues. Keep studying don't fall behind.
And I look to see you in the next class. Welcome back to our discussion on reporting issues. Now, you know that I've assigned six, multiple choice questions that I wanted you to complete before starting this class. If you haven't done that, then shut the class down. Now get your answers before we begin.
That's such an important part of this process. Always get your answers first. Then we discuss the questions. So let's look at number one. Number one says which of the following representations. Does an auditor make explicitly. And which implicitly when issuing an unmodified opinion? How about conformity with GAAP?
That's explicit, right? In the opinion paragraph don't we say, in our opinion, the financial statements referred to above present fairly in accordance with accounting principles, generally accepted in the United States of America. Can't be more explicit than that. How about. Adequacy of disclosures.
That's never said explicitly that's implied. The answer is D that's implicitly, because when we say that the financial statements are presented fairly in accordance with us GAAP us GAAP requires that all disclosures be adequate and complete. We don't mention disclosures, but GAAP requires it. So if the statements are in conformity with us GAAP, Then it is implied that all disclosures are adequate and complete.
Number two, when subsequently discovered facts lead to a change in the auditor's opinion, which of the following must be added to the auditor's unmodified opinion? I hope he went right down to D the basis for an unmodified opinion paragraph. There's no such thing. No such thing as a basis for unmodified opinion, paragraph doesn't exist.
So hopefully right away, you look at D and said, can't be, and you were right now, we're left with a, B and C either an emphasis matter, paragraph a B, and other matter paragraph, or C me either an emphasis of matter paragraph or an other matter paragraph. And you may remember it is see, this is that case.
Yes you are required. To have a paragraph about this. Anytime that subsequently discovered facts have led to a change in opinion, you are required to have an added paragraph to the unmodified opinion. It's true, but they leave it to the auditor's judgment, depending on the level of importance that the auditor places on this item, they can either add an emphasis of matter paragraph or.
An other matter paragraph, it's up to the auditor's judgment answers. C number three. How does an auditor make the following representations when issuing the standard auditor's report the standard on modified opinion on comparative financial statements? How about consistent application of accounting principles?
Is that explicit or implicit? No, it's implicit. When we say that the financial statements are presented fairly in accordance with us, generally accepted accounting principles, us generally accepted accounting principle, us generally accepted accounting principles requires that us GAAP be consistently applied.
We don't say that GAAP was consistently applied. We say that the financial statements were presented. Fairly in accordance with us GAAP, which requires consistency. So that's implicit. How about the others? The second column auditor considers internal control. That's explicit, isn't it? In the auditor's responsibility paragraph.
Don't we say in the auditor's responsibility paragraph that the auditor considers internal control relevant to the entity's preparation and fair presentation of the financial statements in order to design audit procedures, that's explicit in the auditor's responsibility. Paragraph number four, if a client makes a change in accounting principle, that is in separable from a change in estimate.
This material event should be handled in the accounting records as a change in you may remember that when there's a change in estimate effected by a change in principal or inseparable from a change in principle in the accounting records, it's handled as a change in estimate. We don't touch prior periods just going forward.
We make the change prospective only. That's handled in the accounting records as a change in estimate as I'm sure. But is it a or B, is it in the CA is it in the accounting records as a change in estimate and the auditor would add an other matter paragraph? Or is it be a change in estimate? And the auditor would add an emphasis of matter paragraph it's B it's a required emphasis of matter paragraph.
Number five. The following emphasis of matter paragraph was included in an auditor's report to indicate a justified lack of consistency. As discussed in note T to the financial statements, the company changed their method of accounting for long-term contracts. It's a change in principle. How does, how should the auditor report on this matter if the auditor concurred with the change?
What type of opinion, if the auditor concurs with the change, if it's a justified change and the auditor concurs with the change, it's an unmodified opinion. And where would the explanatory paragraph be? Of course, if it's an unmodified opinion, The explanatory paragraph, the emphasis of matter paragraph would be after the opinion paragraph.
And the answer is big because we're not modifying the opinion. So these explanatory paragraphs emphasis of matter paragraph other matter paragraphs come after the audit opinion paragraph, we're not modifying the opinion. So answer B number six, for which of the following events. Would an auditor issue, a report that omits any reference to consistency.
When would we omit any reference to consistency? Answer a change in the method of accounting for inventory. That's a change in principle. We would change the audit report and add an emphasis of matter paragraph. It would be required. So that's not it. They want to know when we would admit any reference.
Two consistency. How about B? I changed from an accounting principle that is not generally accepted to one that is generally accepted. That's correcting an error and if it's correcting an error that involves a principle, it's a required emphasis of matter paragraph. So that, that can't be the answer.
It would not be admitted. D says management's lack of reasonable justification for a change in principle. If there's a lack of justification, that's a consistency problem. If it's not justified, then it's a GAAP problem. It's a GAAP problem. So of course it's going to have to be referred to, and we'll get to that later in the class, but answers see a change in the useful life to calculate the provision for depreciation.
That's just a simple change in estimate, a simple change in estimate. Is not mentioned in the audit report. So if you estimate you use to estimate that a machine would have a useful life of four years, and now you've gained more information, you think it's going to have a useful life of six years. That's a simple change in estimate is not referred to in the audit report at all.
So that's why the answer is C. I want to mention when mention one more thing about the unmodified opinion, just in case. This comes up in the CPA Exam. If the auditor wants to address other reporting responsibilities in the audit report, other than generally accepted auditing standards. Again, if the auditor wants to address other auditing responsibilities in the audit report, other than generally accepted auditing standards.
Before the introductory paragraph, you would now have a heading report on the financial statements that would be. Before the introductory paragraph report on the financial statements. And then after the opinion, paragraph, you would have another paragraph with a heading report on other legal and regulatory requirements.
You might see that now so far, what we've basically said in these classes is that if there's no problem with the financial statements, no problem with financials. And no problem with the audit, the client deserves a clean opinion, an unmodified opinion. What if there is a problem with the financial statements let's get into this.
What if there's a problem with the financials? What if there's a problem with the audit? Of course now an unmodified opinion is not going to be possible. Let's start with a problem with the financial statements. What if you S GAAP. Is not consistently applied. What if there is a significant departure from U S GAAP or whatever, applicable financial reporting framework.
You're testing again, it could be efforts, but we'll stay with us GAAP. It's all with us. GAAP is not consistently applied. If there has been a significant departure from us GAAP, what if disclosures are not adequate and complete? If there's a problem with the financial statements, as I say, it's a different world, because if there's a material GAAP problem, if there's a material GAAP where disclosure problem, the auditor has to issue a qualified opinion, that results in a qualified opinion, if it's a very material pervasive, an all encompassing pervasive GAAP problem, the auditor has to issue an adverse opinion.
So remember that. If there's a material GAAP, problem, qualified opinion, very material pervasive, adverse opinion. If you look in your viewers guide, you'll see an example of a qualified opinion. Notice when you write a qualified opinion, the introductory paragraph. Exactly the same management responsibility paragraph.
Exactly the same. Isn't it. Good. That everything is memorized. You've got that unmodified opinion memorized. So you can just focus in now on the changes, look at the auditor's responsibility paragraph. It is different. Now the auditor's responsibility paragraph concludes by saying, we believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our qualified opinion.
So now we add an explanatory paragraph before the opinion paragraph, because we're modifying the opinion. And it has a heading basis for qualified opinion. So you see the difference in approach. We're now adding an explanatory paragraph before the opinion paragraph because we're modifying the opinion.
And as I say, it has a heading basis for qualified opinion. It says the company's financial statements do not disclose significant related party transactions. In our opinion, disclosure of this information is required. By accounting principles generally accepted in the United States of America. And now we modify our opinion paragraph in our opinion, except for this is an except for qualified opinion, in our opinion, except for the omission of the information disclosed in the basis for qualified opinion, paragraph the financial statements referred to above present fairly in ex it's an except for qualified opinion.
When you go in that CPA Exam, make sure, cold. The changes that have to be made. What if it is a very material pervasive, all encompassing GAAP or disclosure problem? Now the auditor has to issue an adverse opinion and then your viewers guide, you'll see an example of the adverse opinion.
Notice introductory paragraph. Exactly the same management responsibility paragraph. Exactly the same. But the auditor's responsibility now concludes by saying, we believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our adverse opinion. Now, what's coming now.
We have to add an explanatory paragraph before the opinion paragraph, because we're modifying the opinion. This example says as described in note X to the financial statements. The company carries its property plant equipment at appraised values. And of course now the opinion paragraph is very different in our opinion, because of the significance of the matter discussed in the basis for adverse opinion, paragraph the financial statements referred to above do not present fairly.
This is the opposite of a clean opinion. It's an adverse opinion. It is the last thing. The client wants, but apparently in this case has earned it. Why aren't they disclosing that information? They won't disclose it. Then we have to slap them down with an adverse opinion. So you see how you handle problems with the financial statements.
If there's a material GAAP, problem, an except for qualified opinion, very material GAAP, problem, adverse. In our next class, we'll continue our discussion of reporting issues. Keep studying. Don't fall behind. I'll see you in the next class.
Welcome back in this class. We're going to continue our discussion on reporting issues. And you'll remember that in our last class we talked about. What we do in terms of the audit report, if there is a problem with the financial statements, if there's a GAAP or disclosure problem, we know if there's a material GAAP or disclosure problem, the auditor has to issue an except for qualified opinion.
If there's a very material, a pervasive GAAP or disclosure problem, the auditor has to issue an adverse opinion. In this glass, what I want to talk about. Is what we do in terms of the audit report. If there's a problem with the audit, let's start with a scope problem. What if the auditor is unable to obtain evidence?
That's what a scope problem is. It's unavailability of data. The auditor is not able to obtain evidence. And there's inadequate records. The auditor's not able to obtain minutes of meetings. The auditor's not able to observe the inventory count at the end of the year. Something like that. If there's a material scope problem, the auditor issues, an except for qualified opinion, if there's a very material, pervasive scope problem, the auditor has to disclaim an audit opinion.
So remember that. There's a material scope problem, an except for qualified opinion, very material disclaim. Now, what if there's a client imposed scope limitation? The client will not let you confirm their accounts receivable it's client imposed. Of course you ask management to remove the limitation.
Of course, if they won't. You communicate this problem with those in charge of governance. You do that of course. But what if you're stuck with the fact that management will not let you confirm accounts receivable? If it's material and pervasive, the auditor, disclaims an audit opinion. It's that simple.
There's a client imposed scope limitation, and you've communicated this with those. In charge of governance and nothing is done about it. Then you have to decide if it's material and pervasive, it's all encompassing. The auditor would disclaim an audit opinion. Now in international standards, in that situation in international standards, the auditor would be required to withdraw.
Now, if you look in your viewers guide, you'll see an example of an except for qualified opinion. When there's a scope limitation. Remember if there's a material scope limitation, that's an except for qualified opinion. And here's the example in the viewer's guide. And you'll notice right away, introductory paragraph exactly the same management responsibility paragraph.
Exactly the same. But now of course, the auditor's responsibility paragraph has to conclude. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our qualified opinion. And now we're going to add an explanatory paragraph before the opinion paragraph, because it does modify the opinion and it'll have a heading basis for qualified opinion.
In this example, we were not engaged as auditors of the company until after December 31 year one. And therefore we're unable to observe the counting of the physical inventory at the beginning or end of the year as a result. We were unable to determine whether any adjustment might've been necessary in respect to recorded inventories and the elements making up the statements of income changes in stockholders' equity and cash flows.
And now the opinion paragraph it's an except for qualified opinion. So the opinion paragraph is going to say and are in our opinion, except for the possible effects of the matter described. In the basis for qualified opinion, paragraph the financial statements referred to above present fairly. So you can say if it's a material scope problem, you wish you an except for qualified opinion.
Now, if there's a very material, pervasive scope problem, the auditor is going to have to disclaim an audit opinion. And in your viewers guide, you'll see an example of a disclaimer of opinion. When there's a very material scope, limitation, notice the introductory paragraph has changed. Now, the introductory paragraph says we were engaged to audit
the accompanying financial statements of XYZ company management responsibility. Paragraph is unchanged. Now the auditor's responsibility paragraph is changed. Our responsibilities to express an audit opinion on these financial statements based on conducting the audit in accordance with auditing standards generally accepted in the United States of America because of the matters described in the basis for disclaimer of opinion paragraph.
However, we were not able to obtain sufficient, appropriate audit evidence to provide a basis for an audit opinion. And now of course, we're going to add an explanatory paragraph before the opinion paragraph, because we've modified the opinion and it'll have a heading basis for disclaimer. It says due to the introduction of a new computerized accounts receivable system, there were a number of misstatements in accounts receivable.
We were unable to confirm by alternative means. Accounts receivable, which total X in the balance sheet at December 31 year one. And of course now the opinion paragraph has a different heading it's now called disclaimer of opinion as a heading, because of the significance of the, because of the significance of the matters.
Describe the basis for disclaimer of opinion, paragraph, we have not been able to obtain sufficient, appropriate audit evidence to provide a basis for an audit opinion. Accordingly, we do not express an audit opinion on these financial statements. So that's how you handle scope problems. You have a material scope problem, an except for qualified opinion, very material disclaim.
How about an uncertainty? How do we handle an uncertainty? Let me say, first of all, If there's an uncertainty like a lawsuit, and assuming that the auditor was able to obtain sufficient appropriate evidence about the lawsuit, about the uncertainty and assuming it's fully disclosed in the financial statements, then the auditor would issue a standard unmodified opinion and may add it's not required, but may add based on the auditor's judgment, an emphasis of matter paragraph that's.
Your typical uncertainty, the auditor has been able to obtain sufficient appropriate audit evidence about that lawsuit about that uncertainty it's fully disclosed in the financial statements. No problem, standard unmodified opinion, and the auditor, depending on their judgment may add an emphasis of matter.
Paragraph. Let me address this possibility. Let's say there's an uncertainty that's causing a material misstatement in the financial statement. Now, you know how to handle that, right? If there's an uncertainty that's causing a material misstatement in the financial statements it's a GAAP problem. So if it's material and except for qualified opinion, very material adverse, you know that you know your name, that's no problem.
Here's the one that's a little tricky. What if there's an uncertainty caused by the fact that the auditor is not able to obtain sufficient, appropriate audit evidence? That's what's causing the uncertainty. You have an uncertainty caused by the fact that the auditor is not able to obtain sufficient, inappropriate audit evidence about the situation.
Then it's look at it as a type of scope limitation. That's really what it amounts to. If there's an uncertainty that's being caused by the fact that the auditor's not able to obtain sufficient appropriate audit evidence. That's a scope problem. So you know how to handle it. If it's a material uncertainty.
Caused by the auditor's inability to obtain evidence unaccept for qualified opinion. If it's very material, if it's pervasive, you disclaim. Now I want to mention that international standards are a little different international standards of auditing. Say that there could be an interaction of several uncertainties and the interaction of several uncertainties could mean that the auditor is not able to form an audit opinion, even though they were able.
To obtain sufficient, appropriate audit evidence. Let me say that again. In international standards, they concede that it's possible. There could be an interaction of several uncertainties and the result is the audit. The auditor is not able to form an audit opinion, even though they, the auditor was able to obtain sufficient, appropriate audit evidence.
In that case, the auditor would disclaim, even though they were able to obtain sufficient, appropriate audit evidence. But it's important to remember that. Us generally accepted auditing standards with an uncertainty. The auditor only disclaims if they're not able to obtain sufficient appropriate audit evidence.
So remember that in us generally accepted auditing standards, the auditor would only disclaim with an uncertainty if they are not able to obtain sufficient, appropriate audit evidence.
How about a going concern problem? How do we handle that? Remember on every audit, the auditor is responsible to evaluate the audit evidence that they gathered during the audit to determine whether the company, whether the entity
will or will not continue as a going concern. The auditor has that responsibility. They have the responsibility on any audit. To evaluate the audit evidence to determine, is there a substantial doubt about the company's ability to continue as a going concern for a reasonable period of time? What's a reasonable period of time not to exceed one year.
In other words, the auditor is not required to look 10 years out, 20 years out. No, not to exceed one year. Now. What kind of evidence would the auditor consider? To try to determine if there's a going concern problem. They would read minutes of meetings, legal letters, very important. And in your viewers guide, you'll see a list of negative trends.
That might indicate a going concern. Problem, recurring losses, negative cash flows, adverse financial ratios. They're defaulting on raw on loans. They're unable to get. Usual trade credit terms. There are arrearages rearages of dividends. There's pending legal proceedings. They've lost the legal right to a patent.
There's a whole list of negative trends. And then in your viewers guide, you'll see some mitigating factors disposal of assets that would actually might be a good sign where they're trying to dispose of unproductive assets. And concentrate on their more profitable parts of the business. They're restructuring debt.
They are reducing or delaying expenditures. They've increased stockholders' equity, they've acquired more capital they've somehow reduce their dividend requirements. Those would be mitigating factors, but on every audit, the auditor has to look at all the evidence to determine is there. A substantial doubt about the company's ability to continue as a going concern.
All right. So let's get to it. How do we handle a going concern problem? It's a problem with the audit. If there is a material going concern, problem material, not pervasive. If there's a material going concern, problem, the auditor issues, a standard. Unmodified opinion, just a standard unmodified opinion with a required emphasis of matter paragraph, right?
We know that's a required emphasis of matter paragraph. If there is a very material going concern, problem, the auditor, disclaims an audit opinion. And of course I should add that the auditor always communicates this concern to those who are in charge of governance as well. But that's the bottom line with going concern problems.
If there's a material going concern, problem, standard unmodified opinion, but the auditor would be required to add an emphasis of matter paragraph, using that language, raising substantial doubt about the entities ability to continue as a going concern, using that very particular language. But if it's a very material going concern, problem, it's pervasive disclaim.
All right. So let me summarize. Here's the way I want you to think in the audit. It here's the way I want you to think in the CPA Exam when you're in the exam. And you can tell from a question it's not going to be a clean opinion. You break it up in your mind this way. Is it a problem with the financial statements or is it a problem with the audit?
If it's a problem with the financial statements, a GAAP or disclosure problem, you know what to do. If it's a material GAAP, problem, unaccept for qualified opinion. If it's very material. Adverse. That's how you handle prob all problems with the financial statements. But what if it's a problem with the audit?
What if there's a scope limitation? If there's a material scope limitation on material, not pervasive an except for qualified opinion, if it's very material disclaim, how about an uncertainty? The one you were the only uncertainty you're worried about is an uncertainty caused by the auditor's inability.
To obtain sufficient, appropriate audit evidence. So it's really a scope limitation. So if it's a very, if it's a material uncertainty caused by the fact that the auditor is not able to obtain sufficient appropriate audit evidence, you wish you an except for qualified opinion. But if it's very material it's pervasive, it's all encompassing disclaim.
And then finally go and concern. If there's a material going concern, problem. What do you do? Material not pervasive. You issue a standard unmodified opinion, but you are required to add an emphasis of matter paragraph. But if there's a very material going concern, problem disclaim. Now you will notice that before you start the next class.
I want you to do 14 questions. There are 14 questions. I want you to answer. And as always, it's important that you do those questions first, get all of your 14 answers before you start the next class. And I look to see you then
welcome back in this class. We're going to continue our discussion on reporting issues. And I want to begin with the 14 questions that I assigned for you to finish before starting this class. So let's look at these questions. In the first question they say an auditor most likely would express an unmodified opinion and would not add an emphasis of matter or other matter paragraph to the report.
If the auditor EY says wishes to emphasize that the entity had significant transactions with related parties, remember that is an optional emphasis of matter paragraph. So they may add an emphasis of matter paragraphs not required, but they may for significant related party transactions, B says they concur with the entities change in its method of accounting for inventory.
No five photo life. Oh, that's a required emphasis of matter paragraph when there's been a change in accounting principle that has a material effect on the statements C discovers that supplementary information required by. The FASBI has been omitted. We haven't talked about that yet, but as you would probably guess if you omit required supplementary information, that would require an other matter paragraph, as we did discuss in a product, a prior class, anyway, it is required.
Other matter paragraph, it is answer D. If the auditor believes there's a remote likelihood of a material loss from an uncertainty. If it's a remote uncertainty, it wouldn't necessarily even have to be disclosed in the financial statements. So it's highly unlikely that there would be an emphasis of matter or other matter paragraph, not for a remote uncertainty.
Next question, an emphasis of matter paragraph following the opinion, paragraph of an auditor's report describes an uncertainty as follows as disgusted. In note X to the financial statements, the company is dependent in a lawsuit. So they're describing an uncertainty they've added an emphasis of matter paragraph notice following the opinion paragraph.
So they're asking, what type of opinion would this be? It's not adverse or qualified a, B or C because any kind of explanatory paragraph, basis for adverse opinion basis for qualified opinion would be before the opinion paragraph when you're modifying the opinion. No, this would be part of an unmodified opinion.
Answer D. Next an auditor concludes that there's a substantial doubt about the entities ability to continue as a going concern for a reasonable period of time. If the entities financial statements adequately disclose its financial difficulties, the audit report would require an emphasis of matter paragraph.
That's true. That specifically uses the phrase reasonable period of time. Not to exceed one year. No, that remember that the key phrase in the required emphasis of matter paragraph would be raising substantial doubt about the entities ability to continue as a going concern. So there's nothing about to exceed one year.
There's no, in that column, but yes, the phrase going concern is specifically mentioned, and the answer is C.
which of the following conditions or events most likely would cause an auditor to have a substantial doubt about the entities ability to continue as a going concern, a significant related party transactions while significant related party transactions certainly have to be a disclosure, but wouldn't necessarily indicate a going concern problem.
And preferred stock dividends well would be a negative trend. Same thing with D restrictions on disposal of assets is present. That could be a negative trend, not being able to dispose of unproductive assets, perhaps, but see your D wouldn't raise a substantial doubt about the company's ability to continue as a going concern, but answer Baywood, if you can't get usual.
Trade terms. It's a very bad sign. Next, which of the following phrases should be included in the opinion paragraph, when an auditor expresses a qualified opinion. How about the first column? Are we going to see the phrase? When, in, when read in conjunction with note X now, or we go so no, in the first column, second column.
How about with the following, with the foregoing explanation? Now the answer is D double. No. What we say in the opinion paragraph is in our opinion, except for the possible effect of the matter described in the basis for qualified opinion, paragraph, the financial statements referred to above are presented fairly.
And that's what in the opinion. Paragraph these phrases aren't there.
when qualifying an audit opinion because of an insufficiency in audit evidence, a scope problem, an auditor would refer to the situation in the introductory paragraph. No introductory paragraph is unchanged when there's a material scope problem. Remember when there's a material scope problem, it is an except for qualified opinion.
Very material pervasive. We describe it, but introductory paragraph is unchanged. So no, in the first column, how about management's responsibility paragraph? Is that changed? No. Unchanged. How about the second column? How about the auditor's responsibility paragraph? Yes, that's changed. Because now we have to conclude the auditor's responsibility paragraph by saying, we believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our qualified opinion.
So it is changed answer D no. Yes. Next an auditor may reasonably issue an except for qualified opinion for a sculpt limitation. Yes. A material scope limitation. Is it except for qualified opinion? How about an unjustified accounting change? If it's an unjustified accounting change, that's a GAAP problem.
And if it's material will be an except for qualified opinion, very material adverse, but yes, you could issue a qualified opinion for ed. Either of these situations answers CWS. Next due to a scope limitation, an auditor disclaimed, an audit opinion on the financial statements taken as a whole, but the audit, his report included a statement that the current asset portion of the balance sheet was fairly stated.
I think, you know what? This is, it's a piecemeal opinion. It's not allowed, it's not allowed the auditor can't give an adverse opinion or a disclaimer of opinion on the financial statements taken as a whole, but say. But revenues were fairly stated. That's a piecemeal opinion. It's not allowed. Why? Because of answer a, it would overshadow the disclaimer.
It would overshadow the adverse opinion. It would just overshadow the result. That's why piecemeal opinions are not allowed. Compare that to the next question. Harris CPA has been asked to audit and report on the balance sheet. A Fox company, but not on the statement of income retained earnings or cash flows.
Harris will have access to all information. That's important, no scope, limitations. They have access to all information underlying the basic financial statements. Under these circumstances. Harris may see answers see, except the engagement it's limited reporting objectives. That's not a piecemeal opinion.
You can express an audit opinion just on the balance sheet, as long as there are no restrictions. On the scope of the audit, no limitations. You can examine anything you want to examine and then have limited reporting objectives. That's perfectly okay. That is not what is meant by a piecemeal opinion. Again, what's a piecemeal opinion.
The auditor has expressed a disclaimer of opinion on the financial statement, financial statements taken as a whole, or an adverse opinion on the financial statements taken as a whole and then wants to add. Yeah, but the liability section. It's fairly stated. No, it overshadows the auditor's report, overshadows the real conclusion of it, which is a disclaimer or adverse next, when an auditor qualifies an audit opinion because of inadequate disclosure, what's an adequate disclosure, a GAAP problem, not GAAP disclosure.
Problem. The auditor should describe the nature of the omission in a basis for qualified opinion. Paragraph. And also modify introductory paragraph. No, it's unchanged. The auditor's responsibility paragraph. Yes, because now that has to conclude that we believe that the audit evidence we have obtained is sufficient appropriate to provide a basis for our qualified opinion.
Yes. In the second column, how about the third column? How about the opinion paragraph? Of course, that would be, it would be referred to in the. Opinion paragraph, because now the opinion paragraph has to say in our opinion, except for the possible effect of the matter described in the basis for qualified opinion, paragraph the financial statements referred to above present fairly.
So the answer is C no. Yes. You see how important it is, time and again, that, the unmodified opinion cold, and then what modifications are made to that opinion in certain situations. They are very picky next in which of the following circumstances would an auditor most likely express an adverse opinion.
So these four choices, what would most likely lead to an adverse opinion? How about, Hey, the chief executive officer refuses the auditor access to minutes of meetings. We know what that is. That's a scope limitation. So if it's material. An except for qualified opinion. But if it's very material, if it's pervasive, you disclaim, not an adverse opinion.
B says tests of controls show that the entities internal control structure is so poor. It can't be relied upon. That wouldn't necessarily result in an adverse opinion. What it would result in is extensive substansive testing because you can't rely on the client system. Extensive substantive tests, but it may not result in even a qualified opinion.
It's just, you're gonna have to do a lot more testing. D says information comes to the auditor's attention that raises substantial doubt about the entities ability to continue as a going concern. If it's material except for qualified opinion, very material, pervasive, disclaim, no adverse opinion.
Possibility there. Of course, the answer is C the financial statements are not in conformity with GAAP regarding the capitalization of leases. That's a GAAP problem. And if it's very material, if it's pervasive, if it's all encompassing, it would be an adverse opinion. It would be next in a, if a company issues, financial statements that proport.
To present its financial position and results of operations, but they omit the statement of cash flows. The auditor ordinarily would express what it's not a GAAP. Problem GAAP requires the presentation of a statement of cash flows. So if if your client wants to omit the statement of cash flows, that's a GAAP problem.
And generally speaking, that's material, not pervasive, not all encompassing. So it would be a qualified opinion. Answer B next in the first audit of a client, an auditor was not able to gather sufficient evidence about the consistent application of accounting principles between periods between the current and the prior year, as well as the amount of assets or liabilities at the beginning of the current year.
This was due to the client's record retention policies. They have a terrible accounting system. They're not retaining information. They're not retaining records. If the amounts in question could material with that, could materially affect current operating results. The auditor would of course, disclaim.
This is a very material pervasive, all encompassing, sculpt limitation. So the answer is a audit would be unable to express an audit opinion
and then finally, an auditor would express an unmodified opinion with an emphasis of matter paragraph added to the auditor's report for an unjustified accounting change. No, an unjustified accounting change is a GAAP problem. If it's material qualified opinion, very material adverse. So we're talking about a GAAP problem in that situation.
It's not simply adding an emphasis of matter paragraph. How about a going concern problem? Yes. If it's a material going concern problem, it's an unmodified opinion with a required emphasis of matter paragraph. The answer is C no. Yes. I hope you did very well on that group of questions.
Now I want to talk for a minute about subsequent events, as you probably know, a subsequent event is an event that occurs after the balance sheet date, after the balance sheet date, but before you wish you the statements, now, the important thing to remember is that there are two types of subsequent events type one with a type one subsequent event, the conditions did exist.
On the balance sheet date again, with a type one subsequent event, the conditions did exist on the balance sheet date. So I'll give you an example. Let's say the balance sheet date is December 31 year one. And at December 31 year one, the date of the balance sheet, the company was involved in a lawsuit.
They thought it was reasonably possible that they would lose the lawsuit and settle for a hundred thousand. So because it was a reasonably possible contingency. They put a footnote on the year. One statements. Now let's say that suit is settled February 9th of two, year two, after the balance sheet date.
But before they issue the statements, they settle it February 9th, year two for $500,000. This is a type one subsequent event. The conditions did exist on the balance sheet date. Do you see why I say that? Why do I say the conditions did exist on the balance sheet date? Because wasn't this lawsuit pending.
On December 31 year one, this wa lawsuit was pending. It was active December 31 year one. So here's the point because the conditions did exist on the balance sheet date. The company would have to go back and adjust the year. One statements, put a $500,000 loss on the year one income statement and a $500,000 liability on the year one balance sheet.
And of course, a footnote as well. Why do they have to do that? Because the conditions did exist on the balance sheet date. Now I know you're ahead of me with a type two subsequent event type two, the conditions did not exist in the balance sheet date. Once again, let's say the balance sheet date is December 31 year one.
And on February 9th, year two, there's a fire. There's tremendous fire damage and your office building. You see the difference. That is a subsequent event where the conditions did not exist on the balance sheet date. That fire was not raging on December 31 one. So because the conditions did not exist on the balance sheet date, you would not go back and adjust the year.
One statements. That would be a footnote only. Now his, the question now date, your audit report. Let's say the original date of the audit report before you found out about the subsequent event was January 26th. All right. So the original date of your audit report was January 26, but now this subsequent event has come to your attention February 9th.
Here's the problem. If now you just date your report February 9th, the auditor is now taking responsibility for all subsequent events up to February 9th. So the way to get around that is you dual date, your report. You're going to date your report January 26th, year two, except as to note X. Which is as of February 9th, you dual date, it that's the way around that problem.
That's why you do that. That's why you dual date a report. So now the auditor's responsibility is limited to that one event. If they dual date, that's the date of your audit report? January 26th, except as to note X, which is as of February 9th. Now the auditor's responsibility is just for that subsequent event.
What if.
The auditor subsequently discovered facts that have a material effect on the financial statement after they released their audit report. Now, the auditor discovers facts. They subsequently discover facts that have a material effect on the year. One statements. Now, after they've issued their audit report, not that the auditor has no obligation to continue making inquiry.
After they released their audit report, they don't have an obligation to do that. But what if information comes to their attention that has a material effect on the year one statements, and you've already issued your audit report. And if it has a material effect on the statements, you advise your client to issue revised financial statements and a new audit report.
That's what you do. You have to advise your client to issue revised financial statements. And a new audit report. What if the client refuses? If the client refuses, then you have to notify the client that the audit report must no longer be associated with those statements. You notify the client that, that your audit report can no longer be associated with those statements.
You also notify regulatory agencies and you also notify persons that are known to be relying on the state.
I want to talk about a group audit for a moment.
When you audit a group of financial statements or parents up is what I'm talking about. When you audit a group of financial statements, apparent and sub it's possible that one of the components of the group, one of the subsidiaries, maybe the subsidiary is being audited by their own auditor. They're being audited by what we w what we refer to as the component auditor.
All right. So your audit new group of financial statements, it's parent and sub the sub is being audited by a component auditor. So that component auditor is not part of the group engagement team. It's that group auditor, that component auditor is not part of the group engagement team. Now, assuming that the component auditor or the subsidiaries auditor no is independent.
You've determined, they're independent, they're competent now. Here's what the principal auditor, for the group engagement team has to decide the principal auditor, with the group engagement team has to decide whether to assume responsibility for the work of the component auditor or divide responsibility.
And if you look in your viewers guide, you'll see what it means to the audit report. If the principal auditor with the group engagement team decides to divide responsibility. If they decide to revise, revise, responsibility, notice introductory paragraph is exactly the same management responsibility paragraph.
Exactly the same, but notice the auditor's responsibility paragraph. We did not audit the financial statements of X, Y company, a wholly owned subsidiary whose assets constitute X. You show the magnitude. These statements were audited by other auditors whose report has been furnished to us. You're clearly dividing responsibility and then notice the opinion paragraph in our opinion, based on our audit and the report of the other auditors, it's a clear division of responsibility.
Now, if the principle auditor with the group engagement team decides to assume responsibility for the work of the component auditor, if they just decide to assume response the assumption of responsibility of the work of that component auditor, then. They just issue their, a pet, their standard opinion with no mention made of the component.
Auditor, no reference to the component auditor's report. Cause because if they, you did start referencing the component auditor's report, that could be misinterpreted. You just issue your normal audit report without any reference whatsoever to the component auditor. Now, before. I see you in the next class, make sure you do the four questions that I've assigned and get your answers, and as always keep studying and don't fall behind and I'll look to see you in the next class.
Welcome back to our discussion on reporting issues. And I want to begin this class by going over the four questions that I assigned. First question says on August 13th, the CPA obtained sufficient appropriate audit evidence to support an audit opinion on a client's financial statements for the year ended June 30th.
So that would be the date of the audit report. Then an August 27th out event came to the CPA's attention that should properly be disclosed by the entity, but. The CPA decided not to dual date, not to dual date, the audit report and dated the report just August 27th. Under these circumstances, the CPA was taking responsibility for a all subsequent events up to August 27th.
If you don't dual date, if you're now just date your report, August 27th, then you are taking responsibility for all subsequent events up until that day. Next. Zero corporations suffered a loss that would have a material effect on its financial statements on an uncollectible trade account receivable due to a customer's bankruptcy.
This occurred suddenly because of a natural disaster. You know what? This is, it's a type two subsequent event where the conditions did not exist on the balance sheet date. It's a natural disaster, 10 days after zero's balance sheet date. But one month before the issuance of the statements and the auditor's report under these circumstances, how about the first column?
The financial statements should be adjusted? No, it's not a type one. It's a type two subsequent event would be just disclosed in the current year financial statements, but no adjustment would be made. Next column. The event requires financial statement disclosure. Disclosure, but no adjustment. Yes. We agree with that third column, the auditors report should be modified because of a lack of consistency.
This is not a consistency problem. It has nothing to do with consistency. Next, the auditor's responsibility, paragraph of an auditor's report contains the following sentence sentences. We did not audit the financial statements of easy, Inc. A wholly owned sub. Which statements reflect total assets and revenues, constituting 27% and 29% respectively of the related consolidated totals.
Those statements were audited by other auditors. You know what? This is, it's a division of responsibility, answer a that's really the choice that has to be made when there's a component auditor. Does the principal auditor, the group engagement team assume responsibility for the work of the other auditors or divide responsibility.
That paragraph indicates a division of responsibility. Okay. Pell CPA decides to serve as the principal auditor in the audit of the financial statements of tech consolidated, Inc Smith, CPA audits. One of the subsidiaries. In which situation would Pell make reference to Smith's audit. Now, just as a general matter, when are you going to make reference to the work of the other auditor when you divide responsibility?
So the first statement says Pell reviews, Smith's work papers and assumes responsibility. If Pell assumes responsibility for Smith's work, no mention will be made. There'll be no reference to Smith's work at all. Pell is assuming responsibility for the work of Smith. How about number two? Pellas and I unable to review Smith's Workpapers so your doubt, very strongly they'd assume responsibility without being able to look at the Workpapers however Pell's inquiries indicate the Smith has an excellent reputation, professional competence and integrity here is where you would divide responsibility.
And there would be a re a reference to Smith's audit, answer B number two only. What do we do if you want to, if we want to update an audit opinion, let's say we're auditing year two. Now we also audited year one. And in year one we gave a qualified opinion and now the client has restated the year one statements and a qualified opinion is no longer appropriate.
We really should change that opinion for year one from qualified to unmodified. The way this is handled when just remember anytime there's a change, in opinion, remember that's the case. That's either an emphasis of matter paragraph or an other matter paragraph. It's up to the judgment of the auditor.
And again, anytime there's a, you want to change an audit opinion like this
and in that case, Depending on the importance that the auditor places on this, it can either be an emphasis of matter paragraph or other matter, but it has to be one of the other. So whatever paragraph it is, you will disclose the date of the previous report. The type of previous report was qualified.
The reason why it was qualified, the change that has occurred and a statement that the opinion is now different than the one expressed. In the previous audit report.
What if the prior period was audited by what we call a predecessor auditor you're auditing year two and year one was audited by a predecessor auditor. The predecessor auditor can simply reissue their audit report. If you're auditing year two and year one was audited by what is called a predecessor auditor, and the client wants to show comparative financial statements.
They want to show the year two statements in comparison to your one statements. The predecessor auditor can reissue their audit report. Assuming it's still appropriate. Now the predecessor auditor. No the year one auditor would have some obligations. The predecessor auditor has the obligation to read the current financial statements, compare the current financial statements with the prior year.
And, see if there's been any major changes. The predecessor auditor has to obtain a letter of representation from us. We're called the successor auditor. So the year one audit, excuse me. Yeah. The year one audit of the predecessor auditor. Has to obtain a letter of representation from the year two auditor, the successor auditor and Lisa, the, that letter of representation in that letter of representation, the successor auditor has to state whether, the current audit revealed any matters that in the successor auditors opinion would.
Have a material effect on the, your one statement. So it should be disclosed in the year. One statements. Also the predecessor auditor has to obtain a management representation letter, a letter of representation from management stating if any previous representations back in year one would have to be modified, whether there's been any subsequent events that require adjusting the year, one statements or should have been disclosed in year one.
Now, if there are no changes to that original report, no changes to the year one audit report, then, if it's unrevised, then that audit report would be issued with its original report date. If it is revised, you would dual date. That's simply how it's handled. If. The original audit report. The year one audit report, the predecessors report is issued as is it's not revised in any way.
It would just be dated using the original date of the report. If it is revised, you would dual date. Now what if the predecessor auditor's report is not going to be re-issued. If the predecessor auditor's report is not going to be reissued, then it's a required other matter paragraph that would be a required other matter paragraph in the year two audit report.
Saying that the financial statements of the prior period were audited by a predecessor auditor, not named the type of opinion that was issued. If there were any modifications, why there were modifications, the nature of any emphasis of matter paragraph and also the date of the predecessor auditor's report.
What if the prior period, where the year two auditors? What if you're one. Was not audited. What if year one was reviewed or compiled to a different level of service? So again were auditing year two. It turns out year one was not audited. It was reviewed or compiled a very different level of service.
And let's say that the prior year report is not going to be reissued. That would be a required other matter paragraph you'd have to disclose in the other matter paragraph, which has required the. Service that was performed in the prior period. The date of the prior period report. Describe any material modifications in that report, state that the service, whether it's a reviewer compilation is less in scope than an audit and not, and does not provide a basis for an audit opinion.
You state that it's a different level of service and it does not provide a basis for an audit opinion. What if the year one statements were not reviewed compiled or audited? If the year one statements, if the prior year statements were not reviewed compiled or audited, then that would be a required other matter paragraph.
And you'd have to state that the prior year was not audited reviewed or compiled. The financial statements of that prior year would have to be clearly marked know, not audited reviewed or compiled and. You would state in that other matter paragraph that the auditor is not assuming any responsibility for those statements.
You state that in your other matter, paragraph that you as a CPA are not assuming any responsibility for that prior period.
Let's talk about other information. Other information in a document that contains the audited financial statements. For example, sometimes, or almost hallways audit and financial statements would be included in the annual report to shareholders. That's what happens that the audited financial statements would simply be included in the annual report to shareholders.
So there's other information. Now, the auditor is not required to determine if the other information is properly stated. That's not a requirement for the auditor. The auditor does have some obligations, though. The auditor is obligated to read the other information, to determine if there's any material inconsistency, by the way, I'm not talking about the website or press releases.
That's not what we're talking about. This is again, other information presented alongside. The audited financial statements. What if the auditor does identify a material inconsistency in the other information? If the financial statements need revision, the auditor has identified a material inconsistency, with the financial statements and that other information.
And if the financial statements need revision and management will not do it well, then the auditor would have to modify their opinion. What if the other information needs revision and management refuses, while you would communicate with those in charge of governance and you would have to add a required other matter paragraph, describing the inconsistency, you could also withhold the audit report.
You could withdraw, if there was fraud involved, the statements were misleading. And in the other matter, paragraph, the auditor can disclaim an audit opinion on the other information. Let's talk about supplementary information. Okay. Supplementary information is information outside the basic financial statements that would be presented in a document that includes the audited financial statements.
And it is possible that the auditor could be engaged. To report on the supplementary information in relation to the financial statements as a whole, that's possible where you as an auditor can be engaged to report on supplementary information. In relation to the financial statements taken as a whole here would be the objectives.
If the auditor is engaged to report on supplementary information, they have two objectives. Number one, evaluate the presentation of the supplementary information. In relation to the financial statements and number two report, whether or not the supplementary information is fairly stated in relation to the financial statements.
And by the way, the, in order to do this report on supplementary information, the financial statements must have been audited by the auditor. And there can't have been an adverse opinion or a disclaimer of opinion.
also, the auditor would require a letter of a management representation letter
regarding supplementary information and management must include the audit report on supplementary information in any document that contains the supplementary information. And the audited financial statements that has to be a requirement that management will include the audit report on supplementary information.
Anytime they have a document that contains supplementary information. All right. So what are the audit procedures? If you're going to do a report on supplementary information, what are your basic audit steps? You would first inquire of management, the purpose of the supplementary information and any significant assumptions that they made.
You would obtain that management representation letter about supplementary information. You would evaluate the form and the content of supplementary information with the established criteria, you would reconcile the supplementary information to the audited financial statements, and then finally evaluate the supplementary information for completeness and appropriateness.
Those are the basic five steps again, inquire of management, the purpose of the supplementary information. And then the assumptions that were made to obtain a management representation letter regarding supplementary information, three, evaluate the form and the content of supplementary information with established criteria for reconcile, the supplementary information to the audit and financial statements, and five evaluate the supplementary information for completeness and appropriateness.
Now this report on supplementary information can either be a separate report. It can be a separate report. Or an other matter paragraph. What if there's a material misstatement in the supplementary information and management refuses to revise it? Then you would, as a, as the auditor, you would modify your opinion on the supplementary information.
And if it is a separate report, you could withhold the report. Now there could be required supplementary information. If supplementary information is required. The auditor is required to perform limited audit procedures. They have to inquire of management about supplementary information and determine if it was prepared in it prepared, using established criteria or guidelines, consistent with the financial statements and obtain a management representation letter about the required supplementary information.
I don't remember now, the auditor is not required to audit supplementary information. Auditor's not required to audit required supplementary information, but they have to perform limited procedures and there would be a required other matter paragraph. The other matter paragraph would state that required supplementary information has been included or omitted.
If it were admitted that the auditor did apply the required procedures. You would disclose any material departures from the established criteria you would state any unresolved problems or doubts. And the auditor may disclaim on the required supplementary information. Now, if the auditor is engaged to report on required supplementary information, that's possible.
If the auditor actually has an engagement. To report on required supplementary information. You follow the same steps. We just went over those same five steps, inquire of management, the purpose of the supplementary information and the assumptions that are made, obtain a written mint management representation letter regarding the supplementary information, evaluate the form and the content of supplementary information in relation to the established criteria, reconcile the sup supplementary information to the financial statements.
And evaluate the supplementary information for completeness and appropriateness. And once again, it's going to be reported as either a separate report or an other matter paragraph. And if there are a material misstatements in the supplementary information and management refuses to revise the supplementary information, then the auditor would modify the report.
It was an engagement. They could modify the report on supplementary information and even withhold the report. If it's a separate report,
they say after issuing an auditor's report, an auditor has no obligation to make continue inquiry, continuing inquiries, concerning audit and financial statement. That's true. The audit report is issued. The auditor has no obligation to continue making inquiry. On less. How about a information about a material transaction that occurred just after the auditor's report was issued is deemed to be reliable?
That's next year's transaction. Remember this question started out after issuing the audit auditor's report. This is not a subsequent event. Remember subsequent event is an event that occurs after the balance sheet date, but before we issue the statements here, we've entered the statement.
We don't have any obligation for that material transaction. That's next to your transaction. B a final resolution is made of a contingent liability that had been fully disclosed in the financial statements by no that's next year's activity. We've issued the statements we've issued. The audit report D on event occurs just after the auditor's report was issued.
That affects the ability to continue as a going concern. That will have to be disclosed in next year's audit report. Now the answer is C. If information that existed at the report date, now there's information that existed at the report. Date comes to the auditor's attention and could affect the auditor's report.
That's very different. You'll have to, you may have to notify the client that this audit report can no longer be associated with those financial statements and tell the client they have to issue revised financial statements. With a re with a revised audit report, then there is an obligation answer.
See, next, the predecessor auditor, who was satisfied after properly communicating with the successor auditor has reissued their audit report because the audit client desires, comparative statements, the predecessor's auditor's reports should make notice a, B and C referenced to the work of the successor.
Auditor. That's never going to happen. The predecessor auditor's report is never going to make a reference to the successor auditor ever. The answer D makes the answer's date. It makes no reference to the report of the work of the successor auditor. So that's simple next, a former client requests, a predecessor auditor to reissue an audit report on a prior periods, financial statements, the financial statements are not restated and the report is not revised than what date.
Sure. The predecessor auditor use in the reissued report, answer a, the original date of the report. The date that the prior, the date of the prior period report, it's that simple. If it was revised, you would due date. If that prior report is going to be revised for any reason, you would do all day, but this was not revised next.
An auditor concludes that there is a material inconsistency in the other information, in an annual report to shareholders that also contains audited financial statements. The auditor believes that the financial statements do not require revision, but the client is unwilling to revise or eliminate the material inconsistency in the other information.
Under the circumstances, what action would the auditor most likely take? ACE has considered the matter closed? That's not, it B says issue and except for qualified opinion on the financial statements, as far as we know are fairly stated here, C says disclaim, an audit opinion on the financial statement, it's not going to affect your opinion on the financial statements.
The answer is D you'd revise the audit, his report to include a required other matter paragraph. Describing the material inconsistency. That's what would happen. You'd simply have that required. Other matter paragraph that would describe the inconsistency next. What is an auditor's responsibility for supplementary information, such as the disclosure of pension information, which is outside the basic financial statements, but is required by the GASB.
So we're talking about required. Supplementary information. What is the auditor's responsibility a says the auditor should apply substantive tests, no limited audit procedures, not substantive tests. B says the auditors should apply certain limited procedures to the supplementary information and include an other matter paragraph in the audit report to refer to the required supplementary information.
Yes, answer B. And then finally one more. Under which of the following circumstances would the expression of a disclaimer of opinion would be appropriate, be excuse me, inappropriate. So one is a disclaimer, inappropriate. A, the auditor is unable to obtain audited financial statements of a sub of an investee.
That's a scope limitation. And if it were very materials that were presented pervasive, then a disclaimer would be appropriate. Not inappropriate. C says. The company failed to make account of their physical inventory. During the year, auditor was unable to apply alternative procedures, to verify inventory quantities.
That's a scope limitation. It's very material. If it's pervasive, a disclaimer would be appropriate. D says management refuses to allow the auditor to have access to the company's canceled checks and bank statements. It's a scope limitation. If it were very material, but were pervasive. A disclaimer would be appropriate by the answer.
B management does not provide reasonable justification for a change in principle. That's a GAAP violation and a GAAP violation is either going to be a qualified opinion for a material GAAP problem. Or if it's very material, if it's pervasive, adverse Noah disclaimer would be inappropriate for answer B, keep studying don't fall behind.
And I looked to see you in the next class. Welcome back in this class, we're going to discuss fraud, committed by clients and non-compliance with laws and regulations committed by clients. Let's begin with fraud. That the objective of an audit is to provide reasonable assurance.
That the financial statements are free of material misstatement, reasonable assurance that the financial statements are free of errors and fraud. That's our objective. But of course there's an enormous difference between errors and fraud, because fraud is intentional fraud by definition is intentional deception of the users of financial information, intentional deception.
Of the users of financial information. We know that management is responsible for the detection and the prevention of fraud. The auditor is responsible to provide reasonable assurance that the financial statements are free of errors and fraud. And the auditor has to be aware of the risk of fraud throughout the audit.
Starting with the planning phase. When you start an audit, there should be no preconceived notions about management's integrity. In other words, the audit at the beginning of an audit should have a high degree of skepticism. The audit team should discuss how and where fraud could occur at every client on every audit.
You should be aware of the risk factors. That might indicate possible fraud. And of course the basic rule of thumb is change equals risk. Anytime there's a change, risk goes up. So you look for a high turnover in the company or in a department, when there's a lot of new employees coming and going, no.
Are employees really aware about what's going on? It's easier to commit fraud. So look for a high turnover in the company or in a department, that's a risk factor. That's a red flag, new technology, a downturn in the economy. So employees are tempted to take shortcuts, aggressive earnings, projections, same thing.
If there are aggressive earnings, projections, employees might be tempted to take shortcuts. Look out for negative cash flows, offshore holding companies, increased competition. Again, the general is change equals risk when something changes the risk of errors and fraud rises. Now, when we do an audit.
We have to assess control risk and the auditor should assess control risk. In light of the risk of fraud, the auditor should include unpredictable audit tests in the audit. In other words, don't do the same audit tests every year. And the auditor should test situations where management can override controls.
In other words, the auditor should examine journal entries, adjustments where management has over written the controls. And of course, remember the auditor is required to document the consideration of risk
of fraud in the work papers. Now, generally there are two types of fraud. First there's fraudulent financial reporting. What do we mean by fraudulent financial reporting? This is intentional deception of the users of financial information. In other words, material mistakes, or omissions in the financial statements to deceive the users, that's called fraudulent financial reporting, material, mistakes or omissions in the financial statements to dis meant to deceive the users.
Now, if the auditor suspects. Fraudulent financial reporting, the auditor should do extensive substantive testing. The other category of fraud is asset misappropriation. In other words, theft, and if the auditor suspects, asset misappropriation or theft, the auditor should do more tests of controls, especially on assets that have a high degree of inherent risk.
You know what inherent risk is? The risk that a given account by its very nature could be subject to fraud. So if the auditor suspects, asset misappropriation, the auditor should do much more testing of controls, especially on assets with a high degree of inherent risk. And also the auditor should do targeted analytical procedures.
Also, it's important to remember that an audit done under us generally accepted auditing standards may not detect fraud. That's why we have detection risk. Detection risk is it's the risk that the auditor will fail to detect errors and fraud that do in fact exist. That's why we have audit risks.
Ultimately the risk that we give an unmodified opinion, a clean opinion. And yet the financial statements are materially misstated. So an audit done under generally accepted auditing standards may not detect fraud. We have to accept that. Now, if fraud does exist, if fraud does exist, the auditor has to inform the appropriate level of management and those in charge of governance.
Even if it's insignificant, remember fraud. Is always a big deal, always. So even if it's immaterial insignificant, if there's fraud, the auditor has to inform the appropriate level of management and those in charge of governance. If senior management is involved with the fraud or the financial statements are materially misstated.
Of course the auditor should immediately inform those in charge with governance and. Consult legal counsel about any obligations to informed third parties. Let's talk about illegal acts. When I say illegal acts, I'm talking about non-compliance with laws and regulations by the client.
Non-compliance with laws and regulations by an act of omission or commission by the entity. Could it be intentional or unintentional committed in the name of the entity or on behalf of the entity by those in charge of governance, by management, by employees. And of course, the problem with noncompliance with laws and regulations is that it can result in fines or significant litigation.
The. Client is responsible management is responsible for ensuring that the entity complies with all laws and regulations. The auditor's responsible to provide reasonable assurance that there has been no noncompliance with laws and regular regulations that have a direct material effect on the financial statements.
Now non-compliance with laws and regulations that have an indirect. Effect on the financial statements, like some obscure environmental regulation, it's beyond the scope of the audit. Now, if the auditor does discover noncompliance with laws and regulations that have a material effect on the financial statements, the auditor has to consider the effect on the internal control environment management integrity.
The auditor has to consider whether disclosures have been. Complete, whether the audit report should be modified as a qualified opinion, an adverse opinion. And of course, if the client won't take corrective action, the audit should withdraw. Keep studying. I'll look to see you in the next class. Now, as you probably know, you really begin.
Your study of reporting issues by studying and memorizing the standard unmodified opinion. And hopefully you've already had our class on the unmodified opinion, but just to start us off to get us in the mood, to get us in the right frame of mind, I want to go over the standard unmodified opinion. And in fact, I want to start with this question.
How does a client. Earn an unmodified opinion. How does a client deserve an unmodified opinion? Basically there are six requirements. If your client meets six requirements, your client gets an unmodified opinion, a clean opinion. Number one, there can't be any significant departures from us GAAP or whatever the appropriate.
Whatever the applicable financial reporting framework is that you're testing whatever it might be, but that's number one, there can't be any significant departures from U S GAAP in this class. We'll assume that the framework is U S GAAP. Number two, us GAAP, or the framework must have been consistently applied between accounting periods.
Number three, there must be adequate and complete disclosures. Number four, there can't be any significant uncertainties, no significant uncertainties. Number five, no significant scope, limitations. And number six, no significant going concern problems. If your client meets those six requirements, the client gets a clean opinion, an unmodified opinion.
Now when you break those down, you look at those six requirements. If you look at the first three, no significant departures from us GAAP or whatever the framework is. Number two, us GAAP with a framework must've been consistently applied, number three, adequate and complete disclosures. Aren't we really saying in the first three, that there can't be any problem with the financial statements.
It's really that simple. That can't be any problem with the financial statements. And if you look at the last three, No significant uncertainties, no significant scope, limitations, no significant going concern problems. Aren't we saying in the last three, no problems with the audit. That's really what it boils down to.
If there are no problems with the financial statements, no problems with the audit, the client gets a clean opinion, an unmodified opinion. So let's take a quick look at a standard unmodified opinion in the viewer guide. You'll see an example. Of the standard unmodified opinion. Notice the heading independent auditor's report.
This, if an auditor, if a CPA is going to provide any kind of assurance on financial information of any kind, the CPA has to be independent, in fact, independent in appearance. So right in the title, independent auditor's report. And remember our goal in an audit. Is to provide reasonably positive assurance that the financial statements are free of material misstatement, reasonably positive assurance, that the financial statements are free of errors and fraud.
That's what it comes down to. And as I say, if the CPA is going to provide any type of assurance on financial information, the CPA has to be independent. So there it is right in the title, independent auditor's report. It's addressed to the company it's addressed to the board of directors, the shareholders, but never management.
Of course, we start with the introductory paragraph. We have audited. We make it very clear. What we've done. This is not a review. This is not a compilation. We have audited the accompanying financial statements of XYZ company, which comprise the balance sheet as of December 31 year one. And the related statements of income changes in stockholders' equity and cash flows for the years that ended and the related notes to the financial statements.
That's the introductory paragraph. Then there's the management responsibility paragraph. We're going to make it very clear. What management is responsible for, what the CPA, what the auditor is responsible for. So the next paragraph is the management responsibility. Paragraph management is responsible for the preparation and fair presentation of these financial statements in accordance with accounting principles generally accepted in the United States of America.
This includes the design implementation and maintenance of internal control, relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error, then next of course, Is the auditor's responsibility. Paragraph. Our responsibility is to express an audit opinion on these financial statements.
Based on our audit, we conducted our audit in accordance with auditing standards, generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements.
The procedures selected depend on the auditor's judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error in making those risk assessments, the auditor considers internal control relevant. To the entities preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate and the circumstances, but not for the purpose of expressing an audit opinion on the effectiveness of the entities and journal control accordingly, we express no such opinion on audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management as well as evaluating the overall presentation of the financial statements.
We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. And then finally, the opinion paragraph itself, in our opinion, the financial statements referred to above present fairly. Remember this is a clean opinion. This is an unmodified opinion present fairly in all material respects.
The financial position of XYZ company as of December 31 year one, and the results of its operations and its cash flows for the year, then ended in accordance with accounting principles, generally accepted in the United States of America. The report is dated no earlier than the date on which the auditor has obtained sufficient appropriate evidence on which to base the audit opinion.
Now, after the opinion, paragraph. The auditor may add an emphasis of matter paragraph to emphasize information. That's fundamental to the user's understanding of the financial statements. That's what the auditor is doing. When the auditor adds an emphasis of matter paragraph, this is information that's properly presented and disclosed in the financial statements, but the auditor wants to emphasize the information to aid the user's understanding of the financial statements.
Now, after the. Opinion paragraph and any emphasis of matter paragraph the auditor may add an other matter. Paragraph an other matter paragraph is the aid, the user's understanding of the audit report or the auditor's responsibility. Now, as we said, if the client needs six requirements, the client gets a clean opinion.
The client gets an unmodified opinion. And as we broke it down, the first three requirements were saying, there's no problem with the financial statements. The last three requirements were saying, there's no problem with the audit. That's what it comes down to when there's no problem with the financial statements, when there's no problem with the audit, client gets clean opinion.
Client gets an unmodified opinion, but what if there is a problem with the financial statements? I think, if there is a significant departure from us GAAP, if us GAAP has not been consistently applied. If disclosures are not adequate and complete, if there is a GAAP disclosure problem, you know what to do.
If there's a material GAAP or disclosure problem, the client gets an except for qualified opinion. If it's very material, if there's a very material GAAP or disclosure problem, it's PR it's pervasive. Client gets an adverse opinion, really very simple. There's a material GAAP or disclosure problem. Client gets an except for qualified opinion, very material pervasive adverse.
Now, what if there's a problem with the audit? Know what, if there is a scope problem? What if there is a going concern problem? What if the, what if there is a problem with the audit? Let's start with a scope problem. The auditor is not able to gather evidence is on availability of data. If there's a material scope problem, the client gets an except for qualified opinion.
If it's very material, a very material scope problem, pervasive, the auditor has to disclaim an audit opinion. How about a going concern problem? If there's a material going concern problem, the client does get an unmodified opinion. Again, a material going concern problem. Means that the client would get an unmodified opinion, but there would be a required emphasis of matter paragraph with that language.
We know. So well, raising substantial doubt about the entities ability to continue as a going concern. Now let's talk about uncertainties. If there's an uncertainty causes the financial statements to be materially misstated, that's possible. If there's an uncertainty. That would cause the financial statements to be materially on materially misstated.
Then that's a GAAP disclosure problem. So if it's material and except for qualified opinion, if it's very material, if it's pervasive, adverse opinion, but what if there's an uncertainty because the auditor is not able to gather enough evidence if there's an uncertainty, because the auditor's not able to gather enough evidence.
Then that's a scope problem. Isn't it? Yeah, you're right back to basically a scope problem. So if it's material except for qualified opinion, if it's very material, if it's pervasive, the auditor would have to disclaim an audit opinion. Now, once you're comfortable with the unmodified opinion, you have the unmodified opinion firmly in your mind, you're ready to move on to other reporting issues.
And we'll get into other reporting issues in our next segment. We'll see you then
welcome back in this section. We're going to begin our discussion about engagements other than an audit of a complete set of financial statements under us GAAP, or I firs, or another general purpose framework. We're going to begin our discussion on reports on. Special purpose financial statements. Now, when you talking about special purpose financial statements, there are four main areas.
Number one, there would be an audit of financial statements prepared in accordance with a special purpose framework. That's number one, an audit of financial statements prepared in accordance with a special purpose framework. Number two, there would be audits of a single financial statement. And specified elements, accounts, or items of a financial statement.
Number three would be reports on compliance with aspects of contractual agreements or regulatory requirements in connection with audited financial statements. And then number four would be reports on summary financial statements. Now we're going to begin with number one. Because it is the most heavily tested of those four areas.
Remember number one would be audits of financial statements prepared in accordance with a special purpose framework. There are five special purpose frameworks. Number one would be the cash basis of accounting. Number two would be the tax basis. Number three would be regulatory basis. Number four would be.
Any other basis of accounting with a definite set of logical criteria applicable to all material items in the financial statements like price level. Now those first for cash basis, tax basis, regulatory basis, and any other basis, like price level with a definite set of criteria, we normally refer to those first four as boas.
Oh, C B O a other comprehensive basis of accounting, other than us GAAP. Think of those first bore as Bowen's other comprehensive basis of accounting, other than us GAAP. And number five would be contractual basis. Now, if you look in your viewers guide, you'll see an example of a report.
On financial statements prepared in accordance with the cash basis of accounting now, because you have studied and memorized the standard unmodified opinion, you're in a very good place now, because once you have that down now, when you study an area like this, you can just focus in on the differences.
And if you look in the viewer guide, you'll see an example of this report and the differences are underlined. Notice in the introductory paragraph, you can't use GAAP terms because this is not us GAAP. This is a special purpose framework. This is the cash basis. So you don't say balance sheet. Notice we say a statement of assets and liabilities arising from cash transactions.
Can't say balance sheet. That's a GAAP term. You can't say statement of income changes in stockholders' equity statement of cash flows. No. It's the related statement of revenues collected and expenses paid. Notice the management responsibility, paragraph management is responsible for the preparation and fair presentation of these financial statements in accordance with the cash basis of accounting described.
In note X, this involves determining that the cash basis of accounting is an acceptable basis. For the preparation of the financial statements in the circumstances, management is also responsible for the design implementation and maintenance. Then it's the same. After that point, notice the auditor's responsibility, paragraph unchanged, and then finally the opinion paragraph, in our opinion, the financial statements referred to above present fairly.
This is a clean opinion, an unmodified opinion in all material respects. The assets and liabilities arising from cash transactions and its revenues collected and expenses paid in accordance with the cash basis of accounting described. In note X notice, once again, there can't be any GAAP terms. Now, after the opinion paragraph, now there would be a required emphasis of matter paragraph stating that the financial statements have been prepared in accordance with a special purpose framework.
It would refer to the note in the financial statements that describes the framework and States that the special purpose framework, the cash basis is a basis of accounting other than U S GAAP. It's an octopus. Okay. Now there would be a required other matter paragraph, listen carefully. Now there would be required.
Other matter paragraph that restricts use. If the special purpose framework is regulatory basis, not intended for general use. Let me say that again. You would have a required other matter paragraph that restricts use of the report. If the special purpose framework is regulatory basis, not intended for general use because.
And in that case, it's restricted to the parties within the entity and the regulatory agency. If it's not intended for general use and its regulatory basis, this report is going to be restricted to parties within the client, within the entity and also regulatory agencies. Also, if it's contractual basis, if the special purpose framework is contractual basis, the is going to be limited to the parties in the contract.
now keep in mind that even though a special purpose framework is being used here, we've done an audit. What, if there's a problem with the financial statements, what if instead of a GAAP problem, what if there's an Aqua problem? You know what to do. If there's a problem with the financial statements, if it's material a qualified opinion, if it's very material, if it's pervasive, adverse opinion, what if there's a problem with the audit?
All these issues arise again. What if there's a scope problem? You know what to do a material scope problem, a qualified opinion. If it's very material, if it's pervasive, disclaim, what if there's a going concern problem? If it's a material going concern, problem, the client gets an unmodified opinion with a required emphasis of matter paragraph.
If it's very material, if it's pervasive disclaim. And then one more time. How about uncertainties? If there's an uncertainty that's causing the financial statements to be materially misstated that's a knock power problem. So if it's material qualified opinion, very material adverse. But if there's an uncertainty caused by the fact that the auditor is not able to obtain sufficient evidence, it's a scope problem.
So if it's material qualified opinion, if it's very material disclaim, my only point is not to forget that we've done an audit here, even though these are special purpose financial statements, they're using a special purpose framework. We have done an audit. Now, if you look in your viewers guide, You'll see an example of an audit report done for financial statements that were prepared in accordance with the tax basis of accounting, the basis of accounting they using for tax purposes.
And once again, the differences from the standard unmodified opinion are underlined. So you can focus right in on the differences. Once again, notice in the introductory paragraph. You can't use GAAPter in the management responsibility paragraph, we say that management is responsible for the preparation and fair presentation of these financial statements in accordance with the basis of accounting use for income tax purposes, the auditor's responsibility, paragraph unchanged.
So you know that anyway. And then in the opinion, paragraph, you can't use GAAP terms, and we're going to say that. The statements are presented fairly in accordance with the basis of accounting used for income tax purposes described in note X and notice the required emphasis of matter paragraph stating that the financial statements have been prepared in accordance with a special purpose framework, refers to the note in the financial statements that describes the framework and States that the special purpose framework is a basis of accounting, other than us GAAP.
And then finally, you'll notice in your viewers guide, an example of an audit report done for financial statements that were prepared using a regulatory basis. And again the differences are underlined, no introductory paragraph notice you can't use GAAP terms that make sense in the management responsibility paragraph.
Management is responsible for the preparation and fair presentation of these financial statements in accordance with the basis of accounting
to comply with the requirements of the regulatory agency, the auditor's responsibility paragraph again, is unchanged. And in the opinion paragraph, we're going to say the financial statements are presented fairly. This is a clean opinion, an unmodified opinion presented fairly in accordance with. The financial reporting provisions of section Y of regulatory Z, whatever it is, notice the required emphasis of matter paragraph, because this is regulatory basis, not intended for general use the required emphasis, the required other matter paragraph that restricts use, because again, it's regulatory basis not intended for general use and then filing you viewers guide.
You'll see an example of an audit report on financial statements that were prepared under contractual basis. And you'll notice again, the required other matter paragraph that restricts use, because this is going to be restricted to parties within the entity and parties to the contract.
Welcome back. Let's look at these questions together. In the first question, it says an auditor's report on financial statements prepared on the cash receipts and disbursements basis of accounting would include all of the following, except so they want to know what's not in this report. A says a reference to the note in the financial statements that describes the cash receipts.
And disbursements basis. No, that is in the report. That's not the answer. So he says an audit opinion as to whether the financial statements are presented fairly in conformity with the cash receipts and disbursements basis. No, that of course is in the report. We've done an audit. We're expressing an audit opinion.
D says a statement that the audit was conducted in accordance with generally accepted auditing standards. We know the auditor's responsibility. Paragraph is unchanged that would be there. But answer B is not there statements, the cash receipts and disbursements basis of accounting is not a comprehensive basis of accounting.
No, there's a statement that it is right. There's a required emphasis of matter paragraph that is required to say that it is an other comprehensive basis of accounting other than us GAAP. So answer B would not be in the report. Next question. When an auditor reports on financial statements prepared in an, on an entities income tax basis, the auditor's report should a says disclaim an audit opinion on whether the statements were examined in accordance with generally accepted auditing standards.
That's not true. We've done an audit. The auditor's responsibility paragraph is unchanged. B says not express an audit opinion on whether the statements are presented in conformity with the comprehensive basis of accounting. No, of course we will express an audit opinion. We've done an audit. Our objective is to express an audit opinion.
C says include an explanation of how the results of operations differ from the cash receipts and disbursements basis of accounting. There's nothing like that in the report. Explaining how the results of operations would differ, but answer D would be in the report state that the basis of presentation is a comprehensive basis of accounting, other than GAAP.
Remember that is the answers day what's going to be in that report is a required emphasis of matter paragraph that States that the financial statements. We're prepared in accordance with a special purpose framework and referring to the note in the financial statements that describes the framework and state specifically answer D that this special purpose framework is a comprehensive basis of accounting, other than us GAAP.
Now that's their answer D next, which of the following titles? Would be considered suitable for financial statements that are presented or prepared on the cash basis? If you prepare the financial statements on the cash basis, you can't use GAAP terms. So that knocks out a income statement, B statement of operations, D statement of cash flows.
Now the answer is going to be C we're going to refer to a statement of revenues collected and expenses paid, get use any kind of GAAP terms. And then finally, an accountant who is not independent of a client is precluded from issuing a, says a report and consulting services. You don't need independence for that because you're not providing any assurance on financial information, BNC, compilations, which we'll be talking about later in this glass, you're just compiling.
You're not giving any kind of assurance on information, just compiling. Numbers that management gives you in the financial statements, but you are precluded from answer D issuing a special report on compliance with contractual agreements, because you are providing assurance on financial information. So you are required to be independent.
All right, let's continue on our discussion of. Special purpose financial statements. And the second special area in this topic would be an audit of a single financial statement or a specified elements, accounts, or items within a financial statement. Now, of course, if you're auditing a single financial statement, that could be that you're auditing a balance sheet, you're auditing.
An income statement. You're auditing a statement of cash flows. If you're auditing a specified element, you could be auditing a schedule, a pension expenses, a schedule of royalty income, profit sharing. Now these engagements can be done as a separate engagement or in conjunction with an audit. Now, if you're doing one of these reports on a far reaching element, if you're doing a report on net income, if that's the specified element, that's a far reaching element
because it has such far reaching implications to the entire financial statements. So anytime you're doing a report on a far reaching element, like net income, Then it has to be done in conjunction with an audit has to be also if you're auditing a specified element, you must also audit any interrelated items.
So if you're auditing sales, you must also audit receivables. If you're auditing inventory, you must also audit payables. If you're auditing fixed assets, you must also audit. Depreciation. So anytime you're auditing a specified element, you must also audit any interrelated items. Interestingly, in international standards and international auditing standards, you are not required to audit the interrelated items, but in generally accepted auditing standards, U S generally accepted auditing standards, you are required to audit any interrelated items.
Now, this is important, whether you are, whether you auditing a single financial statement or a specified element, the auditor is required to obtain an understanding of the purpose for which the report is being prepared, where the auditor is required to obtain an understanding of the intended users and required to understand the steps that were taken by management to determine.
The appropriate financial reporting framework in the circumstances also materiality is an issue. If you're auditing a single financial statement, you determine materiality in relation to that single financial statement, not in relation to the complete set of financial statements. Me say that again, in terms of materiality, if you're auditing a single financial statement, You're going to determine materiality in relation to that single financial statement, not in relation to the entire set of financial statements.
If you're auditing a specified element, you determine materiality separately for each element. And of course, usually an audit of a specified element is much more extensive than the audit would be for that element as part of an audit and have a complete set of financial statement.
now when you're auditing a complete set of financial statements and also auditing a single financial statement, and you're also auditing a specified element to understand the circumstances we're auditing the complete set of financial statements. We're also auditing a single financial statement. We're also auditing perhaps a specified element.
You are required. You are required to issue a separate report. You have, you are required to issue a separate audit report with a separate opinion for each engagement that's required that you are required to issue a separate audit report with a separate opinion for each engagement. Now, can they be published together?
They can be published together. If you're issuing an unmodified opinion on the complete set of financial statements and the reports are differentiated again. The reports can be published together. If you're issuing an unmodified opinion on the complete set of financial statements and the reports are differentiated.
Now, the report on a specified element in that report on a specified element, you are required to have an other matter paragraph. I'm talking about the report on a specified element. You are required to have an other matter paragraph with the date of the audit opinion. On the complete set of financial statements, the date of the auditor's report and the type of the opinion, if you modify the opinion on the complete set of financial statements and it's relevant to the specified element, again, if you're modifying the opinion on the complete set of financial statements and it's related relevant to the specified element, then the auditor has to express an adverse opinion on the specified element.
Assuming. The helmet would have a material effect on the financial statement. Let me say that again. If the auditor is going to express a modified opinion on the complete set of financial statements and it's relevant to the specified element, then the auditor has to express an adverse opinion on the specified element.
Assuming it would have a material effect on the financial statements. If the auditor expresses a disclaimer of opinion on. Sorry, the auditor must express a disclaimer of opinion on the specified element. When the auditor modifies the opinion on the complete set of financial statements, due to a scope limitation.
Again, the auditor is required to express a disclaimer of opinion on the specified element. If the auditor is modifying opinion on the complete set of financial statements due to a sculpt limitation. Now let's talk about a piecemeal opinion. This is very important. If the auditor expresses an adverse opinion or a disclaimer of opinion on the complete set of financial statements, understand the situation.
Now, if the auditor has expressed an adverse opinion or a disclaimer of opinion, on the complete set of financial statements that precludes an unmodified opinion on a single financial statement. Because that would contradict the adverse opinion that would contradict that. Disclaimer, that's a piecemeal opinion that's not allowed.
So again, remember if the auditor expresses an adverse opinion or a disclaimer of opinion on the complete set of financial statements, then that precludes the auditor expressing an unmodified opinion on a single financial statement. That would be a piecemeal opinion because that unmodified opinion on the single financial statement would contradict the adverse.
Opinion or disclaimer, stay with me. If the auditor expresses an adverse opinion or a disclaimer of opinion on the complete set of financial statements. And the specified element is a far reaching element.
The auditor can not express an unmodified opinion on the specified element. If it's a far reaching element like net income, cause that would contradict. The adverse opinion, the disclaimer of opinion on the complete set of financial statements. Again, that would be a piecemeal opinion would not be allowed.
Now, if the specified element is not far reaching, if it's not far reaching and the auditor considered considers it appropriate to express an unmodified opinion on the specified element, it's not far reaching that's okay. If the opinion on the specified element is not published. With the opinion on the complete set of financial statements does not accompany the opinion on the complete set of financial statements.
They'll let you do that. So again, if the specified element is not far reaching, and the auditor wants to express an unmodified opinion on the specified elements, not far reaching that's okay. But that report cannot be published with the report on the complete set of financial statements.
And cannot accompany the report on the complete set of financial statements, but it is allowed one more point, if there's an emphasis of matter paragraph or an other matter paragraph in the audit report on the complete set of financial statements and it's relevant to the single financial statement or the specified element, then you must also include the.
Emphasis of matter paragraph or other matter paragraph in the report on the single financial statement or the specified element. One more time, if there's an emphasis of matter paragraph or an other matter paragraph in the audit report on the complete set of financial statements and it's relevant to the single financial statement or the specified element, then you will report on the single financial statement or the specified element must also include that emphasis of matter or other matter paragraph.
If you look in your viewers guide, you'll see a report. On a single financial statement, and it's an unmodified opinion. And notice look at the, again, once again, the standard unmodified opinion, like the back of your hand. So you want to focus in on the differences, which are underlined. If you notice in the introductory paragraph, we have audited the schedule of accounts receivable in the management responsibility.
Paragraph management is responsible for the preparation and fair presentation of the schedule. So you don't have to make little changes here in the auditor's responsibility. Paragraph, our responsibility is to express an audit opinion on the schedule. And of course, in the opinion, paragraph, the schedule referred to above presents fairly it's an unmodified opinion and notice the required other matter paragraph disclosing that we audited the complete set of financial statements.
The date of the auditor's report and the type of opinion that was expressed. Now, the third special area and reports on special purpose financial statements would be a report on compliance with aspects of a contractual agreement or regulatory requirements in connection with audited financial statements.
Now the auditor's goal in this area. Is to express what is called negative assurance, which means nothing came to the auditor's attention. That would cause the auditor to believe that the entity failed to comply with the specific aspects of the contract of a contractual agreement or a regulatory requirement.
So that's the goal of this engagement to express negative assurance. Negative assurance is okay if. The auditor has not identified any instances of non-compliance. Of course. So during the audit, the auditor can't have noted any instances of non-compliance the auditor must've expressed either an unmodified or a qualified opinion on the financial statements notice not adverse or a disclaimer.
So the auditor must've expressed either an unmodified or a qualified opinion on the financial statement. And the other requirement is that the covenants and the contract, or the regulatory requirements have been subjected to audit procedures as part of the financial statement audit. So you do have to apply procedures to the aspects of the contractual agreement or to the regulatory requirements as part of the audit.
Now, What if the auditor expresses an adverse opinion or a disclaimer of opinion on the financial statements? If the auditor expresses an adverse opinion or a disclaimer of opinion on the financial statements, our report on compliance can only be issued if they've, I D if the auditor has identified, instances of non-compliance notice that.
So if the auditor expresses an adverse opinion, Or a disclaimer of opinion on the complete set of financial statements. Now they'll only be a report on compliance when the auditor is identified instances of non-compliance. Now, if the auditor does identify instances of non-compliance, the report has to identify and describe those instances of non-compliance.
Now this report on. Compliance with contractual agreements or regulatory requirements can either be done as a separate report if it's done as a separate report. No, there'll be an other matter paragraph that restricts use why you're restricting use while you're restricting use two. If it's regulatory requirements you're restricting use to the entity and regulatory agencies, if it's contractual.
Requirements then you're restricting use to the entity and parties to the contract. So this report on compliance can either be a separate report or it can just be included in the auditor's report on the complete set of financial statements, where they re with a required other matter paragraph. The other matter paragraph would give the negative assurance and.
Restrict use. And then the final area in special purpose financial statements would be a report on summary financial statements. Now a report on summary financial statements must be done in conjunction with an audit it's required to have been done in conjunction with an audit and. The auditor in this case is either going to issue an unmodified opinion or an adverse opinion.
Those are the only two choices it's either going to be unmodified or adverse unmodified means that the summary is consistent in all material respects with the audited financial statements. That's what an unmodified opinion would mean in this context that the summary is consistent in all material respects with the audited financial statements.
So that's. That would be unmodified. The other choice would be adverse saying that the summary's not consistent. The summary's not consistent
with the audited financial statements and management has refused to make any necessary changes basically is what that means. Now, one more point, if the auditor's going to express an adverse opinion or a disclaimer of opinion. On the financial statements, the complete set of financial statements.
Then they would, they withdraw from this engagement. You don't express an audit opinion on the summary. One more time. If the auditor is going to express an adverse opinion or a disclaimer of opinion on the complete set of financial statements, while then you withdraw from this engagement, you do not do a report on the summary of the financial statements.
You do not.
Welcome back in this session, we're going to talk about reporting on prospective financial statements. And of course, when we say prospective financial statements, we're talking about forecasts or projections, let's start with some definitions of forecast is what a forecast is to the best of our client's knowledge and belief.
What will be our client's expected financial position in the future. That's a forecast to the best of our client's knowledge and belief. What will be our client's expected financial position in the future. That's a forecast. It's a general use statement and it could take the form of actual financial statements or simply a report.
Our projection is what. Given one or more hypothetical assumptions, what will be our client's financial position in the future? That's a projection given one or more hypothetical assumptions. What will be our client's financial position in the future? A projection is a limited use report. Now a CPA has three possible associations with forecasts and projections.
Number one. The CPA could do an examination. Now, an examination is very similar to an audit, but you're not examining historical data. You're examining prospective information, but it's very similar to an audit. And the objective of an examination is for the auditor to express an audit opinion. And if the auditor expresses an unmodified opinion with an examination, what does that mean?
An unmodified opinion would mean the financial statements. The forecast, the projection conforms with guidelines established by the AICPA for forecasts and projections. That's what an unmodified opinion would meet in this would mean in this context. So if a CPA issues, an unmodified opinion on a forecast or projection, it's saying.
That the financial statements do conform with the guidelines established by the AICPA for forecasts and projections, or it could be a qualified opinion or could be an adverse opinion. But the objective of an examination like an audit is to express an audit opinion. A second possibility with forecasts and projections is for the CPA to do a compilation.
And of course, You know what a compilation means in this particular, in, in the case of a compilation, the CPAs just compiling, not giving any assurance whatsoever, just compiling, presenting information supplied by the management, into the form of a forecast or a projection. So of course for compilation independence would not be required because no assurance is going to be given.
And the compilation report has to state an examination was not done. The compilation report would state a compilation was not done. You are disclaiming any opinion. And then the third possibility with forecasts and projections would be agreed upon procedures. The goal of agreed upon procedures. Is for the CPA to apply the procedures and present the findings.
That's what happens with agreed upon procedures. The CPA applies the procedures and presents the findings. Now in all three cases, whether it's an examination or a compilation or agreed upon procedures, the re the report has to state that the results may not be achieved again, whether it's a, an examination, a compilation, or agreed upon procedure report.
The report has to state that the results may not be achieved and that the CPA has no updating responsibility. And I want you to be aware that reporting on prospective financial statements is an example of an attestation engagement. This is an attestation engagement, and let's be more precise. What is an attestation engagement anytime?
The CPA is providing a written conclusion about an assertion that is the responsibility of another party. Let me say that again. An attestation engagement is an engagement where the CPA is providing a written conclusion on an assertion. That is the responsibility of another party. We always call that the responsible party.
And for attestation engagements, the CPA has to follow the attestation standards and we'll get into the attestation standards in more detail in our next session. I'll see you there. Welcome back. As we said, in our last session, an attestation engagement is an engagement where a CPA is asked to provide a written conclusion.
About an assertion that is the responsibility of another party called the responsible party. And an attestation engagement could be an examination. We know an examination is very similar to an audit. The objective of an examination is to express an audit opinion could be unmodified, could be qualified, could be adverse and.
It an examination can be on prospective financial information, like a projection of forecast. It could be on management's written assertion about the effectiveness of internal control could be on management discussion and analysis. Another possibility for an attestation engagement would be a review.
Now when a review is done as an attestation engagement, the objective is for the CPA to express what is called negative assurance note. It's not limited assurance, negative assurance. Negative assurance means nothing came to our, nothing came to our attention. That would cause us to believe that the subject matter is not presented in all material respects in conformity with the criteria.
That's the objective of a review done as an attestation engagement to express negative assurance. Again, not limited assurance, negative assurance, nothing came to our attention, which would cause us to believe that the subject matter is not presented in all material respects in conformity with the criteria.
And then one final possibility would be agreed upon procedures.
When the CPA does an agreed upon procedures engagement, the CPA is not expressing an audit opinion, not expressing negative. Sharon's basically in an agreed upon procedures engagement. The CPA is listing the procedures that were performed and presenting the CPA's findings. Now. When a CPA takes on an attestation engagement, the CPA has to follow the attestation standards.
Just want to go through the standards with you very quickly. If you go through the attestation standards they're listed in your viewer guide, you'll see, there are five general standards go over them quickly. First draining the practitioner must have adequate. Technical training and proficiency in the attestation function.
So the first is training. Second is knowledge. The practitioner must have adequate knowledge of the subject matter. And of course they could conduct a special that they could consult a specialist as well. But the practitioner has to have adequate knowledge of the subject matter. Three is criteria.
The practitioner can only perform an attestation engagement on an insertion capable of being evaluated against suitable criteria. That's available to users as we saw in forecast and projections, having to conform to criteria established by the AICPA for forecasts and projections for as independence, it has to be there.
Independence is required for an examination. Independence is required for a review and independence is required for agreed upon procedures because you are providing assurance even for prospective information. Number five is due professional care. The practitioner must exercise due professional care in planning and performing any attestation engagement.
So those are your five general standards. Then there are two standards of field work. The first standard of field work is planning and supervision. All engagements must be adequately planned and all staff assistants must be adequately supervised. And then the second standard of field work, sufficient evidence must be obtained to form a basis for the practitioner's conclusion.
You'll notice that in the standards of field work, The practitioner is not required to obtain an understanding of the client's internal control. I want you to notice that
then there are four standards of reporting. First, we have to identify the assertion or the subject matter that is being examined or reviewed. Second. You have to state your conclusion. If it's an examination, you're expressing an audit opinion. If it's a review, the objective is to express negative assurance. If it's agreed upon procedures, you're listing your findings.
You have to state whether the assertion conforms to the criteria. Number three, you have to list any reservations, if any, and of course, number four restrictions. If any. I want to say more about an agreed upon procedures report and what is required in an agreed upon procedures engagement.
I think, what an agreed upon procedures engagement is it's an engagement where the CPA is engaged to issue a report on findings based on specific procedures performed on subject net on subject matter. That's what an agreed upon procedures engagement is. It's an engagement where the CPA is engaged to issue a report on findings based on specific procedures performed on subject matter.
What is required for an agreed upon procedures engagement. While the CPA has to be independent, the responsible party has to take responsibility for the adequacy of the procedures. The responsible party and the CPA have to agree on the procedures that are to be performed. And the criteria that will be used to determine the findings, the subject matter has to be capable of reasonably consistent measurement.
The CPA and the responsible party have to agree on any materiality, the limits and the use of the report has to be restricted to specific parties. And if it's agreed upon procedures on prospective information, that's possible, it's agreed upon procedures on prospective information. The report must include a summary of any significant assumptions in your viewers guide.
You'll see an example of agree to have an agreed upon pre-seed procedures report on specified elements, accounts, or items within a financial statement. And I just want to point out some highlights. If you look at the report, notice independence is in the title. You have to be independent to do. I agree on an agreed upon procedures engagement.
Notice the report identifies the subject matter. The written assertion, the character of the engagement and the report has to state notice the report States that the responsible party is responsible for the subject matter. It States that the procedures performed. We're the responsibility of the responsible party and the procedures performed are those that were agreed to
it. States that the engagement was conducted in accordance with attestation standards established by the AICPA. It States that the sufficiency of the procedures solely the responsibility of the responsible party. The CPA disclaims notice CPA disclaims any responsibility for the sufficiency of the procedures.
The report has to list any materiality limits and the report has to state that an audit was not done. An examination was not done. A review was not done.
And the report has to disclaim an audit opinion on the element and state that there's no negative assurance being given. And finally notice you, the CPA lists any reservations and restricts use. And if this work, if this is perspective information, you have to state that results may not be achieved.
Welcome back. Let's do these questions together. And the first question it says, when an accountant compiles a compilation, a financial forecast. So we're dealing with prospective financial information. It's a forecast. The accountant report should include ACE as an explanation of the differences between a financial forecast and a financial projection.
There's nothing. That's never a part of any report explaining the difference. How about be a caveat that the prospective results of the financial forecast may not be achieved now? That's true. The answer is B that when you're dealing with prospective financial information, whether it's an examination, a compilation agreed upon procedures.
The report is going to state that results may not be achieved. The answer is B C says a statement that the accountant's responsibility to update the report is limited to one year. No, there's no responsibility to update. Remember whether it's, if it's prospective financial information, whether it's an examination of compilation agreed upon procedures, the report is going to state that the CPA has no updating responsibility.
And D says a disclaimer of opinion on the suitability of the internal control or a member in the attestation standards and the standards of field war, the practitioner, the CPA is not required even to obtain an understanding of the client's internal control. So that's not required. Now the answer is B whether it is an examination, whether it is a compilation, whether it's agreed upon procedures, when you're dealing.
With prospective financial information, the report has to state that the results may not be achieved next when an accountant examines projected financial information. So we're dealing with a projection, it's an examination. The account, the accountants report should include a separate paragraph that I think you'd stop right today.
Restricts use. Remember that a projection is a limited use report. A forecast is a general use report, but a projection is limited use. So you didn't have to go. You didn't have to go beyond a
next question. When an accountant compiles projected financial statements. So it's a projection. And we're doing a compilation. The accountant's report should include a separate paragraph that AA says explains the difference between a compilation and review. Of course not B says documents, the assessment of risk of material misstatement due to fraud.
All we're doing is compiling C expresses limited assurance. We're not providing any assurance at all. It's date describes the limitations on a. Projections usefulness.
The next question, accepting an engagement to compile on entities. Financial projection, most likely would be inappropriate if the projection is to be included in well, right off the bat that a projection is a limited use report. So it has to be you can't include it in an offering statement to the public.
It's a limited use report. It's B that would be very inappropriate. And then finally, the last question says a practitioner has been engaged to apply, agreed upon procedures in accordance with statements on standards for attestation engagements, to prospective financial information, which of the following conditions must be met for a practitioner to perform the engagement.
ACE says the prospective financial statement must include a summary of significant accounting policies. That's not a requirement. B says the practitioner takes responsibility for the sufficiency of the procedures. No, that's the responsibility of the responsible party D says the practitioner reports the criteria to be used in the determination of the findings.
No, the. The criteria has to be agreed upon between the practitioner and the responsible party. And of course, it's see the practitioner and the specified parties must agree upon the procedures to be performed by the practitioner. There are more questions I want you to have done before you look at the next session.
Welcome back. Let's do these questions together. First question says a CPA is engaged to examine an entities financial forecast. So we're doing an examination. It's a forecast. The CPA believes that several significant assumptions do not provide a reasonable basis for the forecast. Under these circumstances, the CPA should issue an adverse opinion.
Answer a yeah. These assumptions do not provide a reasonable basis for the forecast. That's an adverse opinion. That's pervasive.
Next mill CPA was engaged by a group of royalty recipients to apply agreed upon procedures to the financial data supplied by modern company regarding Martin's written assertion about the, about its compliance with contractual requirements to pay royalties. Mills report on these agreed upon procedures would contain well, the basic format of the report is you list your procedures that were performed and your findings.
And the answer is B. You're going to list the procedures that were performed and mills findings. That's the basic structure of the report and agreed upon procedures report next, a practitioner's report on agreed upon procedures. That is in the form of procedures and findings should contain. I think you went right to it.
See, it's a limited use report that have to be a restriction on the use of the report member and agreed upon procedures report is limited use.
Yeah. Which of the following professional services would be considered an attestation engagement? We know what attestation engagements are. The CPA's asked. To provide a written conclusion about an assertion. That's the responsibility of another party. So it's not a advocating on behalf of a client about trust tax matters under review by the IRS.
It's not be providing financial analysis, planning and capital acquisition services as a part-time in-house controller. It's not see advising management in the selection of a computer system. No, it's D preparing the income statement and balance sheet for one year in the future, based on client expectations and predictions.
That's a forecast. That's what an attestation engagement is. We're going to provide a written conclusion on an assertion. That's the responsibility of somebody else.
the next question. A CPA is engaged to examine management's assertion that the entity schedule of investment returns is presented in accordance with specific criteria and performing this engagement. A CPA would comply with the provisions of what we know it's an attestation engagement. So the answer is D.
Welcome back in this class, we're going to continue our discussion of attestation engagements. And one possibility we want to look at is the fact that our client could provide an assertion about the effectiveness of their internal control in a report. And that report would accompany our audit report.
And as an attestation engagement, the CPA could do an examination. And express an audit opinion on management's assertion about the effectiveness of their internal control. Now, that the objective of any examination is to express an audit opinion in this case, express an audit opinion based on some objective control criteria on whether or not this assertion is fairly stated.
In other words, we're going to express an audit opinion on the effectiveness of internal control. In all material respects again, based on some objective control criteria, bottom line, we're going to express an audit opinion on whether this assertion is fairly stated. Let's go over the basic steps of an examination.
Of course, step one, that would have to be a planning phase in step two, the CPA would have to obtain an understanding. Of all the internal control policies and procedures that are in place. So in step two, you're just trying to understand what's there, you're obtaining an understanding of all the internal control policies and procedures that have been put into place.
In step three, you would evaluate the design of internal control policies and procedures. So in step three, you're evaluated. Now you start evaluating the design of all the internal control policies and procedures in step four. You would test and evaluate the effectiveness. How effective are they? All right.
I understand the controls. Now. I know what they are now. Step four, I test and I evaluate how effective they are. The effectiveness of internal control policies and procedures. And then of course, the final step, step five, we form an audit opinion about management's assertion, about the effectiveness of their internal control.
If you look in your viewers guide, there is an example of this report. And I just want to look at some highlights. You look at the heading independent it's right in the heading, we have to be independent to do an examination because the basic rule is if we're going to provide any type of assurance on any type of financial information, the CPA has to be independent, in fact, independent in appearance.
So that's right up front in the heading. Notice the introductory paragraph we have examined. It's very clear what we did. This was not agreed upon procedures. We have examined look at the scope paragraph. Our examination was in accordance with attestation standards established by the AICPA. We obtained an understanding of internal control over financial reporting.
We tested, we evaluated the design and operating effectiveness of internal controls. We performed. Are the procedures we deemed necessary under the circumstances. And then we say our examination provides a reasonable basis for our opinion. Now notice right after the scope paragraph, there is the inherent limitations paragraph very important.
So right after that scope paragraph, we have our inherent limitations. Paragraph misstatements due to errors and fraud may still occur and not be detected or corrected. This is an inherent limitations. Paragraph Ms. Statements due to errors and fraud may still occur and not be detected and corrected another inherent limitation.
This can not be projected into the future. You can't project our opinion into the future because the effectiveness of internal control is at an a point in time at an instant in time. And then of course, finally the opinion paragraph. And this is an examination. Our objective is to give an audit opinion. We could give an unqualified opinion.
This assertion is fairly stated based on the control criteria, unqualified opinion. This assertion by management is fairly stated based on the control criteria, where we may have to give an adverse opinion. We may have to disclaim an audit opinion. Let's do some questions. Number one, which of the following representations does an accountant make implicitly, not explicitly implicitly when issuing a standard report for the compilation of a nonpublic entities, a non issuer's financial statements.
So what is implicit when we do a compilation report, B the financial statements have not been audited. No, that's explicit that stated C a compilation consists. Principally of inquiries and analytical procedures. Now that's a review. This is a compilation date. The accountant does not express any assurance on the financial statements.
Of course, the fact that we disclaim that's explicit, but answer a, that the accountant is independent. That is implicit. Do you have to be independent to do a compilation? No, you don't have to be because you're not providing any assurance on the financial information. You're just compiling numbers given to you by management.
So it's not that independence is required to do a compilation. It's not, but if you're not independent, it has to be stated. If you're not independent, it has to be stated. So if you say nothing, independence is presumed. So that is implicit. Number two, when an account is engaged to compile. So again, that's a compilation to compile a non-public entities, a non-issue is financial statements.
That omit substantially all disclosures required under GAAP. The account would indicate in the compilation report that the financial statements are what a not designed for those who are uninformed about these matters. Don't forget that buyer beware paragraph. You have to include that if there are omitted disclosures, number three.
Which of the following procedures is usually performed by an account in a review engagement of a non public entity, a non-issue or sending a letter of inquiry to the Anthony's lawyer who do a legal letter, answer a in a review. Now a review is analytical procedures and inquiries. That's what it is. And a legal letter answer a that's an audit procedure.
How about C. Confirming receivables. That's an audit procedure. We're not doing an audit D communicating significant deficiencies material, weaknesses, or significant deficiencies material weaknesses, or what you noted during an audit, not a review answer. Be comparing the financial statements with statements for comparable prior periods.
That is an analytical procedure. And that's what a review is. Inquiries analytical procedures. So the answer is date number four, which of the following procedures should an accountant perform during an engagement to review the financial statements of a non-public entity, a non-issue or again, it's a review a says communicate significant deficiencies are noted during an audit.
We're doing a review sending our bank confirmation letters. That's an audit procedure. D examining cash disbursements. That's an audit procedure, but answer B I management representation letter is required at the end of a review. So it's not only inquiries and analytical procedures in a review.
You have to get a managed representation letter. So the answer is B number five, gold CPA is engaged to review. To review the year four financial statements of North. So we're doing a review of the year for financial statements, a non-public non issuer, previously goal audited the year three financial statements.
All right. So notice we're doing a lower level of service here. So back in year three, we did an audit. Now year four, we're doing a review. So we're doing a lower level of service this year. Gold decides to include a separate paragraph in the year four review report because North plans to present comparative statements for years three and four, the separate paragraph would indicate what a says that the year four review report is intended solely for the board of directors management.
Now you don't restrict the use of a re a review report. A review report is a general use statement B. There are justifiable reasons for changing the level of service. You don't have to justify the reasons. If you have to have a statement that the year three auditors report may not may launch may no longer be relied upon.
Now that statement doesn't have to be their answer is C you do have to have a statement that no auditing procedures have been performed since the date of the year three report number when there's a lower level of service, when you did an audit last year and. You are doing a review this year, when you're doing a lower level of service, you have a couple of, you have a couple of choices.
You can just re-issue the prior year's report, or you can do what they've decided. And you do have a separate paragraph stating the responsibility or assuming for the prior period. And you also have to have in that paragraph, the date of the prior year report, the type of opinion. That was given if it was a qualified opinion, the reasons why it was qualified and you have to state, as it says, no auditing procedures have been done since number six in performing an attestation engagement, a CPA, typically a supplies, litigation support services, no assesses control risk at a low level.
Remember. Getting an understanding of the entity and its environment and including internal control is not one of the field work standards. We're an anticipation engagement. So we don't, we're not assessing control, risk provides management consulting services. That's not it, but answers say in any attestation engagement, you have to express some kind of conclusion about the assertion.
Number seven. Which of the following is a conceptual difference between the at testation standards and the generally accepted auditing standards? B says the requirement that the practitioner be independent in mental attitude is omitted from the FM station standards. No, that's not true. That is our fourth general standard in the attestation standards.
You still have to be independent because you providing some assurance on financial information, see the attestation standards do not permit. And that test engagement to be part of a business acquisition study or feasibility study. No, normally an attestation engagement as part of a larger engagement.
That's no problem. That's not a true statement. Answer date, none of the standards of field work in generally accepted auditing standards are included in the agitation standards. That's not true. Two of the three are the same, right? Planning and supervision evidence. Those two are in the field work standards for generally accepted auditing standards and for the amputation standards.
So two of the, three of the same, of course the answer is at the at gestation standards, provide a framework for the attest function beyond historical statements because they apply to any other written conclusion. About the reliability of an assertion. That's the responsibility of somebody else? The answer is a number eight.
I CPA's report on. Agreed upon procedures related to management's assertion about the entities compliance with specified requirements should contain a restriction, answer a that's restricted.
Number nine, which of the following is not an attestation standard. A, the practitioner must obtain a sufficient must obtain sufficient evidence to provide a reasonable basis for their conclusion. That's the second standard of field work. So that is in the authorization standards. How about B the practitioner must identify the subject matter or the assertion being reported on that's the first reporting standard in the agitation standard.
So that's there. See, the practitioner must plan the work and properly supervise the assistants. That's the first field work standard and the act station standard. So those are all there, but as efficient understanding of internal control, that is not one of the field work standards in the attestation standards because.
Again, an attestation engagement is part of a larger engagement. Number 10 negative assurance be expressed when an account is requested to report on what? Before we read any of the choices here, we know in an attestation engagement, you're not allowed to give negative assurance. We know that. But how about the first one results of applying agreed-upon procedures to an account within, on audit and financial statements?
Can you give negative assurance? No, you present your findings to a compilation. We're not providing any type of assurance at all. So the answer is D neither one or two. Don't fall behind. Keep up with your work and I'll look to see you in the next class.
Welcome back in this class, we're going to begin our discussion of internal control, a very heavily tested topic in the auditing exam. And just to get us started, get us warmed up, get us in the mood. Let's quickly go over the basic steps in the audit process. The first step of the audit process, as is to establish an understanding with the client.
We're going to lay out as clearly as we can, the objectives of the engagement, the services we're going to perform any limitations on the services we're going to perform. We're going to spell out as clear as we can, the auditor's responsibility, the client's responsibility. And as we're going to document our understanding with the client in the engagement letter.
Then we will move on to the second step of the audit process, which is the planning phase. In the planning phase, we have to obtain an understanding of the entity and its environment, including internal control in the planning phase. We're going to begin our risk assessment. We're going to, we're going to use risk assessment procedures through observation inquiry, inspection and analytical procedures.
So we begin our risk assessment in the planning phase. And of course the risk assessment procedures we use will depend on the size of the client. Its complexity. Our previous experience with the client. And in the planning phase, we have to discuss with the audit team, how susceptible the financial statements are to material misstatement, how susceptible these financial statements are to errors and fraud.
Then in the third step of the audit process, now we start to get more targeted in the third step of the audit process. We start to evaluate the risk of material mistake and let's get right down to it. We have to evaluate the risk of material misstatement related to particular, Resurgens, as a set of financial statements is nothing more than a list of assertions management is asserting.
This is our cash balance. Management is asserting. This is our inventory management is asserting. These are our disclosures. That's all a set of financial statements amounts to is a set of assertions. So in the third step, We evaluate the risk of material misstatement, the risk of errors and fraud related to particular assertions.
What's the probability of errors and fraud related to particular assertions. We're getting more targeted now. And our evaluation of the risk of material misstatement in particular assertions will determine the nature and the extent. And the timing of our further audit procedures. That's what it amounts to that our evaluation of the risk of errors and fraud will ultimately determine, and the nature, the extent and the timing of all our subsequent audit procedures notice N E T nature extent timing and E T net always think of auditors on a sea of transactions and they have to throw out their net the nature of the extent, the timing.
Of their audit procedures. Let's just think about this for a minute. Why would our evaluation of the risk of material misstatement related to particular assertions? Why would it affect the nature of the evidence that we gather? Because if we think the risk of material misstatement is low, if it's a low probability of material misstatement in a particular assertion, we're going to use.
The client's records will rely on the client. The client's records. We think the client system is good, but at the risk of material, misstatement is high. We're going to need more outside corroboration aren't we so notice our evaluation of the risk of material misstatement. It does affect the nature of the evidence we gather on the audit.
Same thing. With the extent of the evidence, we're going to need to form an audit opinion. If our evaluation of the risk of material misstatement is low, we're not going to need as much evidence. To be able to form an audit opinion, we'll need less. But if our estimate, our evaluation of the risk of material misstatement is high, then we're going to need a lot more evidence, much more evidence to form an audit opinion.
So notice our evaluation of the risk of material misstatement affects the extent of the evidence that we gather on the audit. And it also affects timing. Why? Because if we evaluate the risk of material misstatement to be low. We're going to do more interim testing. If we wait the risk of material misstatement to be high, we're going to do our testing.
After year end, our evaluation of the risk of material misstatement affects the net. We throw out and ITI the nature of the evidence, the extent of the evidence and the timing of the year evidence of our audit procedures. Now in the fourth step of the audit process, we get right down to it. We design. And perform all of our audit procedures.
We're going to use tests of controls, substantive testing. We're going to design a, perform our audit procedures to address the risk of material misstatement in particular assertions. So now we perform our audit procedures in step four in step five, we evaluate all the audit evidence that we gathered on the audit.
And in step six, we form an audit opinion. And we issue our audit report. Now we know those are the basic six steps in the audit process. And when I say that we're now going to discuss internal control. What it means is we're going to zero in on steps, two, three, and four. Aren't we in these classes on internal control, we're really going to zero in on steps, two, three, and four.
Because why do we need to have an understanding of internal control? In step two, we need an understanding of internal control to do our initial risk assessment. In step three, we need an understanding of internal control to evaluate the risk of material misstatement in particular assertions. And in step four, we need an understanding of internal control in order to design our audit procedures.
To address the risk of material misstatement in particular assertions, you have to have an understanding of a client's internal control to do an audit. And again, in particular steps, two, three, and four.
Now, why don't we get down to it? What are the objectives of internal control? There were three. Major objectives to internal control. Number one, the first objective may be the most important. Arguably the first objective of internal control is to provide reasonable assurance. That material misstatements are being prevented, detected corrected on a timely basis.
Reasonable assurance that there is reliability and financial reporting. I think you'd have to argue that may be the most important objective of internal control to provide reasonable assurance that material misstatements errors and fraud are being prevented, detected corrected on a timely basis.
Reasonable assurance on the reliability of financial reporting. Second objective of internal control provide reasonable assurance of compliance with laws and regulations. Pretty important, reasonable assurance. That the entity is compliant with laws and regulations. And then the third objective of internal control is to provide reasonable assurance on the effectiveness and efficiency of operations.
Now, I have to say, when we say reasonable assurance on the effectiveness and efficiency of operations, the auditor is not all that concerned with efficiency, but it is one of the objectives. Of internal control. Now, as I say we always think, or try to think very clearly and delineate between management's responsibilities and the auditor's responsibilities.
And when in this particular context, management's responsibility is the establishment and the maintenance of the internal control structure. That's the client's responsibility. That's management's responsibility. The establishment and the maintenance of the internal control structure. What's the auditor's responsibility in this context?
The auditor's responsibility is to see if the controls are working. The auditor's responsibility is to determine is the internal control structure, preventing detecting, correcting material, misstatements errors, and fraud on a timely basis. In other words, the audits responsibility. Is to determine the effect that the internal control structure is having on the financial statements.
That's the auditor's responsibility. That's us. That's our responsibility is the internal control structure functioning well, is it effective? Is it preventing, detecting, correcting errors and fraud on a timely basis? What effect does the internal control structure have on. Financial statement assertions.
And as always, we, as auditors, we as accountants, all we care about is the substance of something we don't care about its form. Don't show me a pretty flowchart. Give me a nice little narrative on your controls. That's the form. What we always care about is the substance are the controls effective.
That's what we, as auditors have to determine and. I should mention that there are always inherent limitations. There are always inherent limitations, no matter what controls you place into service, into effect, you could create the most perfect internal control structure ever devised by man.
And there are inherent limitations. There are inherent problems. In other words, unavoidable, inherent, baked in the cake. Humans are fallible. That's an inherent limitation in the most perfect system ever devised by man. People make mistakes. People are fallible. They're not perfect. That's an inherent limitation.
We're stuck with it. It's baked in the cake. In any system, you could have the most beautiful turtle control structure ever devised by man and have perfect separation of duties. But what if there's collusion? That's unavoidable. That's inherent. The it's the possibility of collusion between employees is inherent it's unavoidable in any system and also management override.
The fact that no matter what controls are put into place, management could always circumvent the controls that could happen in any system. So there are inherent limitations in any system unavoidable, just baked in the cake. And we have to accept that. Now, getting more detailed. Now let's talk about the components that make up internal control.
There are five components that make up internal control and the memory tool I want you to use to remember the five, cause you gotta remember the five is C R I M E crime. Just remember strong internal controls help to prevent crime. C R I M E. That little memory tool will help you remember the five components of internal control.
The C stands for control activities. When we say control activities, we're talking about the specific policies and procedures that are in place to assure that all transactions are properly initiated, authorized, approved, executed, and recorded. One more time, a control activities, refer to the specific.
Policies and procedures. The client has in place to assure that all transactions without exception are properly initiated, authorized, approved, executed, and recorded
control activities includes a proper segregation of duties. It is essential in any internal control structure that we separate authorization, record keeping and custody of assets. Remember that those functions must be separated. That's a proper segregation of duties. When you separate authorization, record keeping and custody of assets, a RC, I always tell my students that's the arc that protects us from a sea of troubles.
When we separate authorization, record keeping and custody of assets control activities also includes things like physical controls, locks on doors. Employee ID badges all the policies and procedures in place to assure that all transactions are properly initiated, authorized, approved, executed, and recorded.
Now the are in crime is risk assessment. Now what we're talking about here is not the auditor's assessment of risk. Oh, no risk assessment in this context is how your client. Manage the concept of risk, the risk of material misstatement. How does your client, how does management handle the risk of material misstatement?
The risk of errors, and fraud. And remember that from a client's point of view, there are external risks and there are internal risks. There are internal risks, like new employees, a high turnover of employees, rapid expansion. New technology, new products. Remember this basic formula change equals risk.
Just remember that basic formula that's without question a true statement. Anytime there's a change, there's a risk. It's true in your life as well. If you change jobs, there's a risk. There's a risk that you may not like the new job that you would prefer. Your old job change equals risk. Anytime something changes.
There's some risk involved. But there are not only internal risks. There are external risks, a downturn in the economy, a downturn in the industry, would, if there's a downturn in the economy or downturn in the industry, does increase competition. Would your employees be tempted to cut corners?
That kind of thing. How does your client manage the concept of risk? What's your client's risk assessment? How does your client handle internal risks? S external risks. So the R and crime is risk assessment. I in crime is information and communication information return refers to the quality of the accounting records.
Bottom line information really refers to the quality of the accounting records, whether they are electronic or manual. What's the quality of the accounting records. Communication means a lot of things, communication between management and those in charge of governance, particularly the audit committee communication between management and regulatory agencies, and also communicating individual responsibilities to employees.
Communication is very important. Part of internal control. Amma's monitoring. H w what's management's ability to evaluate internal control over an extended period of time. So again, monitoring, monitoring refers to management's ability to evaluate internal control over an extended period. How does management handle breakdowns?
There are inevitable breakdowns can management handle breakdowns and take corrective action. And of course monitoring includes an internal audit function. It's a huge part of monitoring. Does the client have an internal audit function? And then finally the on crime is environment, the control environment.
What's the overall attitude, the overall actions of management, the board of directors. Do they set a tone that emphasizes internal control? Is there a written code of conduct? Does the board of directors does management. Do they communicate ethical values? Is there an active board of directors, an active audit committee?
Is there an internal audit function? No, what's management's philosophy. Is it hands-on or is it absentee? And it's important to remember that if there's a weakness in control environment, anytime there's a weakness in the control environment that will have a pervasive effect. On the internal control structure and you can, there's a weakness in the in control environment.
That's very disturbing that will tend to have a pervasive effect on the entire internal control structure. Now, very important. The auditor is required. To document their understanding of the internal control structure in the work papers that's required. The auditor is required to document their understanding of each of the components of crime.
This is required. You either required to do something or you're not required. This is required. The auditor has to document the Workpapers, their understanding of each component of C R I M E.
So remember that requirement as well. Now in our next class, we'll continue our discussion of internal control and I will look to see you then keep studying. Yeah. Welcome back to our discussion on internal control. In our last class, we said that ultimately an auditor uses their understanding of a client's internal control.
To assess the risk of material misstatement, the risk of errors and fraud in particular resurgence. That's how we're going to use ultimately our understanding of internal control to assess the risk of errors and fraud material misstatements in particular assertions. And what I want to get into in this class is the concept of risk as risk.
Is unavoidable in auditing. So unavoidable. Why? Because ultimately we're going to issue an audit opinion on financial statements and we have not examined. We have not examined a hundred percent of the documentary evidence that supports the financial statements. Isn't that the situation we're in. As auditors, ultimately, we're going to have to express an audit opinion on financial statements and we have not examined a hundred percent of the documentary evidence that supports the statements.
It's not possible. It's not practical. The client wouldn't pay for it. Oh no. We have to examine a hundred percent. No, of course not. Oh no. We have to examine a hundred percent of the documentary evidence that audit's would take no years, thousands and thousands of man hours that the client wouldn't pay for it.
And on top of that, even if we did examine a hundred percent of the documentary evidence that supports the financial statements, we could misinterpret something. We could still miss something. We could still fail to detect errors and fraud that are in the records as possible. There's always a risk and auditing it's unavoidable.
And the risks that you take an auditing have names. And you've gotta be comfortable with the names of these risks, because this is tested a lot. The ultimate risk you take in auditing is called audit risk. Alright, what's audit risk is really very simple audit risk. This is the ultimate risk of taken auditing.
It's the risk that the financial statements are materially misstated. It is the risk that the financial statements have material errors and fraud. The financial statements are materially misstated, but we issue a clean opinion. We miss it and we issue an unmodified opinion that is called audit risk. It is the ultimate risk.
We always take an auditing that the financial statements are misleading. The financial statements are materially misstated, and somehow we miss it and issue a clean opinion. We issue an unmodified opinion. Now audit risk is actually made up of other risks. Control risk is the risk that the internal consult structure is not functioning well controlled risk.
It's the risk that internal controls are not preventing, not detecting, not correcting material misstatements on a timely basis. It's the basic risk that the internal control structure is not functioning well. And remember every internal control structure has controlled risk, whether there's an audit or not, whether there's an audit or not.
Every internal control structure has a certain amount of control risk. Now in an audit, the auditor comes in and tries to evaluate what's the control risk in this particular internal control structure, but every internal control structure has control risk. It's the risk that internal controls. Are not preventing, not detecting, not correcting errors and fraud on a timely basis, then there's inherent risk.
Inherent risk is the risk that a given account by its very nature could be overstated. Again, inherent risk is the risk that a given account by its very nature could be subject to errors and fraud could be materially misstated cash has a lot of inherent risk, securities, liquid assets have a lot of inherent risk cash has more inherent risk than furniture and fixtures.
Why? Because it's easier to, fold up cash and stick it in your pocket and walk away with it than it is to try to bring your desk home. To try to steal a chandelier. Cash has a lot of inherent risk furniture and fixtures have less inherent risk, but inherent risk. Is the risk that a given account by its very nature could be materially misstated.
Now listen carefully. The combination of control, risk and inherent risk that equals the risk of material misstatement. Very important to remember that control risk plus inherent risk equals the risk of material misstatement that gives you your risk of material misstatement. The risk. Then in the count could be materially misstated that a disclosure could be materially misstated.
That is the risk of material misstatement. It's a combination of control, risk and inherent risk. And then finally there is detection risk. Oh. And I meant to mention that, every account balance, every assertion has some inherent risk to it. Whether there's an audit or not. Now again, the auditor will come into an audit and evaluate the inherent risk in a particular assertion, but every assertion has some inherent risk.
Again, unrelated to the audit, whether there's an audit or not. Now it's up to the auditor to come into a system and evaluate the inherent risk in a particular assertion. And as I say, the combination of control, risk and inherent risk, that gives you your risk of material misstatement. And then finally, the last risk you have to be aware of is detection.
Risk detection. Risk is the risk that the auditor will fail to detect material misstatements, fail, to detect errors and fraud to do in fact exist. This is the one risk that only exists because there's an audit because it's the risk related to the auditor. This is the only risk we've talked about. That only exists when there's an audit called detection risk.
It's the risk that the auditor will fail to detect material misstatements that do in fact, exist errors and fraud that do in fact exist. Now, what the exam loves to test is how these risks interrelate. And if you look in your viewers guide, you'll see a little table. I want to talk about it because it's very important.
You notice the relationships between these risks notice there are three columns in your viewers guide. The first column is the risk of material misstatement member that's made up of what control, risk and inherent risk. And then the next column is detection risk. And the third column is your further audit procedures.
So I think what's he think about the relationships here. If the auditor evaluates the risk of material misstatement in a given assertion to be high, that meaning there's a high probability of material misstatement in this particular assertion, then the auditor will set the detection risk to be low. In other words, the audit would want there to be a low probability.
They'll fail to detect errors and fraud because they think there's a lot of it. Notice there's an inverse relationship between the risk of material misstatement. And detection risk. And of course the exam likes to play with this language where there's an inverse relationship where there's a direct relationship.
So I want you to notice there's an inverse relationship between the risk of material misstatement and detection risk. So if the auditor assesses the risk of material misstatement in a particular session to be high, there's a high probability of errors and fraud. And the auditor then would set their detection risk to be low.
They want there to be a low probability. They'll fail to detect errors and fraud because they think there's a lot of it. So what's the effect on further audit procedures. Extensive. We do a lot of further audit procedures, a lot of substantive testing notice there's an inverse relationship between the risk of material misstatement and detection risk.
There's an inverse relationship. Between detection risk and our further audit procedures, right? If detection risk is set low, then we do much more audit procedures, much more substantive testing. There's an inverse relationship between detection risk and our further audit procedures. Now, if you just cover up mentally that middle column, just cover up in your mind that middle column, there's a direct relationship between the risk of material misstatement and audit procedures.
If we evaluate the risk of material misstatement in a particular assertion to be high, we do a lot of testing. Just common sense. That's a direct relationship. We evaluate the risk of material misstatement in a particular session to be low, we do less testing. It's just common sense. There's a direct relationship between the risk of material misstatement and offer the roter procedures.
Now this could also be expressed. Mathematically. Notice you can express all of this in qualitative terms, high or low, you can also do it quantitatively. Let's say that the risk of material misstatement, the auditor estimates, or evaluates the risk of material misstatement to be 10%.
And the auditor wants to set the detection risk. Excuse me, the inherent the auditor evaluates the inherent risk. Pardon me, the auditor sets the detection risk to be 10%. Let's express this numerically. If the auditor estimates the risk of material misstatement to be 10% and the auditor sets the detection risk at 10%.
What's your audit risk? The risk of material misstatement times the detection risk, we'll give you your audit risk. So if the risk of material misstatement is estimated by the audit would be to be 10% and the auditor. Sex the detection risk 10% take 10% times 10%. That means your audit risk is 1%.
That's let's say the auditor wants to take an audit risk of about 1%. The risk of material misstatement times detection risk will give you your audit risk and audit risk is made up of those two risks and you can express it mathematically. So with thinking mathematically, you can see what happens.
What if the risk of material misstatement is 20%. And I still want to have an audit risk, no greater than 1%. Then I'd have to set the detection risk at 5% would go down. It's an inverse relationship, right? If the risk of material misstatement was up 20%, and I still only want to take as an auditor, an audit risk of about 1%, then I'll have to set the detection risk to be lower 5%, 20% times 5% is 1%.
There's an inverse relationship between the risk of material misstatement. And detection risk. There's an inverse relationship between detection risk and further audit procedures. There's a direct relationship between the risk of material misstatement and audit procedures. Now for our next class, you'll see in your viewers guide that there are 12 multiple choice questions that we're going to be doing in our next class.
I'm assigning those 12. In other words, I want you to have your answers to those 12 questions before you come to the next class and then we'll discuss them together, but get those 12 questions done. And in the next class, we'll go through them together. I'll see you then
welcome back to our discussion on internal control. In our last class, I assigned 12 questions that I wanted you to have done before coming to this class. If you don't have your answers to these questions, you really should shut the class down and get your answers first. That makes a big difference. You try the questions, get your answers before we discuss them together.
But let's look at these 12 questions. Number one, which of the following most likely would not be considered an inherent limitation of the potential effectiveness of an entity's internal control. What's not an inherent limitation. It's not be management override because that is an inherent limitation.
You're stuck with that in any system management can override the controls. That would be true in any system it's baked in the cake inherent unavoidable in any system. Same thing with answers. See mistakes in judgment, human beings. Humans are fallible. How do we avoid that? That's inherent, that's unavoidable in any system de collusion.
Collusion, you can have proper separation of duties, but if employees are going to collude, that would circumvent those controls. The possibility of collusion is inherent unavoidable in any system. So B, C and D are inherent limitations, but answer a incompatible duties. That's not inherent. You can prevent incompatible duties by having proper separation of duties that you have some control over.
If you have a proper separation of duties, there shouldn't be an N. There shouldn't be any incompatible functions. What's an incompatible function. You never want an employee to be in a position where they can both perpetrate something and cover it up in the records. That would be an incompatible function.
If an employee is in a position where they can perpetrate something and cover it up in the records, that is an incompatible function, and that is not an inherent limitation in a system. That can be prevented by separating authorization, record keeping, and custody of assets. That's the arc that will protect us from it.
You have troubles. Number two in the consideration of an entities, internal control, an auditor is basically concerned that the controls provide reasonable assurance. That ACE as operational efficiency has been achieved. We want it to be achieved, but that's not what the auditor. Is basically concerned with, see management cannot override the controls D controls have not been circumvented by collusion.
Again, the auditor would be certainly concerned about both of those things, although they're inherent in any system, but that is not. What they're basically concerned with what the auditor is basically concerned with in any control in internal control structure is answer B that errors and fraud have been prevented, detected corrected on a timely basis.
That's the bottom line. That's the auditor's primary concern. Every time in any system errors and fraud material misstatements, are they being prevented, detected corrected on a timely basis. Number three proper segregation of functional responsibilities in an effective internal control structure calls for the separation of the functions of, answer B authorization, recording and custody of assets.
Number four, proper segregation of duties reduces the opportunities to allow persons to be in a position to both, answer D perpetrate, something, and then conceal the errors and fraud. Answer D five overall attitude and awareness of an entities board of directors concerning the importance of internal control usually is reflected in answers.
See the control environment, do they emphasize internal control? Do they have a written code of conduct? Do they convey ethical values? That's the control environment. And as we said in our other class, If there's a weakness in the control environment, that component of internal control that will have a pervasive effect on the internal control structure six.
Okay. Which of the following is not a component of an entity's internal control? We know the components are C R I M a crime strong internal controls should prevent crime. And of course the answer B control activities is the C in crime. Answer see information and communication is the I in crime answer D the control environment is the Ian grind.
So B, C and D are components of internal control. The answer is a control. Risk is not a component. It's not one of the components of internal control. It's an, it is something, unfortunately, that's in every internal control structure. There's a certain amount of control risk in every internal control structure.
Whether there's an audit or not. There's some control risk, some risk that the internal control structure is not functioning well, but that's not an element. That's not a component of internal control. The components are C R I M E. And if you know that you knew what had to be answered a seven, the primary objective of procedures performed.
To obtain an understanding of an entity and its environment, including internal control. What step are we in the audit process here? Step two. It's always important to think that way, where am I in the audit process? A lot of times in the exam, when you doing a multiple choice, that should be something you stop and think about just for a second.
Wait a minute in this question, where am I in the audit process? Cause it can matter here. We're in step two. We're obtaining where we are retaining an understanding of the entity and its environment, including internal control. So the primary objective of procedures to obtain an understanding of an entity its environment, including internal control is to provide an auditor with a says knowledge necessary to assess the risk of material misstatement and the design of further audit procedures.
Now that's steps three and four, right? That's not the second step of the audit process. That's really steps three and four, where we assess the risk of material misstatement in order to divide in order to design our audit procedures to address the risk of material misstatement. So that steps three and four were in step two here.
B says it's an, our primary objective would be an evaluation of the consistency of application of all management policies. We do care about consistency. We do consistency of application. We care about that. It's not our primary objective C says, as a basis for modifying our tests of controls, it may be, we may use our understanding of the entity, its environment, including internal control to use as a basis for modifying our tests of control.
Why? Because if controls are strong, we probably will test the controls. We'll test the controls to make sure they're as strong as we think they are. If the controls are very weak, why would you test the controls? If you already know they're bad, why would you test them to just prove how bad they are?
I'll say that again, controls a strong, you would test the controls just to document they're as strong as you think they are. If you assess control risk to be. Very high, a high probability of errors and fraud. Why would you keep testing the controls just to show how bad they are, you'd go right to more substantive testing.
So it's true that this would be a basis for modifying our tests of controls, but it's not our primary objective. Our primary objective is answered D to gather, audit evidence, to use in assessing inherent risk. W what we're doing in step two, when we obtain an understanding of the client, It's environment internal control is trying to understand the type of errors and fraud that could exist that could occur.
Where is the inherent risk? That's really what we're doing in the planning phase. What are we dealing with here? What are the types of errors and fraud that could occur? Where is there an inherent risk? That's our primary objective answer D number eight, which of the following factors?
Would most likely be considered an inherent limitation on internal control? What's the answer be human fallibility, human judgment. That's an inherent limitation in any system. It's unavoidable, human beings are fallible. And that of how well you design the system. You're stuck with that. It's baked in the cake in any system number nine, which of the following is an inherent limitation of internal control.
I'm sure you pick it out right away. Collusion. Go ahead. Design a perfect system, have perfect separation of duties. If at the possibility of collusion is always there, that employees could collude to circumvent the system that possibility is inherent in any system. Judgmental sampling is just an audit procedure.
That's not inherent limitation. That's an audit procedure you may use or not answer C and D segregation of duties. Employee peer review. Those are controls, not inherent limitations. Number 10, the objective of tests of details of transactions performed as tests of controls is to what they're getting at in this question is that you can perform tests of controls.
And substantive tests, basically tests of controls and tests of details simultaneously on the same transaction. And when you are performing tests of details as a test of controls, you're doing that for answer D to evaluate whether the internal control procedures are effective. That's why you're doing it.
You're using tests of details as a test of controls. To see if the control was effective to see if the transaction was handled properly. Notice the answers, see to detect material misstatements that would be using tests of details as a substantive test answer sake. But if it's used as test of controls is to see if the controls are effective.
Number 11, when obtaining an understanding of an entity's internal control we're in step two in the audit process. Aren't we. Where we obtain an understanding of the client and its environment, including internal control, an auditor should concentrate on the implement implementation of the procedures.
Why, you know why? Because it's substance over form. We know what don't give us a list of procedures. We want to know if they've been implemented. We want to know if they're effective. We want, we concentrate on implementation of the procedures because of answer D management can establish procedures, but then not enforce compliance with them.
Don't give me a flow chart. Don't give me a narrative. What great controls you have. Have they been implemented? Are they enforced? We care about the substance of the controls, not the form. And then finally, number 12 in an audit of financial statements. An auditor's primary consideration regarding internal control policy or procedures is whether the policy or procedure a reflects management philosophy and operating style.
I suppose it should C says, provides safeguards over access to assets. That would be a consideration, certainly a control enhances management decision-making processes. That would be a C and D. Certainly all important objectives of internal control. What's the primary consideration regarding an internal control policy or procedure answer B how does it affect financial statement assertions?
That's what we really care about. How does it affect assertions now, before you do the next class, I want you to do 10 more questions. Get those 10 questions done. And then I'll look to see you in the next class. Welcome back. Let's take a look at these questions together in number one, they ask in planning and audit.
So we're in the planning phase. We're in the second step of the audit process, the auditor's knowledge about the design of relevant internal control policies and procedures should be used for what purpose? I'm sure he went right to it. It's for a, the reason we're obtaining a knowledge about. The entity its environment internal control is to try to identify what's there to try to identify where the potential material misstatements might be, where the potential for errors and fraud could possibly occur.
That's why we're obtaining this knowledge. It's not B it's not to assess operational efficiency. We've said in these classes, that may be one of the objectives of internal control. It's not really the auditors focus, how efficient. The internal control structure is it's not C determining whether controls have been circumvented by collusion.
Collusion is something we have to accept is inherent as a possibility in any system, no matter how well you design the system, one of the inherent limitations, one of the things we have to accept is that employees might collude to circumvent the system. We just have to accept that, but. That's not why we're obtaining knowledge about the design of internal control policies and procedures to determine if there's been collusion.
That's not our purpose, but we have to accept the possibility is there. And it's not to document these, this level of control risk that comes later in the audit. That's going to come later in the third step. When we are evaluating the risk of material misstatement in particular assertions, we're going to have to.
Document our assessed level of control risk related to particular assertions. So it is answer a number two in obtaining an understanding of an entity's internal control. Again, we're in the planning phase in a financial statement, audit an auditor is not obligated to what is the auditor not obligated to well, answer a determine whether the.
Control procedures have been implemented. No, we are up. It's exactly what we're obligated to determine. Don't just give me a flow chart. I want to know exactly what controls have been implemented and try to understand that internal control structure. Tell me what's been implemented. That is my obligation in the planning phase B perform procedures to understand the design of internal control policies.
We are obligated to do that in the planning phase C. Document our understanding of the company's internal control. We are obligated. What we're not obligated to do in the planning phase is answer D search for significant deficiencies in the operation of internal control. Now we may identify deficiencies later in these classes.
We'll talk about how we handle control deficiencies, significant deficiencies material weaknesses in internal control that we identified during the course of an audit. But we're not obligated to search for them, certainly not in the planning phase. So that's what we're not obligated to do. And the answer is D number three in obtaining an understanding we're in the second step of the audit process planning phase in obtaining an understanding of an entity's internal control, an auditor is required to obtain knowledge about we'll look at the second column knowledge about the design of policies and procedures.
That's exactly what we're. Required to do, but not the first column. We're not required to gain knowledge about how effective the policies are that comes later. The answer is no. Yes. Answer B later in the third step, when we are evaluating the risk of material misstatement in particular assertions, then we're going to get into how effective the control policies and procedures are.
Number four, which of the following statements is correct concerning the use of prior audit evidence. We're at the same client year in, year out, what is correct concerning the use of prior audit evidence regarding the operating effectiveness of controls? Let's go right to it. The answer is big.
If the auditor uses prior audit evidence for several controls, the auditor should have a sufficient portion of them in each audit. Sure should test a sufficient portion of them in each audit so that each is tested at least every third audit. That is the requirement. So if you are at the same client every year, and you're going to rely on controls, assuming they have not changed, you want to test a sufficient portion of them so that all the controls get tested.
At least every third audit at least every three years. Now, if a control has changed, that's different. Now we're assuming the controls have not changed. These are controls. You rely on year in, year out. You just, you are required to test a portion of them so that all of them get tested at least every three years.
But if our control has changed, you're required to test it for the current audit. And if a control is related to a significant risk, you are required to test it in the current one.
Number five. On the basis of audit evidence gathered and evaluated, an auditor decides to increase the assessed level of control risk from that originally planned to achieve an overall audit risk. That is substantially the same as the planned audit risk. The auditor would what I hope you went right to a deep answer.
B decreased detection risk. Remember if you look at this quantitatively, you see what happens if. The risk of material misstatement. And remember the risk of material misstatement is made up of control, risk and inherent risk. If the risk of material misstatement is assessed to be around 10% and the auditor sets the detection risk at 10%.
What's your overall audit risk, 10% times, 10%, 1%. Remember risk of material misstatement times detection risk equals audit risk quantitatively. When they say on the basis of audit evidence gathered and evaluated, the auditor is going to increase their assessment of control risk. If you assist, if you increase your assessed level of control risk, that means the risk of material misstatement would go up.
So let's say the risk of material misstatement goes up to 20%. How do I end up with the same overall audit risk of 1%? I would lower my detection risk to 5%. Remember risk of material, misstatement times detection risk. Equals your audit risk. And it's an inverse relationship. If the risk of material misstatement goes up and you want to maintain the same overall audit risk, then you're going to have to set your detection risk lower.
If the risk of material misstatement goes down and you want to keep the same audit risk, you could set your detection risk higher. You could take off higher risk that you could fail to detect material misstatements because you don't think there were many. It's an inverse relationship. Number six, which of the following audit techniques ordinarily would provide an auditor with the least assurance about the operating effectiveness of internal control.
What's going to provide you with the least assurance. Answer a inquiry, be inspection, see observation. Those are your risk assessment procedures. They are supposed to provide assurance, but answer D a system flow chart that doesn't provide you one of your Sharon's. That's just a pretty picture.
That's just the form to understand the substance we'll use observation inquiry, inspection, analytical procedures. These are our risk assessment procedures. That's what's supposed to give us assurance. To find out the substance of the system. Don't show me a flow chart, although I'll try, it helps, but that's not providing me any assurance at all.
Number seven in obtaining an understanding of a manufacturer is manufacturing entities, internal control, concerning inventory balances, an auditor, most likely would. Again, think where we are in the audit process, obtaining an understanding we're in the second step. We're in the planning phase. In the planning phase, you're not going to answer a analyzed liquidity ratios, turnover ratios.
You're not going to answer B perform analytical procedures, not in the planning phase, not in the planning phase when you're just obtaining an understanding of internal control policies, procedures. You're not applying. Analytical procedures at that stage in the planning phase, of course, in the overall planning phase, we are required to use analytical procedures, but we're not using analytical procedures to understand internal control.
Okay. And in the planning phase, we're not in obtaining an understanding. We're not answer D performing counts. That's more of a substantive test. No, what we're doing in the planning phase in obtaining an understanding of the system is answer C revealing the entities description of inventory policies and procedures.
That's what we're doing at that stage of the audit.
Number eight. After obtaining understanding of the entity and its environment and assessing the risk of material misstatement on audited sides to perform a test of controls. Now let's stop right there. They've obtained an understanding of the entity and its environment and its internal control, and they assess the risk of material misstatement.
So we're out of the planning phase now. And they've decided to perform tests of controls. If you've decided to do tests of controls, has the auditor assessed the internal control structure to be weak or strong? What do you think if they're going to do tests of controls? The auditor has assessed that the internal control structure is strong, not weak.
If the internal, if the auditor assesses the internal control structure to be weak. In other words, if the auditor assesses control risk to be high, they're not going to test the controls. Why would you keep testing the controls to show how bad they are? You wouldn't know you, you test controls when you assess control risk to be low.
When. You've decided that the internal control structure is strong. That's when you test the controls two, from that, there are strong that the controls are as strong as you think they are. That's when you test controls. So that's what's going on here. They're going to test controls. They must think the internal control structure is strong.
Control risk is low. The auditor, most likely decided that answer D says there were many internal control weaknesses. No, it's not answer D. Now this internal control structure is strong. So how are we going to test the controls to make sure they're as strong as we think they are? It's not see, they're not increasing the assessed level of control risk for certain assertions.
If they're going to increase the level of control risk, they think internal controls are weak. They're not going to test those controls and it's not being to say additional evidence to support a further reduction in control. Risk is not available. It might be. Hopefully it will be. It doesn't that's not what the auditor has decided.
What the auditor has decided is a that it's more efficient to perform tests of controls that would result in reduction of its would be more efficient to perform tests of controls that would result in a reduction in substantive testing. That's what, that's the purpose. It's more efficient to test the controls.
Confirmed that they're strong and that's going to result in much less substantive testing. You have to do less for the roter procedures. Remember these relationships, if control risk goes down, you can set your detection, risk higher, an inverse relationship. And the detection risk is higher. That means you can do much less substantive testing.
That's really the objective. So the auditor's decided that's more efficient I'll test the controls, determine how strong they are, and therefore I can do less for the rudder procedures, less substantive testing, number nine, inherent risk and control risk differ from detection risk in that. All right. So they want to know how inherent risk and control risk differ from detection risk.
How about a. They differ in that they arise from the misapplication of auditing procedures. That's what detection risk is. You can't say there, that's not how inherent risk and control risk differ from detection risk. Answer a is what detection risk is not how they differ. Do they differ in the sense that they may be assessed in either quantitative or non quantitative terms?
No, they all can be. They all can be assessed in either quantitative or non quantitative terms. So that's not how they differ. They all can be. How about D they can be changed at the auditor's discretion? The auditors assess assessment of inherent risk assessment of control risk can. Be changed at the auditor's discretion.
That's true. But the actual inherent risk of say cash, the actual control risk in a system that these risks exist, whether there's an audit or not, and the auditor can't change them at their discretion. As I say, the auditor's assessment of inherent risk can be changed. The auditor's assessment of control risk can be changed at the auditor's discretion.
But the actual risk can't be changed. There's a certain amount of inherent risk in a given account, in a given disclosure, there's a certain amount of control risk in any internal control structure that can't be changed. It exists, whether there's an audit or not, and it can't be changed at the auditor's discretion.
So that's not how they differ. Although detection risk can be the auditor can set the detection risk, where they want it to be. So the the achieve the overall audit risk that they're willing to take. The answer is C inherent risk and control risk differ from detection risk in that they exist independently of the audit.
That's exactly right. There's inherent risk in cash, whether there's an audit or not this control risk in any internal control structure where there's an, whether there's an audit or not, but detection risk only exists. If there's an audit. Because it's the risk. The auditor will fail to detect material misstatements that exist in an audit.
So detection risk only exists if there is an audit. So that is how they,
number 10, the acceptable level of detection risk is inversely related to what is detection? Risk inversely. Related to hope you went right to an answer. A, the assurance provided by substantive testing. If an auditor sets their detection risk low, they want it to be a low probability. They'll fail to detect material misstatements.
Then what happens to substantive testing? It goes much higher. You do much more substantial testing, much further audit procedures. It's an inverse relationship, keep studying don't fall behind and I'll look to see you in the next class.
Welcome back in this class, we're going to continue our discussion of internal control. And as we know, there are five components that make up internal control. There's control activities, there's risk assessment, information and communication monitoring and the environment, and the way we're going to remember those components for the rest of our lives is crime strong, internal control should help to prevent crime.
And what we're going to focus on specifically in this class is the C in crime control activities. The specific policies and procedures that are in place that will assure that all transactions are properly initiated, authorized, approved, executed, and recorded. Now, when we say control activities, what sort of control activities are we looking for?
I want to give you a memory tool. I want to give you a memory tool on the type of control activities. That should be in any really strong internal control structure. And I think you'll find that this memory tool will help you of course, with multiple choice and perhaps in a simulation, if you're given a narrative of a system, maybe a flow chart, what control activities do you look for?
Let's go over the control activities that belong that are essential. In a strong internal control structure. My memory tool is band-aids just remember the way you stop the bleeding is with band-aids. Let's go over. What it stands for. The B in band-aids is bonding employees that work with cash.
Liquid assets, securities should be bonded. And as you probably know, bonding is an insurance policy. And it works on a number of levels. First of all, if an employee does steal cash, the client is insured. So they would get an insurance recovery, but it works on another level as well before any insurance company pays out a claim, they do a thorough investigation.
They get to the bottom of what happened. They find out who was responsible and not only do we know that. The employees know that. And the insurance companies have a reputation. They are brutal. They get to the bottom of what happened. And as I say, employees know that, so it serves as a deterrent as well.
It's a good control. So if cash is stolen, if liquid assets are stolen, then the client would get a recovery. Of course that's important, but don't forget that deterrent effect employees know that the insurance company would not pay out a claim without finding out who was responsible. It's an important control with liquid assets.
The a and band-aids is authorization and approval. It's critical to control how transactions are initiated, authorized and approved. Very important controls. The N in band-aids numeric and crosschecks numeric checks. Very simple things. Pre-numbered documents. Pre-numbered you don't think of it as a control.
It's a control pre number checks. Pre-numbered purchase orders. Pre-numbered receiving reports. It's an important control because if they're pre-numbered, then we know the total population of something. It's a very essential control. Crosschecks there should be crosschecks on many crosschecks in a good system.
A bank reconciliation is a cross-check you'll see. Later in these classes, we're going to go through the purchases accounts payable system. And in the purchases accounts payable system, the accounts payable department does a cross-check between the original purchase requisition and the purchase order and the receiving report and the vendor's invoice.
There's a cross-check between all those documents. Before the accounts payable department prepares evoucher package, crosschecks very important in a strong internal control structure. The D is documentation. Documentation is essential for the audit trail. Again, later in these classes, when we talk about the purchases accounts payable cycle, we're going to see all these documents have been filed for the audit trail, the original purchase requisitions, the purchase orders, the receiving reports, the invoices, the voucher packages.
There's an accounts payable, subsidiary ledger. Everything is documented. Everything is recorded. It's essential for internal audit and it's an important control. And of course it helps. And it's essential for monitoring the to monitor the system. It has to be fully documented. The a and bandaids would be appropriate.
Physical controls, simple things. Locks on doors. Employee ID badges are safe. These are controls. They should be. Appropriate physical controls. The eye is the internal audit function. The internal audit function, it having an internal audit function is a control in itself. And again, it helps with the M in crime to monitor the system.
The second D is detailed personnel policies and procedures. They have to be detailed, very carefully detailed. Personnel policies and procedures. Who does the hiring, who does the firing, who approves pay raises things you might not think of forced vacations? If there is collusion in a system, if somebody is doing something and hiding something in the records, very hard to do that, unless you show up every day and keep the con game going.
So having forced vacations. Is a control, something you'd look for in detailed personnel policies and procedures and the SN band-aids. Do I even have to say it? You know what? The S stands for segregation of duties. It is essential for internal control that we separate authorization from recordkeeping and custody of assets, a RC, separate authorization, recordkeeping, and custody of assets.
That's the arc. That protects us from a sea of troubles. We never want an employee to be in a position where can, where they can both perpetrate something and cover it up in the records. That would be an incompatible function. And the way we prevent incompatible functions is by having a proper separation of duties.
So if bandaids, and I know you will, that should help you in many types of questions in the exam, because it should be in your head. What. Specific control activities should a strong internal control structure have
in number one, they say after testing a client's internal control activities, an auditor discovers a material weakness in the operation of a client's internal control under the circumstances the auditor most likely would. A says issue a disclaimer, because there's a weakness in internal control. Now C says issue a qualified opinion.
No, not because it's a weakness in internal control. Withdraw answer D withdraw from the engagement. No, no answer be, if there's a weakness in internal control, they're going to increase their assessed level of control risk, and therefore increase substantive testing. Remember, there's a direct relationship between the risk of material misstatement and audit procedures.
If the risk of material misstatement goes up and remember risk of material, misstatement is a combination of control, risk and inherent risk. So if you've increased your
assessed level of control risk, the risk of material misstatements has gone up and at the risk of material, misstatements has gone up. You have to do much more extensive. Further audit procedures, much more extensive substantive testing. That's the effect. Answer B number two. The ultimate purpose of assessing control risk is to contribute to the auditor's evaluation of the risk of what answer D material misstatements that's.
That's the ultimate purpose of assessing control risk.
It's coming up with auditor's evaluation. Of the risk of material misstatements that exist in the financial statements answer date. It's not answer a, it's not to contribute to the auditor's evaluation of the risk. That specific internal control activities are not operating as designed. That is controlled risk.
So you can see the purpose of control risk is to contribute to the auditor's evaluation of control risk a is controlled risk. So it was B. The collective effect of the control environment may not achieve the control objective. That's really part of well risk, and it's not okay to contribute to the auditor's evaluation of the risk that tests of controls may fail to identify activities relevant to assertions.
That's not the ultimate purpose. Now the ultimate purpose of assessing control risk is to evaluate the risk of. Errors and fraud in the financial statements. Number three, what is the most likely course of action that an auditor would take after determining that performing substantive tests on inventory will take less time than performing tests of controls?
If to start with, before you even start looking at answers, what does that mean to you? If an auditor has decided that performing substantive tests on inventory will take less time. In other words, be more efficient than testing controls. Then controls must not be very good, right? If the controls were strong, then your best course of action is to test some controls, make sure that they're operating effectively and do much less substantive testing.
It's much more efficient, but here they've decided that doing more substantive testing will be more efficient. The controls must not be very good. So they want to know what is the most likely course of action. It's not D perform only tests of controls. Why would you test the controls? We've already decided that they're not very good.
It's not D a says assess control at the minimum level. No. And at maximum controls must be not very good here. So you wouldn't assess control risk to be at minimum, probably at maximum. And
would be with the most likely course of action, B before I'm both tests of controls and substantive tests. No. Why would you want to do both? If take, if performing substantive tests is going to take less time, it's got to be more efficient than the answer is C just perform only substantive tests. Why test the controls.
We don't have to prove how bad they are. Let's just go right to substantive testing. It'll take less time.
What we're going to get into next is how an auditor handles deficiencies in internal control identified during the course of an audit. And the bottom line is an auditor is required. To submit a written communication to management and those in charge of governance on any significant deficiencies and material weaknesses found during the course of an audit.
That's the bottom line. An auditor is required to submit a written communication to management and those in charge of governance on significant deficiencies and material weaknesses found during the course of an audit, let's get into some definitions. What's a control deficiency. A control deficiency is the deficiency in design, a deficiency in design or operation of controls that does not allow management or employees to prevent, detect correct material misstatements on a timely basis.
Like over that again, a control deficiency is a deficiency in design. That means the control is not there. When you see there's a deficiency in design, it means the control is not there. Or operation. That means the control is there. It's just not effective. So when you see, Oh, a weakness in control that in operation, that means the control is there.
It's just not effective. All right. So it's deficiency in design. The control is not there or operation it's there, but it's not effective of controls that does not allow management or employees to prevent, detect correct material, misstatements, errors, and fraud on a timely basis. And as we said, an auditor is required to submit a written communication to management and those in charge of governance for control deficiencies that are determined to be significant deficiencies or determined to be material weaknesses.
That's what we're saying that an auditor is required to submit a written communication to management and those in charge of governance for control deficiencies that have been determined to be significant deficiencies. Or material weaknesses, let's go over what these are. What's a significant deficiency.
A significant deficiency is a very bad control deficiency. That's what we're saying. A significant deficiency is simply a very bad control deficiency. More precisely. It is an internal control deficiency or a combination of deficiencies. Important enough. To merit, attention to management and those in charge of governance.
One more time, a significant deficiency, a very bad control deficiency. It's a deficiency or a combination of deficiencies. Important enough to merit, attention by management or those in charge of governance. What's a material weakness is our very bad, significant deficiency. That's what a material weaknesses.
It's a very bad, significant deficiency. It is. A deficiency or a combination of deficiencies, such that there is a reasonable possibility that material misstatements are not being prevented, detected corrected on timely basis. One more time on material weakness, it's a very bad, significant deficiency. It is a deficiency or a combination of deficiencies, such that there's a reasonable possibility that material misstatements in the financial statements are not being.
Prevented detected corrected on a timely basis. Now, if you look in your viewers guide, you'll see an example of this written communication. Just point out a couple of things. If you look at it, you'll see in the required written communication that it States what the auditor did, what the CPA did, the purpose of an audit.
It's it States that. They are not expressing an audit opinion on the effectiveness of internal control. Notice that it is stating that they are not expressing an audit opinion on the effectiveness of an internal control. They're also stating that the consideration of internal control is not designed to identify all deficiencies in internal control.
That might be significant deficiencies or material weaknesses. Notice we state. That the consideration of maternal control is not designed to identify all deficiencies in internal control. That might be significant deficiencies or material weaknesses. And then the report defines what a significant deficiency is, what a material weakness is, and then identifies all the significant deficiencies and the material weaknesses that were found.
And notice there's a restriction. Make sure you read that over. And you see the bottom line, if no significant deficiencies or material weaknesses are filed, no written communications required, right? It's that simple. If no significant deficiencies or material weaknesses are found, no written communication is required.
If any significant deficiencies or material weaknesses are found or written communication is required. What if the following year, the audit, it goes back to the client. And the significant deficiency, the material weakness hasn't been fixed while the CPA keeps reporting on that deficiency until it is fixed.
What is the deadline for this written communication? If it's a non-issue or if the client's a non issuer, the written communication has to be filed by the audit report release date. Again, if the clients are non issuer, The written communication has to be filed by the audit report release date, but under no circumstances, can it be filed more than 60 days after the audit replete audit report release date?
That's the rule, the exam loves deadlines. So one more time if the client's a non-issue or the written communication has to be filed basically by the audit report release date, but under no circumstances, can it be filed more than 60 days? After the audit report release date no more than 60 days after the audit report release date exam loves deadlines.
Now, if your client is an issuer, then the written communication has to be filed before the audit report is released before the audit report is released. What if your client requests a written communication that says no significant deficiencies, no material, weaknesses were found. What if your client wants that?
Your client would like a written communication that States no significant deficiencies, no material weaknesses were found that's never done. Unless it were required by a governmental agencies say that would be very rare, but that's really never done because it could be misconstrued. I will look to see you in the next class.
And there are two questions I want you to get done before I see you in the next class. And in the meantime, keep studying don't fall behind. Welcome back to our discussion on internal control. Let's do the two questions I wanted you to answer before we get into new areas. Number one says which of the following matters would an auditor most likely considered to be a significant deficiency to be communicated to management and those charged with governance.
Remember what a significant deficiency is. It's a very bad control deficiency. It's a deficiency or a combination of deficiencies important enough to merit attention. So what's going to be a significant deficiency here. How about a management's failure to renegotiate unfavorable long-term purchase commitments?
That may not be great management, but it's not really related to internal control. Might indicate poor judgment. That would not be a significant deficiency. B recurring operating losses. That may indicate a going concern problem. Again, may or may not have anything to do with internal control D management's current plans to reduce its ownership equity in the entity may or may not have anything to do with internal control, but answers see evidence of a lack of objectivity by those responsible for accounting decisions that.
It looks like a series internal control problem. That could be a significant deficiency. Maybe even a material weakness, a material weakness is a deficiency or a combination of deficiencies that cause a reasonable possibility that material misstatements are not being prevented, detected corrected on a timely basis.
Might even be a material weakness, certainly a significant deficiency. Number two. Which of the following is least likely to indicate the existence of a material weakness in internal control. Oh, remember what a material weakness is a very bad, significant deficiency. It's a deficiency or a combination of deficiencies that would cause a reasonable possibility that material misstatements are not being prevented, detected corrected on a material on a timely basis.
Which of the following would least likely indicate that there's a material weakness a says fraud on the part of senior management? No, that would, that could certainly be a material weakness. That's not it. That likely is B previously issued financial statements were restated to reflect the correction of a material misstatement due to errors or fraud.
So it could be an indication of a material weakness. See those charged with governance. Exercise in effective oversight of the entities, financial reporting and internal control, I would say, but almost by definition, that is a material weakness answer D there's a substantial doubt about the entities ability to continue as a going concern that may have nothing to do with internal control that's least likely great to be a material weakness, answer D.
Now what we're going to get into next in this class. Are some transaction cycles and the transaction cycles. We're going to go through, come up a lot in the exam. You'll see. When you do your homework, a lot of multiple choice refer to these cycles and the documents and the controls in the cycles. There are simulations that come up that are all about the cycles and the documents in these cycles and the controls in these cycles.
So I think it's important. That we step them through. Let's start with the purchases accounts payable transaction cycle. Let's go through the flow of documents. Think about the controls that are built into a, classic purchases and accounts payable, transaction cycle. Notice the cycle all begins in the user department.
The user department is using the raw material and when they run out, they prepare a pre-numbered notice the numeric check. It's an it's pre-numbered we know the total population, a pre-numbered store's requisition. Copy. One is filed for the audit trail. Notice the first and bandaids documentation.
It's really how you monitor the system. You need that audit trail. Copy. One is filed. Copy. Two goes to the store room. Let's go to the storeroom. Storeroom would receive the stores, requisite store record stores, requisition. And send the goods back to the user department. That's what happens on a daily basis.
The store's requisition comes in to the store room and they send the material back. But what happens when the storeroom runs out of raw material? The storeroom prepares a pre-numbered. Now the numeric check purchase requisition. Copy one is filed for documentation for the audit trail for monitoring.
Copy two goes to accounts payable and copy three goes to the purchasing department. Now let's go to the purchasing department. Now let's think about the a and band-aids authorization approval. Obviously the purchasing department has been authorized to handle purchasing for this company, to certain vendors within budget limits, but there's been authority given to the purchasing department to order goods like this.
And that would have to be, this is where the approval would take place. The approval for this particular transaction would be handled here. And the purchasing department receives copy three of the purchase requisition and the purchasing department prepares a pre-numbered. Now the numeric check purchase order.
Copy. One of the purchase order is filed for the audit trail. Copy two goes to the vendor. Copy three. Goes to the receiving department and notice it's a blind copy. The quantity ordered is blacked out so that when the receiving department gets their copy of the purchase order, the quantity has been blacked out.
They have no preconceived notion of what's supposed to come in. It's another control and copy four goes to accounts payable. Let's go to the receiving department. The receiving department receives copy three of the purchase order, the blind copy and. They prepare a pre-numbered another numeric check receiving report.
Now what happens to the pre-numbered receiving report? Copy one is filed for documentation for the audit trail. Copy two goes to accounts payable and copy three. They re they fill in the number they received and send it back to purchasing. You know what it's for across check. He is a crosscheck, very important control because they got a blind copy.
Now, when the. When the goods come in, they fill the number in, send it back to the purchasing department for a crosscheck. All right, now let's go to accounts payable. Now think what accounts payable has in its hands accounts payable has received copy three of the purchase requisition, copy four of the purchase order.
Copy two of the receiving report. And now the vendor's invoice comes in. They would now be another cross-check between all those documents. This purchase would be recorded. By the accounts payable department in the accounts payable, subsidies, ledger, and now the accounts payable department. Prepares a pre-numbered voucher package.
All right. So the accounts payable department does a cross-check between the purchase requisition and the purchase order, the receiving report and the vendor's invoice. There's a cross-check. They record the purchase in the accounts payable, subsidiary ledger, and now they prepare a pre-numbered voucher package.
Copy. One is filed. Copy. Two goes to general accounting. And copy three goes to the treasury department. Let's go to the treasury department. Treasury department receives copy three of the voucher package. They do a cross-check on all the documents and they prepare and mail. The check notice custody of assets stays in one hands, just in one place.
Have you noticed this system did separate authorization, recordkeeping custody of assets. So they would prepare the check and mail the check. Also the treasury department would approve write-offs that's important. Remember if a receivable, a bad debt is written off, that's approved by the treasury department.
Why? Because when you write off a receivable, you're disposing of an asset, it's again, it's custody. We want to keep custody in one department and notice the treasury department. After they mail the check, they canceled the voucher package. They perforate it. They stamp it. So the documents can't be used again to justify another purchase.
Now, general accounting gets copied to the voucher package. They posted to the general ledger. They update the general ledger. Now, one of the reasons you study that transaction cycle, and again, I want to emphasize, you'll see, in your homework, this is not just busy work. The purchases accounts payable cycle is referred to a lot.
In the exam, multiple choice, even simulations the flow of the documents. You want to be really good at this. And when you go over and I know you will several times go over that purchases, accounts payable cycle study, the flow of documents. Notice how we went from the store's requisition to the purchase requisition, to the purchase order to the receiving report, to the vendor's invoice, to the accounts payable subsidiary ledger, to the voucher package, to the check itself.
And to the general ledger, right? Get that flow of documents in your head. The user department prepares the store's requisition the storeroom prepares the purchase requisition. The purchasing department prepares the purchase order. The receiving department repairs, the receiving report, the vendor sends in the vendor's invoice, the accounts payable department updates, the accounts payable, subsidiary ledger.
The accounts payable department prepares the voucher package, the treasury department prepares and mails, the check and general accounting updates. The general ledger
let's look at another transaction cycle. Let's look at the sales accounts receivable cycle. Now the one, the exam is very Fonda noticed in the sales accounts receivable cycle. Everything starts in the sales department. That's where it all starts, where the sales department receives a purchase order from a customer.
They get the customer purchase order. Then the sales department prepares a pre-numbered. There's a first numeric check. Six copy sales order is a pre-numbered six copy sales order. Copy. One goes to the billing department with the customer's purchase order. That's what goes to the billing department? Copy two goes to the ship, the shipping department.
Copies three and four go to the credit department. Copy five goes back to the customer and copy six is filed and why documentation audit, trail monitoring that internal audit function so important, such an important control. All right, now the credit department receives copies three and four of the sales order.
They approve the customer credit and then they send copy three, the approved sales order. To the shipping department and copy four of the approved sales order to the billing department. Let's go to the shipping department. Shipping department received copy three of the approved sale order. They also received copy two of the original sales order from the sales department and the shipping department prepares a pre-numbered another numeric check bill of lading, bill of ladings, a shipping document.
So they prepare a pre-numbered bill of lading. Copy. One goes to the customer. Copy two. Goes to the billing department. And copy three is filed along with copy three of the approved sales order and copy two of the original sales order. All that is filed for documentation for the audit trail. And of course the goods are shipped to the customer.
Let's go to the billing department what's in the billing departments, hands billing department received copy two of the bill of lading from the shipping department. They received copy one of the original sales order and the customer purchase order from the sales department. And they also receive copy four of the approved sales order from the credit department and the billing department prepares a pre-numbered.
Now the numeric check sales invoice is a pre-numbered sales invoice. Copy. One goes to the customer. Copy. Two goes to accounts receivable, copy three goes to general accounting, and then. Copy four is filed along with copy. One of the original sales order, the original customer purchase order and copy four of the approved sales order and the billing department would post the sale to the sales journal.
Let's go to the accounts receivable department counts receivable department has received copy two of the sales invoice from the billing department. They post. This sale to the customer's account and update the accounts receivable master, nor are they, record it in the accounts receivable subsidiary ledger, then general accounting receives copy three of the sales invoice billing, and they posted the general ledger.
They update the general ledger. So once again, study that cycle, you'll just go over it several times. And again, pay particular attention to the flow of documents. Notice how we went from the. Customer's purchase order to the sales order to the approved sales order, to the bill of lading, to the sales invoice and the sales journal, the accounts receivable subsidiary ledger, and the general ledger.
That's the flow. Believe me, it'll help you. It's another transaction cycle that is. Test it a lot in the exam. All right. So the customer sends in the purchase order, the sales department prepares the sales order, the credit department approves the sales order. The shipping department prepares the bill of lading.
The billing department prepares the sales invoice updates, the sales journal, the accounts receivable department updates, the accounts receivable, subsidiary ledger and general accounting updates. The general ledger, make sure you know that flow of documents.
Let's look at another transaction cycle. These all turn up. Let's look at the cash receipts, transaction cycle cash receipts. Now for cash receipts, it would all start in the mail room. We have an employee that opens the mail and prepares pre-numbered notice a numeric check, a pre-numbered daily remittance listing.
For all the checks that come in that day, there would be a pre-numbered daily remittance listing. Copy. One is filed for documentation for audit trail. Copy two goes to the cashier. If there is a cashier, if there's not a cashier, it would go to treasury, go to the treasury department. Copy three goes to accounts receivable, copy four goes to general accounting.
Let's go to the cashier if they do have one and it will be the cashier or the treasury department. The cashier or the treasury department receives copy too, of the daily remittance listing. And they prepare a pre-numbered another numeric check, a pre-numbered deposit summary because the cashier or the treasury department makes deposits daily.
That's an important control. The deposits are made daily, so they prepare a pre-numbered deposit. Summary. Copy one is filed for documentation for the audit trail. Copy two goes to accounts receivable. Copy three goes to general accounting. The exam could mention a bank lockbox, a bank. Lockbox is a good control.
That's where customers send checks directly to the bank. Also, you had mentioned bank reconciliations are an important crosscheck bank. Reconciliation should be done monthly usually by. Accounts. It's usually by internal audit, but bank reconciliation is important. Isn't it is. It should be done monthly.
It's an important crosscheck, usually done by internal audit. Maybe the finance area, usually internal audit let's go to accounts receivable. Accounts receivable gets copy. Two of the deposit summary from the cashier. They also get copied three of the remittance listing from the mail room and they update the account receivable master and they prepare a pre-numbered the numeric check cash receipt.
Summary is going to be a pre-numbered cash receipt summary. Copy. One is filed for the documentation for the audit trail. And copy two goes to general accounting. Let's go to general account and also in the accounts receivable department. They would record this cash receipt in the cash receipts journal.
They would record the cash receipt in the cash receipts journal. Now let's go to general accounting. What does Jen, what does general accounting have in its hands? They have copy four of the remittance listing from the mail room. Copy three of the deposit summary from the cashier or the treasury copy.
Two of the cash receipt summary from accounts receivable. So there is a cross-check. They posted the general ledger. They update the general ledger and that's basically the flow. So once again, you want to study that basic flow of documents and get used to the flow of documents. We went from the remittance listing to the deposit summary, to the account receivable, master cash, receipts, journal cash, receipts, summary, general ledger.
Make sure you go over that flow, several times. Because these transaction cycles are tested. As I say, a couple of things about property plant equipment, we won't go into the same level of detail, but a couple of things to look out for in property plant equipment for property plant equipment, make sure that there's a control that major purchases have to be approved by the board of directors.
Major purchases, property plant equipment should be approved by the board of directors. That should be a control that there's adequate insurance coverage. There should be physical controls, restricting access to property, plant equipment, and also should be a stated policy regarding whether to expense something or capitalize something in terms of human resources, payroll.
Remember the second D and bandaids is detailed personnel policies and procedures. A couple of things to look out for, the human resources department. Should hire people, fire people, all right, there should be detailed personnel policies and procedures. And the human resources department should hire people, fire people and approve salary changes.
The payroll department should just process payroll and a good control is to have a separate payroll account called an impressed account. It's an impressed account. Where you put in the exact amount that's needed for payroll. So when everybody cashes the check, the balance goes to zero, a couple other small things.
If there was a signature machine for checks, any unused checks should be locked up. Unclaimed payroll checks should be handled by internal audit. Again, my advice from this class is make sure you take the time. I know it's not exciting, but take the time. To go over those transaction cycles, make sure you do and study the flow of documents.
You'll see, later in our classes, this is going to help you with evidence as well. When we talk about tracing and vouching to know these documents and the flow of documents, and these transaction cycles will help you a great deal. Now for the next class, there are 15 questions that I want you to have answering 15.
Please answer those questions. And I will look to see you in the next class.
Welcome back in this class. There are 15 questions that we're going to do together, and hopefully you've answered these 15 questions. You have your answers, and now we'll go through them together. Number one says a weakness in internal control over recording retirements of equipment. Most likely would cause an auditor to what.
I think, it's not a trace additions to the other assets account to search for equipment. That's still on hand, but no longer being used. If it's still on hand, it hasn't been retired. Remember we're looking for a weakness and internal control over recording retirements of equipment. So if this equipment still on hand, it hasn't been retired and it's not see review the subsidiary ledger to ascertain whether.
Depreciation was taken that has nothing to do with retirements. My point is it comes down to B or D. That's what you might've really got stuck on. What's your best approach. If you're an auditor, if you think there's a weakness in recording retirements, how about D what if you expect, what if you inspect certain items of equipment in the plant?
And then trace those items back to the accounting records. No, that doesn't work because of the items are in the plant. They haven't been retired. Remember we're afraid there's a weakness in recording retirements of equipment. So if you start by finding something in the plant, it hasn't been retired. The answer is B.
You want to select certain items of equipment from the accounting records and then see if you can find them in the plant. That makes sense. Doesn't it. If you start by selecting certain items of equipment in the accounting records, and then see if you can locate them in the plant, you might find that you have found equipment in the accounting records that you cannot find in the plant because they've been retired and it hasn't been recorded.
That's how you would test to see if there's a weakness in recording retirements. Answer B number two on entities. Internal control requires that for every check request. There'll be an approved voucher, supported by a pre-numbered purchase order. And a pre-numbered receiving report sounds like a pretty good system to me to determine whether checks are being issued for unauthorized expenditures are checks being issued for unauthorized expenditures, an auditor, most likely would select items for testing from the population of what?
If you want to see if checks are going for unauthorized purchases, unauthorized expenditures. You would start with answer B, start with the population of checks. You want to pick a selection of checks and then vouch back to all the supporting documentation and see if it was authorized. You don't want to go to purchase orders.
They've been authorized receive reports that would be based on an authorized purchase order of ours would have all sorts of authority attached to it. That a, B and D. All would be authorized, would be, it would involve an authorized transaction. If you think there are checks going out for unauthorized, start with the population of checks, get a random sample of checks, and then see if you can find all the supporting documentation and see if there's any checks going that are for authorized expenditures.
You can't find the documentation or the documentation is not valid. Three, four effective internal control. The accounts payable department generally would, what would accounts payable do what it a obliterate, the quantity ordered on the receiving department copy of the purchase order? No, the purchasing department does that not accounts payable C says stamp perforate or otherwise canceled the supporting documentation after payment is ma made the treasury department.
Does that see why you have to know these cycles D ascertain whether each requisition is approved. As to price, quantity and quality by an authorized employee who would handle the approval on a purchase requisition, the purchasing department. So a, B, C, and D can't be at it is B accounts payable would establish the agreement of the vendor's invoice with the receiving report, the purchase order, the purchase requisition, before they prepare the voucher package.
It is. Answer be that is something the accounts payable department would do. See why you have to know these cycles. Number four, auditor tests, an auditor's tests of controls for completeness for the revenue cycle usually include determining whether a says each receivable is collected subsequent to year end.
That doesn't tell you whether revenue is complete, just means all the receivables that have been recorded are collected. Doesn't tell you whether there's a bunch of receivables that have never been recorded. You don't know what the revenue is complete. There, just that all the receivables that have been recorded have been collected.
How about see each invoice is supported by a customer purchase order? That's a good control, but you don't know that all the invoices have been recorded. That should be that revenues complete. Dee says each credit memo is approved. That's probably for return merchandise. Nothing to do with how the revenue is complete.
Now, the answer is big. You want to see if there's an invoice for every shipping document and every time goods have been shipped, there's an invoice prepared. Then, revenue is complete. That would be your test. Look at all the shipping documents and make sure that there's an invoice for every shipping document.
Every time something has been shipped as an invoice, then revenue would be complete. Number five. Which of the following controls would be most effective in assuring that recorded purchases are free of material errors. What's the most effective control here. How about a, what if the receiving department compares the quantity ordered on the purchase order with the quantity received and the receiving report receiving department won't be able to do that because they purchase order is a blind copy.
They don't know the amount that was ordered member that would have to go back. To the purchasing department to make this comparison receiving department would fill in the amount, received, send it back to purchasing and they would do the comparison, not the receiving department that doesn't make sense.
How about B vendors? Invoices are compared with the purchase orders by an employee who is independent of the receiving department. That's a good control, but remember, we're looking for the Mo the most effective, but B's not a bad control in accounts payable. See receiving reports require the signature of an individual who's who authorized the purchase.
I don't see the purpose of that really. The receiving department bases everything on an approved purchase order. I don't see why the receiving report would need a signature that doesn't make any sense at all. The answer of course, is D. Notice purchase orders, receiving reports and vendors, invoices are all crosschecked independently matched before you prepare the voucher.
And that course is done by the accounts payable department. Does that impressive crosscheck? If what is a voucher package? That's the most effective control number six. Which of the following procedures most likely would not be an internal control procedure designed to reduce the risk of errors in the billing process.
So what is not an internal control for the billing process here? A comparing control totals for shipping documents with corresponding totals for sales invoices? No, that would be a control for billing, making sure that for everything that's been shipped, there's an invoice. That's a control for billing.
Be using computer program controls on the pricing and mathematical accuracy of the sales invoice. That's obviously a control on billing. We're looking for what would not be see matching shipping documents with the approved sales order before there is an invoice prepared, definitely a control for billing,
but look at D. Reconciling the control totals for sales invoices, with the accounts receivable subsidiary ledger. Yeah, that is a control, but it's not a control for billing because it's too late. If you are reconciling, adding up all your sales invoices and making sure that corresponds to what went into the accounts receivable subsidiary ledger.
The building's already taken place. You're adding up all the invoices that have gone out. That's not a control for billing. Billing has already happened. Seven in testing controls over cash disbursements, an auditor most likely would determine that the person who signs the checks, mails, the checks answer D you keep the custody of assets in one department, separate authorization, recordkeeping, and custody of assets.
Eight, the authority to accept incoming goods in a receipt in. Receiving should be based on what an approved purchase order. That's the authority you receive incoming goods in the receiving department. It's based on an approved purchase order answer D nine, which of the following describes a weakness in accounts payable procedures a says the accounts payable, clerk, files, invoices, and supporting documentation after payment, nothing wrong with that documentation controls audit trail.
Monitoring. It's good. It's good. Control B the accounts payable clerk manually verifies arithmetic on the vendor invoice. What's wrong with that? It's a good control. They will know a weakness. The accounts that answer say the accounts payable system compares the receiving report to the vendor. Invoice.
Sounds like a good control to me.
Answer D. The accounts payable, manager issues, purchase orders. No, that's a breakdown in control. Who should issue the purchase orders? The purchasing department, that's a breakdown in separation of duties. No, the accounts payable manager should not issue purchase orders. The purchasing department should 10, which of the following circumstances most likely would cause an auditor to submit.
To suspect an employee payroll fraud scheme. That's going to make you suspect fraud in payroll. B says payroll checks or district are dispersed by the same employee, every pay day, nothing wrong with that, that I can see it. Doesn't indicate fraud. See employee time cards are approved by individual department supervisors.
That seems fine. A separate payroll bank account is maintained on an impressed. Basis that impressed account ideas, actually a pretty good idea. Everybody cashes their check. The account goes to zero. What might indicate this fraud is a, there are significant unexplained variances between standard and actual labor costs.
If you have unexplained variances, maybe the explanation is fraud. Maybe that is the explanation. Number 11. Proper authorization of write-offs of uncollectable accounts should be approved by hope, treasurer, answer, date, custody of assets. We separate authorization, recordkeeping and custody of assets. And if you approve a write off you're disposing of an asset, when you write off a receivable, that's what you're doing.
So we keep custody and the disposal of an asset, the treasury department. Okay.
12 employers, bond employees who handle cash receipts because fidelity bonds reduce the possibility of employing dishonest individuals. And I'm sure you went right to answer B it's deterrence. It deters dishonesty by making employees aware that insurance companies investigate and prosecute. You bet they do.
They're animals and everybody knows it. And it's good. It's a deterrent. It's what it's meant to be 13 when, excuse me, which of the following situations most likely would lead could lead to an embezzlement scheme? ACE says the accounts receivable bookkeeper receives a list of payments prepared by the cashier.
Personally makes entries in the customer's accounts in the subsidiary ledger. I don't see any problem. There be each vendor invoice is matched with a related purchase order receiving report by the vouchers payable, bookkeeper who personally approves the voucher for payment that's. Okay. I think that nothing that would lead to embezzlement there D vouchers and supporting documentation are examined and then canceled by the treasurer.
Who personally mails the checks that seems like strong internal control to me. Look at answers, see access to blank checks and signature plates is restricted to the cash. Disbursements bookkeeper, who personally reconciles the bank statement. Remember bank statements. It's an important cross check bank statement should be reconciled monthly.
It's an important crosscheck by the internal audit department. Generally internal audit, but a bank reconciliation should never be done by an employee who handles cash. Keeps records, signs, checks, handles receipts or disbursements. Never say it again. Bank reconciliations should be done every month, probably by internal audit.
Maybe the finance area, maybe. But never buy an employee that handles cash, never by an employee that keeps records never by an employee that signs checks never by an employee who handles receipts or disbursements, never, that could lead to fraud answers. See number 14, which of the following questions would an auditor least likely include on an internal control questionnaire concerning the initiation and execution of equipment transaction.
What question would you least likely find on an ICQ on internal control questionnaire concerning the initiation and execution of equipment transactions, a are requests for major repairs approved at a higher level than the department initiating the request. Now that would be on an ICQ regarding the initiation and execution of equipment transaction.
That is about initiation execution, B. Are pre-numbered purchase orders used for equipment and periodically accounted for that would certainly be a reasonable question on that. Internal control questionnaire. See our requests for purchases of equipment reviewed for consideration of soliciting competitive bids.
That certainly belongs on that internal control questionnaire, but answer D. Are procedures in place to monitor and properly restrict access to equipment? That could be on an internal control questionnaire, but not on internal control questionnaire concerning just the initiation and execution of equipment.
Transaction access isn't. It is a control and it might be on internal control questionnaire about access, but not about the initiation and execution of equipment transactions. Wouldn't be on that ICQ. That would least likely be their answer. D and finally, number 15, which of the following events occurring in the year under audit would most likely indicate that internal controls utilized in previous years may be inadequate in the year.
How about eight? The entity announced that the. Internal audit function would be eliminated after the balance sheet date, while that might be a problem in future years, that doesn't indicate that a control you relied on in prior years, it might not be effective in the current audit. Now they're going to eliminate the internal audit function.
That's not a good sign. I don't like it. But again, that could affect future years. Not the year under audit B says the audit committee chairperson unexpectedly resigned during the year under audit that. May or may not have anything to do with internal controls. D the frequency of accounts payable check runs was changed from biweekly to weekly.
That could just indicate an increase in volume, meaning a different difference, a different policy that does not indicate that, controls that you relied on in previous years. Can't be relied on this. On this year. Look at answers. See the chief financial officer waived approvals on all checks to one particular vendor.
To expedite payment, all of that. So there's been a breakdown in controls here, controls that we've always used in the past. Now there's been a breakdown in the current year for this particular vendor that could indicate that the control we used to rely on is inadequate for the current year under audit.
I hope he did well on that set of questions. And as always, I worry that. You're careful not to fall behind, keep studying and I'll look to see you in the next class.
No, welcome back in this class, we're going to begin our discussion of audit evidence and as I'm sure, audit evidence refers to all the information gathered by the auditor during the course of the audit. Which will form a basis for the auditor's opinion on the financial statements. We're talking about all the information gathered by the auditor during the course of the audit, whether it's through observation inquiry analysis examination, whether it's in documentary form or electronic form, which will serve.
As a basis for the auditor's opinion on the financial statements. And when you think about it in just about every step of the audit process, the auditor's gathering and analyzing audit evidence except for the sixth and final step in the audit process where the auditor forms an audit opinion based on the evidence and issues, the audit report in every other step of the audit process, the auditor's gathering and analyzing audit evidence, even in the first step of the audit process.
When the auditor establishes an understanding with the client, that understanding is documented in the engagement letter. The engagement letter will be part of the Workpapers really the engagement letter is the first piece of evidence in an audit, always the first piece of evidence in the audit. Then we move into the second step of planning phase.
In the planning phase, we obtain an understanding of the client. And its environment, including internal control. And in the second step of the audit process, in the planning phase, the auditor performs risk assessment, procedures, observation, inquiry, inspection, and even analytical procedures. And in the risk assessment process, the auditor is trying to identify items that have a high degree of inherent risk.
What inherent risk is. It's the risk that a given account by its very nature could be misstated by its very nature. It could be subject to errors and fraud cash. There's a lot of inherent risk. So the auditor is gathering evidence right away to try to identify items that have a high degree of inherent risk.
The auditor is using analytical procedures in the risk assessment process like ratios. Do identify significant changes from the last accounting period to the current accounting period, the auditor might be comparing budgeted amounts to actual amounts. Again, looking for significant changes, but the auditor is gathering, analyzing evidence in the third step of the audit process.
The auditor's going to use their understanding of the client and its environment and the internal control to evaluate the risk of material misstatement. In given assertions and the auditor's evaluation of the risk of material misstatement in particular assertions will determine the nature of the evidence that will be required on the audit.
The extent of the evidence that will be required on the audit required on the audit. And also the timing of the evidence. Notice, nature extent, timing, the N E T the net. We throw it. We always think of ourselves as auditors on a sea of transactions. Throwing out our net nature extent, timing of audit procedures.
And I know this makes sense to you. Why would the auditor's evaluation of the risk of material misstatement affect the nature of the evidence we gather on the audit, because if the evaluation of risk of the material of the risk of material misstatement in a particular assertion is low. The audit is going to rely more on the client's records.
That's the type of evidence the auditor can rely on, but if the. Risk of material misstatement is high. The auditor's going to need more outside corroboration. So notice the nature of the evidence is affected by our evaluation of the risk of material misstatement. Also the extent if we evaluate the risk of material misstatement to be low, we don't need as much evidence.
We're not gonna have to gather as much evidence split our opinion, but if we evaluate the risk of material misstatement to be high, we're going to need a lot more evidence. And then finally timing as well. If we evaluate the risk of material misstatement to be low, we can do more interim testing. We evaluate the risk of material misstatement to be high we'll, then do our testing after year end.
So notice our evaluation of the risk of material misstatement in a particular surgeon is going to affect the nature of the evidence that we gather the extent of the evidence that we gather and the timing of the evidence that we gather. Then in the fourth step of the audit process. Now we get right down to it.
We design and perform our audit procedures to address the risk of material misstatement in a particular recession, our audit procedures are going to include both tests of controls and substantive tests. Your basic tests of controls, observation inquiry inspection. And we may re-perform some transactions, substantive tests include both analytical procedures and.
Tests of details, but the point is that we're going to examine journals and ledgers and schedules. We're going to examine all the underlying accounting data that supports the financial statements. And of course we, as auditors gather all this evidence to test management, assertions, what is management asserting about account balances?
What is management asserting about transactions? What is management asserting about balances? What does management asserting about disclosures? That's why we're gathering this evidence to test whether
management assertions have any material misstatements. And again, we're talking about ma what testing management assertions about account balances, transactions, totals, and also disclosures. And as audit evidence also includes outside corroboration accounts, receivable, confirmations, bank, cutoff statements.
And it's always important to remember that under us generally accepted auditing standards. An audit must include both. The client's records and also outside corroboration, never forget that an audit done under us generally accepted auditing standards must include evidence drawn from both the client's records and also outside corroboration.
Another important point to remember that substantive tests are required for all material assertions. We have some requirements here. Substantative tests are required for all material assertions. Then as we enter the fifth step of the audit process, we're evaluating the audit evidence. We're going to evaluate all the audit evidence to determine if there are any material misstatements in the financial statements.
We're trying to determine, are there any misstatements in the financial statements that are so significant that a reasonable person could be misled? Are there any. Errors and fraud in the financial statements that are so material that the financial statements are misstated. The financial statements are not fairly stated.
And of course, if the financial statements are not fairly stated, we're going to require our client to make an adjustment to those financial statements. And if they refuse, we're going to have to modify our opinion. And of course the last step. Of the audit process. We have to form our opinion based on all the evidence based on all the evidence we've drawn, we form an audit opinion and issue our audit report, but you can see that all through the audit process, the auditor is gathering and evaluating audit evidence, and we'll continue our discussion of audit evidence in our next class.
I looked to see you that
welcome back. In this class, we're going to continue our discussion of audit evidence. And as we established in our last class all through the audit process, the auditor is gathering and evaluating audit evidence. Now I think we know what it means to gather evidence. It means, get everything you can get your hands on, but how do we evaluate audit evidence?
Under a us. Generally accepted auditing standards to serve as a basis for an audit opinion, evidence must be both sufficient and appropriate. That's how we evaluate audit evidence. Is it both sufficient and appropriate? Because under us generally accepted auditing standards to serve as a basis for an audit opinion, evidence must be both, both sufficient and appropriate.
What does sufficient mean? It means enough in the auditor's judgment, it's enough evidence to serve as a basis for an audit opinion. And of course, to judge sufficiency of evidence, the auditor has to consider the risk of material misstatement because if the risk of material misstatement is high, the auditor is going to require more evidence to be satisfied.
If the risk of material misstatement is low, the auditor won't need as much evidence to be satisfied. And of course, the auditor also has to consider in relation to sufficiency, the quality of the evidence, if the quality of the evidence is high, the auditor won't need as much. If the quality of the evidence is low, the auditor is going to require a lot more.
Now, what is, what does it mean to say that. Evidence has to be appropriate to be considered appropriate. Evidence has to be both relevant and reliable. That's what we mean by appropriateness that the evidence has to be both relevant and reliable. Now relevant means, it's not off the wall.
Relevant means that the evidence has to be related. To the audit purpose. It has to be related to the assertion that you're testing. In other words, if you're testing management's assertion about investments, you don't go off and start looking at purchase orders. It has to be relevant. It has to be related to the audit purpose, the assertion you're testing, not off the wall, as I say, what does reliable mean?
For evidence to be reliable. It has to be persuasive, not conclusive beyond all doubt. That's not the standard now it has to be reliable. It has to be persuasive
and to decide how persuasive a piece of evidence is and the degree of persuasiveness that the auditor requires. The auditor's going to have to consider materiality the materiality of the assertion and its inherent risk. In other words, the more inherent risk in an assertion, the more materiality related to the assertion, the evidence is going to have to be more persuasive, more reliable, but here's what I'm getting to in the exam.
You could get a multiple choice or even a simulation where they want you to evaluate evidence. And decide what's more reliable. They could ask you, for example, what's more reliable a bank statement or client's purchase order. What's more reliable, what's more persuasive, a client's receiving report or an accounts receivable confirmation, you're in an exam and they could ask you to do an evaluation like that, which, you know what evidence is more reliable, what evidence is more persuasive.
What I'm going to give you is a little table that I hope will help you answer whatever question the exam dreams up on what evidence would be more reliable, more persuasive. I'm going to give you five levels of reliability from the most reliable evidence to the least reliable. Let's start at the top level one.
The most reliable evidence is the auditor's direct. Personal knowledge about something, and observation of something, that's the most reliable evidence. That's level one get beat that auditor's direct personal knowledge and observation about something, but let's go to level two.
The second level would be evidence. It seems a little less reliable, a little less persuasive would be evidence that's externally generated. And also externally circulated then level three, a little less reliable would be evidenced. That's externally generated, but internally circulate and then level four, a little less reliable would be evidence that's internally generated, but externally circulated.
And then finally, level five, the least reliable would be evidence that's internally generated and also internally circulated. So what does all this mean? You know what the auditor's direct personal knowledge and observation of something is, but let's go to level two. What do when I say evidence that's externally generated and also externally circulated?
A great example would be a bank cutoff statement. A bank cutoff statement is a statement from the bank that's mailed from the bank to the auditor about 30 days after the audit. So notice. That bank statement is mailed from the bank it's externally generated and it comes directly to the auditor.
It's externally circulated, right? It's both externally generated. It's mailed from the bank and externally circulated. It comes directly to the auditor. In other words, my client never gets their hands on it. That's very persuasive, very reliable evidence. Another example of level two. Would be accounts receivable, confirmations accounts receivable confirmations are on the client's letterhead, but the auditor mails, the confirmation to the customers and the customers mail the confirmations directly back to the auditor.
So notice they really are level two because the auditor mails, the confirmations to the customers they're externally generated and the customers mail the confirmation directly back to the auditor. They're externally circulated. Client never gets their grubby little hands on it. Very persuasive evidence.
Very reliable. Now, since we're talking about accounts receivable confirmations, it's important to remember that there are two types of confirmations. There are generally speaking, two types, positive confirmations and negative confirmations, and it's very important that you understand the difference with a positive confirmation.
We're asking the customer to respond. Whether or not, they agree with the balance. That's what we mean by a positive confirmation where we ask the customer to respond, whether or not they agree with the balance. And generally you use positive confirmations when there's a small number of accounts, large dollar values, weak, internal controls over receivables.
In other words, control risk is high. A lot of disputed accounts. That's generally when you want to use positive confirmation, when you have a small number of accounts, significant dollar values, we can turn a control. Controlled risk is high, a lot of disputed accounts and another strength of positive confirmations.
Another huge string of positive confirmation. Is if the customer does not respond. Remember we asked the customer to respond whether or not they agree with the balance that's on the confirmation, but if the customer does not respond, the auditor has to follow up. The auditor has to contact the customer, find out what the problem is.
Get to the bottom of it. That's another huge strength of. Positive confirmations that there's follow up now with a negative confirmation. I know you're ahead of me with a negative confirmation. We have, we asked the customer to respond only if they disagree with the balance. So it's hard to know what a non-response really means.
Does it mean anything? Presumably a client would act in their own interest, excuse me. Presumably a customer would act in their own best interests. So if we send a statement of their account, And it's overstated, they'll respond. Cause presumably customers would act rationally and protect their own interests.
But what if the mistake is in their favor, would they respond? It's hard to know what does a non-response really mean? Can you really infer anything from a non-response? Generally we use negative confirmations where we ask the customer to respond to only if they disagree with the balance.
When we have a large number of accounts, small dollar values. Internal controls are strong. Control risk is low, very few disputed accounts. Now they're both used, make no mistake about it in an audit. You can use both positive, negative confirmations that both use. And again, they're externally generated the mailed by the CPA, by the auditor, the customer mails, the confirmations directly back.
To the CPA, to the auditor they're externally circulated all also. So they're very reliable, very persuasive. How about level three? How about evidence that's externally generated, but internally circulated? How about a bank statement? A bank statement is externally generated. It's mailed from the bank, but it's mailed to my client.
It's internally circulated. So it's a little less reliable. Level four evidence that's internally generated, but externally circulated. How about a canceled check? It was internally generated. It was written by my client, but it's externally circulated because it went through the bank. It has bank markings on it.
And then finally the fifth and final level, the least persuasive evidence. The least reliable would be evidence that's internally generated and also internally circulated that's internally generated and also internally circulated my client's purchase orders. My client's receiving reports. Of course, a tremendous amount of evidence would be from my client's records, which would be internally generated and internally circulated.
Let me ask you can an auditor use. The fifth level of evidence as a basis to form an audit opinion. Yes. All evidence is used. No, one's saying that an auditor has to use, the first two levels. No, an auditor's using level one level, two level three, level four, level five. Auditor's going to use everything.
They can get their hands on as a basis to form an audit opinion on the financial statements. But as you can see. From going through the levels, generally speaking reliability refers to what it refers to the source of the evidence and the nature of the evidence. That's what ultimately reliability or persuasiveness refers to the source of the evidence and the nature of it.
In other words, generally, evidence is more reliable, more persuasive. If it's obtained from outside sources. Generally evidences more reliable, more persuasive if it's obtained directly by the auditor, if it's an original document, rather than a copy. But as I say, an auditor is going to use everything, they can get their hands on in an audit level, one level, two level three, level four, level five.
They can all be appropriate.
Relevant and reliable. It can all be. Now before you start the next class, you'll see that there are 10 multiple choice questions that I want you to do. And you know how I feel about this so important that you get your answers to those 10 multiple choice before you start the next class. And I will look to see you in the next class.
Keep studying.
Welcome back. That I've assigned 10 questions that I wanted you to get answered before opening this class. I know you've done that. So now let's go through the questions together. Number one, which of the following procedures would provide. The most reliable audit evidence. What's the most reliable.
How about a, how about inquiries of the client's internal audit staff held in private? Just to emphasize how internal this is. That's all internal stuff. Be inspection of pre-numbered client purchase orders filed in the vouchers payable department. Wouldn't that be? Classic level five. In internally generated internally circulated.
It's always been in the hands of my client. My client's records. See analytical procedures performed by the auditor on the entities trial balance. The entities trial balance was internally generated, always internally circulated. So a, B and C are all internal. Examples of evidence, but answer D inspection of bank statements obtained directly from the client's financial institution.
That's classic level two, right? Classic, very reliable, externally generated. It was mailed from the bank and it was mailed directly to the auditor externally circulated, very reliable, very persuasive audit evidence answer D. Number two negative confirmation of accounts receivable is less effective than positive confirmations of receivables because ACE has a majority of recipients usually lack the willingness to respond to objectively.
That's certainly, we expect that with a negative confirmation, as I think we've already mentioned that if. A mistake was in their favor. They might not respond. They're not objective parties, they're just a customer responding to a request. And so they're only supposed to respond if they disagree and, will they disagree if the error is in their favor, it's one of the problems with negative confirmations, but that is.
You can't make that statement about a majority of the recipients. Certainly be says, some recipients may report incorrect balances that require extensive follow-up that may happen, but it's not a problem it's necessarily associated with negative confirmations D negative confirmations do not produce evidential matter.
That is statistically quantum viable. No, it does it. Doesn't negative confirmations. Are used and they are statistically quantifiable auditors, use them and use them as valuable evidence. But of course the problem is C the auditor cannot infer that all non-respondents have verified their accounts. What does a non-response mean?
And again, if the error was in their favor, maybe they would suggest say nothing. You can't assume that a non-response means. That they verified their information. You can't assume that just an inherent problem with negative confirmations, number three, for which of the following judgements may an independent auditor share responsibility with the entities internal auditor, who was assessed to be both competent and objective the external auditor.
The independent auditor can use the client's internal audit staff to. Help with tests of controls, substantive tests, but no, in the first column you can't ask the internal audit staff to share responsibility about assessing anything. The assessment of inherent risks, the assessment of inherent risk.
That's up to the independent auditor. Same thing with the second column. No, can't share responsibility with the internal audit staff about assessing control risk. The assessment of inherent risk, the assessment of control risk falls squarely with the external auditor, the independent auditor. So it's double no answer D number four in auditing accounts receivable, the negative form of confirmation requests most likely would be used.
When I know you went right to an answer B the combined assessed level of inherent and control risk is low. That's when negative confirmations are used, you have a lot of accounts, small dollar value, few disputed accounts and control. Risk is low. Strong internal control. Risk is low.
Inherent risk is low that's. When you're going to use negative confirmations, answer B number five. An independent auditor asked a client's internal auditor to assist in preparing a standard financial institution, confirmation requests for payroll account that had been closed during the year under audit during the year under audit and after the internal auditor prepared the form, the controller signed it and mailed it to the bank.
What was the major flaw in this procedure? I know you went to an answer B the form was mailed by. The controller. Remember all confirmations should be mailed by the auditor and mailed directly back to the auditor. I don't care what kind of confirmation it is. An accounts receivable confirmation.
This is a confirmation to a financial institution, any kind of confirmation like this outside corroboration, you want it mailed by the auditor and then mailed directly back to the auditor externally generated and externally circulated. Number six, the blank form of accounts receivable. Now what the blank form of accounts receivable confirmation.
That's a confirmation that where you ask the customer to fill in the amount it's blank. You don't put in the confirmation, the amount owed to your client based on the client's records, you leave it blank and you ask the customer to fill it in. The blank form of accounts receivable confirmation may be less efficient than the positive form because it is answer C Oh, you get a lot more non responses.
Anytime you ask, the customer, go out, you look up in your records, it's one thing to ask them, in a negative confirmation only respond. If you disagree, that takes a lot less work, but if you ask them. The customer to actually go into their records and figure out, and then fill in exactly according to their records, what is owed, you're asking me to do more work, so you get more non responses.
Number seven, which of the following procedures would yield the most appropriate evidence. What's the most appropriate a scanning of a trial balance. An inquiry of client personnel, a comparison of beginning and ending retained earnings, a, B and C are all internal, but how about D a recalculation of bad debt expense?
Remember the most reliable, the most persuasive evidence is direct personal knowledge of the auditor, obtained through, calculation and observation. So if the auditor recalculates, what the bad debt expense should be, does their own aging schedule. That's very reliable. It's the most on, on, on the five levels we looked at in our last class, it's the most reliable, the auditor's direct personal knowledge based on observation computation number eight, which of the following procedures is considered a test of control.
What's a test of controls. A says an auditor reviews, the entities check register for unrecorded liabilities. That's a test of details. We're trying to find material misstatements there be an auditor evaluates. Whether a general journal entry was recorded by recorded at the proper amount. Again, that's a substantive test.
That's a test of details. Looking for material misstatement. D an auditor reviews, the audit work papers to ensure proper sign-off. That's a quality control procedure. The test of controls of course, is his answers C an auditor interviews and observes personnel to determine proper separation of duties.
That's a test of controls. Number nine, which of the following factors most likely would lead a CPA to conclude that a potential audit engagement should be, should not be accepted. Should not be accepted. A says there are significant related party transactions. That's, as long as they're fully disclosed, that's not a reason to reject the engagement B internal control activities requiring segregation of duties are subject to management override.
Remember that's an inherent risk in any sense. That's just no matter how beautifully you design a system, management's always going to be able to override it. That's an inherent limitation in any internal control system. Even the best internal control system devised by mankind would have that limitation, that management would have the ability to override controls.
You're just stuck with it. So that's not going to lead a CPA to reject a client because they'd have to reject all clients. And we know they don't want to do that. See management continues to employ. An inefficient system of information technology, how efficient a system is. That's more management's concern.
An auditor is not that concerned with how efficient a system is certainly would not reject the client because the system is inefficient. Of course, it's answer D what could get you to reject a client? It's unlikely that sufficient appropriate evidence is available. Remember, you have to have that's not an option.
An auditor has to have sufficient appropriate evidence to form an audit opinion on the financial statements. And if that's not available, they can't take the engagement. It's that simple. Number 10, the company being audited has an internal auditor that is both competent and objective. That is, and that's what we want.
We want, we can use the internal audit staff if it's both. Competent and objective, the independent auditor wants to assign tasks to the internal auditor to perform under these circumstances. The independent auditor may the answer say allow the internal auditor to perform tests of internal controls. When the internal audit staff is competent and objective, we can ask the internal audit staff to help with tests of controls, substantive tests.
As long as they are competent and objective. Now, what I want to get into next is, okay. Another example of evidence that's level two, very persuasive, very reliable, externally generated, and also externally circulated. And it's another confirmation. What I want to talk about is a letter of audit inquiry to a client's attorney.
A letter of audit inquiry to a client's attorney is just like an accounts receivable confirmation, but it's sent to the client's attorney and it'll be mailed by the, like all confirmations by the auditor. It's externally generated. And the lawyer will fill it in and send it right directly back to the auditor.
It's externally circulated. So it's very reliable, very persuasive evidence. Now, before we look at the details of a legal letter, I want to emphasize that management is the primary source of information about litigation claims and assessment. Let's not forget that management is the primary source of information about litigation claims assessments.
But we also have outside corroboration with the client's attorney. And if you look at your viewers guide, you'll see an example of a legal letter. And to remember the basic elements of it, just remember I L C, that'll give you the basic elements. I love legal letter confirmations. I L C. I love legal letter confirmations.
And if you look at the letter in your viewers guide, you'll see the elements, the eye. Notice the letter identifies the client. That's the eye. The first L we asked the lawyer to L give us a list of pending litigation that the attorney has done significant work on. So that's the first L where we asked the lawyer to provide L a list of pending litigation that the attorney's done significant work on.
Also we'd want them to list any unassertive claims or assessments. Any claims or assessments that have to this point that unassertive, that they're aware of. Then the second L we want L a legal opinion. We want the attorney's legal opinion on the outcome of each case. Now it could be in doubt and that's fine.
The attorney could say that's, the outcome is in doubt. That's fine. As long as it's fully disclosed the third out, we want the attorney to disclose third L any limitations. On their ability to respond, maybe it's attorney, client privilege, something like that, but are there any limitations on the attorney's ability to respond?
And then the C's contingencies. We want the attorney to confirm that all C contingencies have been communicated to the client. Just remember, I love legal letter confirmation that gives you the basic elements of the letter. And again, notice again that it's. Externally generated. It's going to be mailed by the CPA to the attorney and the attorney's going to mail it back directly to the CPA.
It's externally circulated it's level two, very reliable. What if the attorney refuses to respond? That's a scope limitation. That's very serious. If the attorney will not respond to the legal ed, that's a scope limitation. So you know how to handle it. If it's a material scope limitation on, except for qualified opinion, if it's very material, if it's considered in the auditor's judgment to be very material pervasive, then the auditor would have to disclaim an audit opinion.
What if the client will not let you send a letter of audit inquiry to their attorney? They refuse. That's a different animal, isn't it? Because that's a client imposed scope limitation. With a client imposed scope limitation that would generally be considered very material persuasive, very pervasive, very material.
So in that case, the auditor would disclaim an audit opinion and withdraw from the engagement. One of the things that can come up in this area, what audit procedures should an auditor use to locate? Any unrecorded litigation claims and assessments, because they could ask you that exactly. How would a, an auditor locate, any unrecorded litigation's litigation claims or assessments?
We'll just remember the five RS will do it. Just follow the five RS and you will locate any unrecorded litigation claims and assessments. The first are review the internal controls that are in place to record litigation claims and assessments. That's the first star review, the internal controls that are in place to record litigation claims and assessments.
The second are request, request a list of litigation claims and assessments from management member management is the primary source of information. How about litigation claims and assessments? The third are read attorney correspondence and the attorney's bills. That's very informational read attorney, client correspondence with your client and bills they send to the client.
Let's say the bill for the last two years has been consistently $500 every month, but all of a sudden this month, it's 15,000. Something's going on that we need to know about the fourth arm. Read minutes of meetings and also the most recent interim statement, look at the disclosures. So it's read minutes of meetings and also the most recent interim statement, especially the disclosures.
And then the final R get a representation letter from management at the end of the audit that addresses litigation, claims and assessment. That's the final art. Get a representation letter from management at the end of the audit, which addresses litigation claims and assessments. Just follow the five RS to locate any unrecorded litigation claims and assessments keep studying don't fall behind.
And I looked to see you in the next class.
Welcome back to our discussion about. Audit evidence, you know that so far in these classes, we've mentioned a couple of important letters that you have to be aware of when you take the exam. We've talked about the engagement letter and we've talked about the legal letter or the letter of audit inquiry to the client's attorney.
There's one more letter that you have to be aware of and comfortable with, and that is the management representation letter. The management representation letter is a letter from management to the auditor at the end of the audit. And really the management representation letter itself is a piece of evidence.
And it's the last piece of evidence in an audit. The engagement letter is always the first piece of evidence in an audit. And the management representation letter is always the last piece of evidence in an audit. And Amanda's representation letter is required under generally accepted auditing standards to get an unmodified opinion.
The client has to provide a management representation letter. In other words, if management refuses to give the auditor, I manage a representation letter that precludes an unmodified opinion because it's a client imposed scope limitation. And it would be pervasive. It would be very material. So what would the auditor do?
The auditor would have to disclaim an audit opinion and withdraw from the engagement. If management will not give the auditor Amanda's representation letter again, what that amounts to is a man is a client imposed scope limitation, disclaimer, of opinion, withdraw from the engagement and the purpose. Of the man's representation letter is to confirm all the representations management has made to the auditor during the course of the audit.
And hopefully the manager representation letter reduces the chance of any misunderstanding. If you look in your viewers guide, you'll see an example of a managed representation letter. And if you just look at it, you can see as an example, what you'd expect to find in a management rep letter. Notice the letter States that the financial statements are presented fairly in accordance with us generally accepted accounting principles or whatever applicable financial reporting framework is being audited.
Notice the letter States that management is responsible for the design implementation and maintenance of internal controls relevant. To the fair presentation of financial statements and the prevention and detection of fraud, the letter States any non-compliance with laws and regulations. It States that all requested information was provided to the auditor during the course of the audit.
It States that there has been proper cut-off. In other words, assets, liabilities, revenues, expenses have been reported in their proper period. It States that all transactions have been recorded and reflected in the financial statements. In other words, nothing has been omitted. It States that all required disclosures are included in the financial statements, including disclosures on related party transactions, subsequent events, litigation, claims, and assessments.
Basically the management representation letter documents, the continuing appropriateness of all the representations that management has made to the auditor. During the course of the audit, it's signed by top management, either the chief executive officer or the chief financial officer, and it's dated the date of the auditor's report now on an international auditing standards, the management representation letter.
Must be dated as close as possible to the date of the audit report, but never after I'll say that again, under international standards, the managed representation letter must be dated as close as possible to the date of the audit report, but never after, but in us generally accepted auditing standards.
It's dated the date of the audit report. It's important to remember that the management representation letter does not by itself. Does not in any way reduce the scope of the audit. It does not in any way reduce audit risk. And it does not in any way, we reduce the auditor's responsibility to detect errors and fraud in the financial statements.
But as I say, it is considered a piece of evidence audit evidence, and it is the last piece of evidence in an audit. Now, before you. Take the next class. You'll see that there are eight questions that I want you to have answered before you do that class. And I will look to see you in the next class and we'll continue our discussion on audit evidence.
Yeah.
Welcome back to our discussion on audit evidence. I assigned eight questions that I wanted you to have answered before coming to this class. So let's begin by talking about these eight questions. And the first question that says, which of the following statements or narrowly is not included among the written client representations made by the chief executive officer and the chief financial officer notice B says there are no unassertive claims or assessments that our lawyer has advised us are probable of assertion.
And that must be disclosed. No, that would be. In the management representation letter. We want that letter to document that there are no there's no litigation claims or assessments that we're not aware of, that haven't been disclosed in the financial statements. No, that would be in that management rep letter C says we have no plans or intentions that may materially affect the carrying value or classification of assets and liabilities.
Again, that would be in the letter. That statement would be there D. No events have occurred subsequent to the balance sheet date that would require adjustment or disclosure in the financial statements. No, that would be in the letter. We want the letter to address subsequent events, but answer a sufficient audit.
Evidence has been made available to the auditor to permit the issuance of an unmodified. It opinion. No, that would not be in the letter. It's not up to the ma up to management to decide whether. The evidence that's been provided to the auditor is sufficient. It's sufficient enough for an unmodified opinion.
That's up to the auditor. Would the letter would not say anything like that? Number two, to which of the following matters would materiality limits not apply in obtaining a written management represent management rep letter? Where would material they not materiality not apply? How about B losses from purchase commitments?
No, we would care whether it's material or not. If it's immaterial, we wouldn't be concerned about it. See the disclosure of compensating balance arrangements involving related parties. We only care about related party activity. If it is material de reductions of obsolete inventory to net realizable value.
Again, we'd only be concerned about that in any way. If it was a material reduction, Answer a, the availability of minutes of stockholders and directors, meetings, material materiality. Doesn't come into that. We want a copy of those. We want to be able to read those minutes. In other words, we wouldn't accept as an answer.
Nothing of materiality was discussed in those meetings. Oh no. We want, we have to see the minutes of those meetings. We don't care if. They say that it w the meetings were about something immaterial. It doesn't matter. Materiality limits wouldn't apply. We have to see those minutes
there. Number three, sets two, which of the following matters again? Would materiality limits not apply when obtaining written client representation, ACEs violations of state labor regulations? No. We only care about those violations. If they were material, not some technical insignificant. No minute violation.
We're not worried about that would have to be material materiality limits would apply to that. B says disclosure of line of credit arrangements. Again, the disclosure is important. If it's material see information about related party transactions, related party transactions must be disclosed. If they are material materiality limits would apply.
But answer D instances of fraud involving management materiality limits. Wouldn't come into that. There shouldn't be any fraud by management, even a penny, any fraud at all by management would be a matter of concern would have to be communicated to those in charge of governance, materiality limits wouldn't apply to fraud involving management.
Number four, the following most likely would cause an auditor to consider whether a client's financial statements contain material misstatements. Will be an indicator that the financial statements are materially misstated, ACEs management did not disclose to the auditor that they consulted with another accountant about significant accounting matters.
That's okay. As long as the auditor can discuss with those in charge of governance, the auditor's view of the matters, the auditor's view of the situation. That's okay. B says the chief financial officer will not sign the management representation letter until late in the audit, but that's usual practice that the managed representation letter comes at the end of the audit.
So that's not a problem. See audit trails of computer generated transactions exist only for a short time. That's.
That's not a good thing,
but it wouldn't indicate necessarily that there are any material misstatements in the financial statements. But how about D the results of an analytical procedure disclose unexpected differences? Oh, unexpected differences. It's a red flag. It may indicate that. There are material misstatements. Number five when considering the use of management represent management, re written representations as audit evidence about the completeness assertion on auditor should understand that such representations.
I'm sure you went right to it. It's a compliment, but do not replace substantive tests designed to support the assertion. That's what the managed representation letter does. It compliments, but does not by itself replace any substantive testing. It doesn't in any way, reduce, audit risk or the auditor's responsibility to detect material misstatements in the financial statements.
That's what it does. It compliments and that's all it does. Number six, the refusal of a client's attorney. To provide information requested in an inquiry letter generally is considered, it's a scope, limitation answer be, and you'd have to decide, is it a material scope limitation, or is it very material if it's material scope limitation, and except for qualified opinion, very material pervasive disclaim.
And of course it's not answer D a reportable condition. Reportable condition is a deficiency. In internal control.
The answer is number seven, which of the following procedures would an auditor most likely perform regarding litigation? ACE says confirm directly with the clerk of court that the client's litigation is properly disclosed. No, the, that is not how the auditor would nail down whether a disclosure is adequate.
About litigation asking the clerk of court. They wouldn't know, see says inspect the legal documents in the client's lawyers possession. Can't do that. You don't have a right to do that. It's confidential information D says, confirm the details of pending litigation with the clients, adversaries legal representation.
Now, that's not going to happen. Again, it's all confidential client information. You can't go to your adversaries attorneys and ask for information. Of course, it's big discuss with management it's policies and procedures for identifying and evaluating litigate. That is a procedure an auditor would perform regarding litigation because management is the primary source of information about litigation claims assessment.
So answer B is exactly what the auditor would always do. Go to management, ask for a list of litigation claims and assessments. Number eight, a client is a defendant in a patent infringement lawsuit against a major competitor, which of the following items would least likely be included in the attorney's response to the auditors letter of inquiry.
ACE as a description of the potential litigation in other matters or related to an unfavorable verdict in the patent infringement lawsuit. No, that's exactly what would be, that's what we want the lawyer to comment on a discussion answer, be a discussion of case progress and the strategy currently in place by client management to resolve a lawsuit against exactly what we want as a response.
From a legal letter. We want the attorney to comment on that. See an evaluation of the probability of loss and a statement of the amount of, or range of loss. If an unfavorable outcome is reasonably possible. Of course, that's exactly what we want the lawyer to provide us in the legal letter. And we want the lawyer to have provided that to the client because it's a contingency and for purpose of adjustment or disclosure in the financial statements, the client needs that information and we need it confirmed.
And the legal letter, but what's least likely to be in the legal letter, answer D an evaluation of the ability of the client to continue as a going concern. That's the auditor's responsibility that's not the lawyer's responsibility and it's not part of a legal letter.
Welcome back to our discussion on audit evidence. And as The reason why we are gathering and analyzing all this audit evidence is to determine if there are any material misstatements, any errors and fraud in management, assertions, and as auditors, we're going to design our audit procedures to address the risk of material misstatement in particular assertions.
So what assertions are we talking about? We know. That financial statements are really just a set of assertions management is asserting in the financial statements that this is our cash balance management is asserting. These are our fixed assets. Management is asserting. These are our liabilities management is asserting.
This is my capital structure. Management is asserting. These are my disclosures. It's all financial statements really represent is a set of assertions. So exactly what assertions are we testing? Just remember that we are going to test three categories. Of management assertions. We're going to test management assertions on account balances on transactions, and also on presentation and disclosure.
Let's start with account balances. What assertions will management be making about account balances? First there's an assertion about completeness that this account balance is complete. Nothing has been omitted. Next management also asserts ownership, rights or obligations about an account balance.
In other words, if the account balance is an asset, the company has ownership rights to the asset. If it's a liability, it's an obligation of the entity. So management is asserting ownership, rights or obligations about an account balance. Next valuation allocation, accuracy. Management is asserting that the account balance is valued properly, accurately, that estimates are reasonable.
And then finally existence or occurrence that the account balance represents an event that actually occurred and account balance represents an asset, a liability, or a piece of information in the financial statements. Capital stock balance, no retained earnings that actually exists. So management also makes assertions about existence or occurrence.
This account balance actually exists. These events actually occurred. Now, if you organize that, notice that management assertions about account balance. Account balances really come down to the word cold. C O V E the C is completeness. The O is ownership rights or obligations. The V is valuation allocation, accuracy, and the ease, existence or occurrence.
So in your mind with any category of assertions, always start with the word cold. It's always a good place to start. Start with Cove. Let's move on to transactions. What assertions will management make about transactions? What we'll start with Cove. First of all, the transactions are complete. Nothing has been omitted.
All transactions have been recorded. Management is asserting that. So don't forget completeness. We're also going to add cutoff to the C that all. Assets liabilities revenues expenses have been recorded in their proper period. All transactions have been recorded in the proper period. There's been proper cut-off.
So C now stands for completeness and also cut off. Oh, will be occurrence that this transaction represents something on event that actually did occur. The valuation allocation accuracy. The transaction is valued, properly. Estimates are reasonable. All adjustments have been made that are required. And then finally existence occurrence existence.
The transaction represents an event that actually did occur.
Okay. That actually does exist. The transaction does represent a financial transaction that did actually exist. Now, in addition to cov, we're going to four transactions. In addition to cov, we're going to add understandability and classification that the transaction is understandable and it's been classified properly.
The transaction is understandable and properly classified. What. Assertions will management make about presentation and disclosure? We'll start with cold. First of all, completeness, all the presentation disclosures are complete. Nothing is omitted,
always ownership, rights obligations that the assets that are presented or disclosed. The entity has ownership rights to those assets. The liabilities that are presented or disclosed, represent obligations of the entity, the valuation allocation, accuracy that everything presented has been everything presented or disclosed has been valued properly.
Accurately estimates are reasonable and then finally existence or occurrence. Everything presented or disclosed actually exists, actually did occur. And then we'll add understandability and classification. Everything is presented disclosed in an understandable manner. Everything that is presented disclosed is classified properly now.
If you always start with Cove and you add understandability and classification, you really get the management assertions down. And I want to mention that the public company, accounting oversight board standards for assertions really come down to Cove as well for the peekaboo standards. The C is completeness O is ownership rights or obligations.
V is valuation allocation. Accuracy is existence or occurrence. So even in the peekaboo standards, you start with Cove for management assertions, and they add presentation and disclosure. Now, what I'm going to do is let's just boil this down to one memory tool. So that way you just have to remember one memory tool.
Whether they're asking about management assertions for account balances, transactions, presentation, disclosure. You're always going to come back to Cove. The C is going to stand for completeness cutoff classification and also understandability that's the C now and Kohl's completeness cutoff classification.
And. Understandability. Oh, ownership rights or obligations V valuation, allocation, accuracy, E existence or occurrence. So when you're in the exam, if they start talking about management assertions, it doesn't matter whether it's related to an account balance or a transaction or a presentation and disclosure, you come right back to Cove and you'll have, I hope the management assertions right at your fingertips.
Now, before I see you in the next class, there are three questions that I want you to have done. I know you'll get your answers to those three questions. And I look to see you in the next class.
Welcome back to our discussion on audit evidence. Let's begin this class by going over the three questions that I assigned to you in the first question it asks, which of the following explanations most likely would satisfy an auditor. Who questions management about significant debits to the accumulated depreciation account.
It's been a lot of debits to accumulated depreciation. What's going to satisfy the auditor as an explanation about, Hey, the estimated remaining life of plant assets was revised. I hope you thought that's a change in estimate you changing the estimate of life. And when you change an estimate, you ignore prior periods and then.
You only adjust depreciation going forward. It only affects the current period and future periods if they're involved. So that wouldn't explain any sudden debits to accumulated depreciation. We're just going to change our estimate of life. Going forward to change an estimate prospective only nothing retroactive C says the prior year's depreciation expense was erroneously understated.
If it was understated, then it's correction of an error. You'd have to go back to an automatic prior period adjustment where you'd have to increase the depreciation. And that would increase accumulated depreciation that would cause credits to accumulated depreciation, correcting that error, not debits to accumulated depreciation D says overhead allocations will revise the ERN.
When you're doing overhead allocations, that's just going to affect how you allocate. The debit to depreciation expense, the credit to accumulated depreciation would not be affected at all. That wouldn't explain in any way why there are debits to accumulated depreciation. What would explain debits to accumulated depreciation is answer B plant assets will retire during the year.
That would cause debits to accumulated depreciation, and that would satisfy the auditor because it makes sense. Number two. An auditor scans, a client's investment records for the period just before and just after year end to determine that any transfers between categories of investments have been properly recorded.
The primary purpose of this procedure is to obtain evidence about management's financial statements of what, why would we focus in on it transfers from trading to available for sale to held to maturity. Classification answer D our main focus would be are these investments classified properly?
And therefore, are trading securities valued, properly is available for sale. Securities are the available for sale securities valued properly are held to maturity, securities value properly, but. Are the investments classified properly. If you've transferred it investment from trading, which is a current asset, always to, non-current availed for sale is that investment classified properly.
That's why we're focusing in on transfers between categories of investments.
Number three, after making inquiries about. Credit granting policies and auditor selects a sample of sales transactions and examines evidence of credit approval. This test of controls most likely supports the management assertion of what it's not about rights and obligations. We care about whether credit approval has been given is to determine whether accounts receivable, sales.
Have been valued properly. What this is all about is the assertion of valuation and allocation. And the answer is C not rights and obligations. It's not why we're focusing in on credit approval. We want to make sure that accounts receivable is valued. Properly. Sales are valued, properly answer C well, that been saying that in the final analysis, auditors design all their audit procedures.
To address the risk of material misstatement in management assertion and the audit procedures. The auditor will use include both tests of controls, observation, inquiry, inspection re-perform transactions, and also substantive tests, analytical procedures, and tests of details. Let's talk about analytical procedures.
Is the process of analyzing plausible relationships between financial data and plausible relationships between non-financial data, to identify variances, to identify something that's unexpected changes. We're analyzing plausible relationships between financial data, plausible relationships between non-financial data.
For example, an analytical procedure could be something very simple looking at last year's allowance for bad debts compared to this year's allowance for bad debts. See if it's approximately the same. Why is it significantly a higher amount? Why has it changed another example you could take? A company's average effective interest rate times their average outstanding debt and see if it approximates the interest expense on the income statement.
Why wouldn't it? Why wouldn't it come close? And as I said, we could even be analyzing plausible relationships in non-financial data. We could look at last year's disclosures compared to this year's disclosures. And focusing on what's changed. We could compare budget to actual. There's a million examples.
Now it's important to remember that analytical procedures are required. Remember in auditing, you're either required to do something or you're not. And analytical procedures are required in the planning phase of an audit to assist the auditor and understanding the entity and its environment and incur internal control analytical procedures are required in the planning phase.
To help the auditor identify items with a high degree of inherent risk. Also analytical procedures are required in the review stage. The final stage of an audit, the review stage to test the validity of the conclusions reached by the auditor. Do they make sense to evaluate the overall financial statement presentation?
So analytical procedures are required in the planning phase of an audit, and they're also required in the review stage. Of an audit. Now analytical procedures can be used as a substantive test. An auditor is not required to use analytical procedures as a substantive task, but it analytical procedures are one substantive test that can be used to test management assertions.
But if you do use analytical procedures as a substantive test, it only gives you circumstantial evidence. You have to get corroboration all L and we'll look at procedures can do is give you circumstantial evidence. Again, it requires additional corroboration. Now, one very important example of analytical procedures would be ratios, ratio analysis.
And as you're probably aware, the exam tests, ratio analysis, In financial accounting and reporting, but it also tests ratio analysis and the auditing exam as well. And I always tell my students that, the only way you can handle racial questions in the exam is by knowing the formula. Let's be honest.
You can't do racial questions. If you don't know a formula, you must memorize formulas for financial accounting and reporting and. For auditing and attestation as well, because again, an analytical procedures include ratio analysis. It's a classic analytical procedure. There are 15 ratios that you absolutely have to memorize.
You have these, what I'm saying is if you know these 15 formulas, it's not every conceivable ratio that exists, but if you know these 15, you're protecting yourself, you're protecting yourself in financial accounting and reporting. And you'll also protect yourself in auditing as well. Let's go over the big 15 ratios that you have to know.
The first two ratios are measures of liquidity first, make sure the current ratio, it's an easy one, but if you're going to calculate the current ratio in the numerator, you want total current assets and in the divisor you want total current liabilities. That's all it is. Total current assets divided by total current liabilities.
That's the current ratio. Also number two, the second one that measures liquidity, make sure the acid test ratio or the quick ratio. If you're going to do the acid test ratio or the quick ratio in the numerator, you want your most liquid assets cash plus marketable securities plus receivables.
And you divide by total current liabilities again in the numerator, your most liquid assets cash plus marketable securities plus receivables and divide by total current liabilities. Again, these, the current ratio and the asset test ratio are measures of liquidity. The ability it measures the ability of men management to meet their short-term obligations.
That's what trying to measure. And generally you want this higher. You want these ratios higher, the better, and as an analytical procedure, if you look at last year's current ratio or last year's asset test ratio, and now this year, It's gone down generally. You want it higher. Higher is better. So if it's gone down, that would be a concern concerned about management's ability to meet short-term obligations.
It might indicate a problem area. Now we're going to talk about measures of activity. The first measure of activity we're going to talk about is one of the exam loves, and that is the accounts receivable turnover. If you're going to calculate the accounts receivable turnover in the numerator, you want net credit sales and in the divisor, you want average receivables.
Now what's average receivables. It's beginning receivables plus ending receivables divided by two that's where a lot of people mess this one up. Remember in the divisor it's average receivables, it's beginning receivables plus ending receivables divided by two. So if you take your. Net credit sales and divide by your average receivables, that'll give you your accounts receivable turnover.
And what it's trying to measure is the quality of the receivables. In other words, higher is better. An account receivable turnover of 10 is better than account receivable of nine. You'd rather see your receivables turnover 10 times during the year, then nine times, 10 times is better than three times.
It's measuring the quality of your receivables. Now you can also show the accounts receivable turnover in days. If you want to show it in days, take the number of days in a year, three 65 and divide by the account receivable turnover. Again, if you want it in days, take the number of days in a year, three 65 and divide by the accounts receivable turnover.
Let's say that's five, just making up a number. If you count receivable turnover is five. It turns over five times, divide that into three 65. That means every 73 days you collect your receivables takes you 73 days to collect your receivables, you to get the lower, the better they're on in terms of days, you'd rather collect your receivables every 60 days, rather than every 73 days.
Again, you'd run, you'd want the divisor to be higher and account receivable turnover, higher is better than lower. And in this case, the number of days. The less days is a better, is indicates a better quality of receivable, but here it's taking 73 days on average to collect the receivables.
Another one, the exam likes is inventory turnover. If you're going to calculate inventory turnover in the numerator, you want cost of goods sold in the divisor. You want average inventory and you know what that is. That's beginning inventory plus ending inventory divided by two. Cost of goods sold, divided by average inventory.
And it's a measure of how quickly you're selling your inventory. And generally you want it higher. You'd rather sell your inventory, 12 times during the year, rather than four times, generally you want it higher. You can also inventory turnover in days. Just take the number of days in a year, three 65 and divide by inventory turnover.
I'll just make up a number. Let's say inventory turnover is 4.5 making up a number. You can't derive that from what I've said. So if I take the number of days in a year, three 65 divided by inventory turnover, let's say that's 4.5. Then in days it's 81 days, it takes me on average 81 days to sell my inventory.
There's also the accounts payable turnover. You're going to calculate the accounts payable turnover in the numerator it's cost of goods sold in the divisor it's average accounts payable, beginning accounts payable. Plus any accounts payable divided by two don't watch out for these divisors it's average accounts payable, beginning accounts payable, plus ending accounts payable divided by two.
If you take cost of goods, sold, divided by average accounts payable, that'll give you accounts payable, turnover. How quickly is it? Is it taking the company? To pay their payables.
And here again, generally higher is better. If payables are turning over six times during the year they used to, and now they're just turning over three times. It's gone down. Remember these are used very often as analytical procedures, these ratios, what was accounts payable turnover last year.
Oh, the payables turned over six times last year. Now this year, they only turned over twice that could indicate if it's slower, it's lower, slower, turning over your payables, that the client's having cash flow problems. You can also show accounts payable turnover in days. You know what to do. Take the number of days in a year, 365 and divide by the accounts payable turnover.
Let's say that's seven again, just making up a number. If my accounts payable turnover, seven turns over seven times divided into three 65. That means on average, it takes me 52 days. Yes. To pay my payables. On average. Now let's talk about measurements of profitability. First of all, gross margin. You know what that is?
The ninth ratio would be gross margin. That's just the company's gross profit over their net sales. That's the gross profit percentage or the gross margin. Number 10 would be net operating margin. Then net operating margin would be in the numerator net operating income is the gross profit minus your operating expenses.
Again, in the numerator, we want net operating income and that is the gross profit minus operating expenses. All your expenses except interest. And you divide by net sales. That's your net operating margin. Now one this, a little complicated that the exam seems to like is the return on assets, the exam complicates this.
You'll see what I mean. Here's the normal formula for return on assets in the numerator. You put the company's net income and divide by average total assets. You know what average total assets would be beginning, total assets plus ending total assets divided by two. So it's not a difficult formula.
And by the way, anytime you see that phrase return on, that means net income over something. If I said, what's return on my house, it's silly, but it would be net income over my house. That's what return on means net income over net income, over whatever you want to measure it against. So return on assets would be net income over average, total assets.
Let me make up some numbers to illustrate. If the company's net income is 10 million and average total assets. Is a hundred million. What's the return on assets? It's the net income, 10 million over average, total assets, a hundred million return on assets would be 10%. I show you the numbers because there's another way to calculate the same 10%.
There's another way to calculate return on assets. The other way to do it is to take the net profit margin times the asset turnover, and the exam gets into this. Just another way to get to the same place. Now, the way to get return on assets is to take. A company's net profit margin and multiply times the asset turnover.
Now, how do you get not net profit margin is the net income divided by the net sales net income divided by net sales. Now I'll use the same numbers here. I'm assuming the net income is 10 million. And let's say that the net sales were 200 million. That would be. A net profit margin of 5%.
Again, if I take the net income, which I'm assuming is still 10 million divided by net sales, which I assume is 200 million. My net profit margin is 5%. I can take that 5% times the asset turnover. What's the asset turnover. That's the net sales, the 200 million we've already mentioned over average total assets, which we mentioned before is a hundred million.
So asset turnover is two times. If I take two times 5%, that gives me 10% an exam. Gets into that way of calculating return on assets. In other words, all they're doing is analyzing return on assets more deeply. It's another way to get to the same thing. If I take the net profit margin, 5% times the return on assets times two, that'll also give me 10% the return on assets.
It's two ways of calculating the same thing. And you say Bob, why did you bring that up? Because the exam has gone at it both ways. You have to know both formulas. Now let's talk about long-term debt, paying ability, make sure the debt to equity ratio, the debt to equity ratio would be total liabilities in the numerator divided by total common stockholder equity.
That's how you figure out the debt to equity ratio by taking the total liabilities of the company and dividing by total common stockholder equity and. This is measuring the amount of protection creditors have, and creditors would rather see this low. In other words, a debt to equity ratio of two is better than a debt equity ratio, a dequity debt to equity ratio of three.
So credit is rare to see this lower also there's times interest earned. If you want to figure out times interest earned. In the numerator. You want your earnings before taxes and before interest in the, or you want your earnings, your net income, but that's before taxes and before interest and that divide by your interest expense.
And it basically shows you the company's ability to make their interest payments and creditors want to see that higher of course, rather than lower. Then finally, There are investor ratios. The first investor ratio is book value per share book value per share. Now, if you're going to calculate book value per share in the numerator, you want total stockholders' equity.
And if you stop and think about it, total stockholders' equity is the book value of the corporation it's assets minus liabilities or total stockholder's equity. So in this ratio, what you're putting in the numerator, when you put in total stockholders' equity, You're putting in the book value of the corporation assets minus liabilities or total stockholders' equity and in book value per share calculations, you divide by the number of shares.
Outstanding. Now be careful don't divide by authorized shares. Don't divide by issued shares. You always divide by the number of shares. Outstanding. So if you take total stockholders' equity or the book value of the corporation, divide by the number of shares outstanding. That'll give you book value per share.
Now the last ratio you've got to be. Comfortable with his earnings per share. And of course I'm talking about earnings per common share. It's not earnings per preferred share it's earnings per common share. That's what earnings per share always means. Earnings per common share. Here's the formula. If you're going to do earnings per share in the numerator, you want net income applicable to common stockholders, that's net income applicable to common stockholders.
To figure that out, you've got to take the company's net income minus the current use of for dividend. One more time in the numerator. You want net income applicable to common stockholders, which is defined as the company's net income minus the current year's preferred dividend and make sure this is clear in your notes.
You're going to back out that current year's preferred dividend, if it's declared or not. If the preferred stock is cumulative, when the preferred stock is cumulative you back up accurate year's preferred dividend, whether it's declared or not. So I'll just make up some numbers. If the company's net income is 250,000.
And the current year's preferred dividend is 4,000. And if the, for is usually cumulative, it's cumulative. I'm going to back out that 4,000, whether it's declared or not. That means net income applicable to common. Stockholders is 246,246,000. Now you divide by the weighted average common shares.
Outstanding for the period. You're going to divide by the weighted average common shares. Outstanding for the period. Don't forget in earnings per share calculations. In the divisor, you've got to weight the common chairs. You've got to wake the common shares by how many months they've been outstanding.
Let me show you how to weight shares. Let's say a company had a hundred thousand shares outstanding on January 1st, and those shares were outstanding for the entire year. A company at a hundred thousand common shares outstanding on January 1st. And those shares were outstanding for the entire year. Because they were outstanding for the entire year.
You give those shares a full weight of one because they were outstanding for the full year. Give those shares a full weight of one. So you'd multiply by one. That's a hundred thousand way to chairs. Let's say they also issued another 20,000 common shares on October 1st. They issued another comp a hundred.
If they issued another 20,000 shares on October 1st, those shares have announced standing for October, November, December three months, three 12. So the year give those a weight of three twelves, a weight of a quarter. That's another 5,000 way to share. So add it up. What's the way that average common shares for the period.
A hundred thousand plus 5,000, 105,000. Now we can calculate earnings per share. If I take the net in net income applicable to common stockholders, remember that was 246,000. That's the net income, 250,000 minus the current years before a dividend 4,246,000 divided by the weighted average common shares for the period, 105,000 earnings per share comes out to $2 and 34 cents a share.
You've got to know how to do that. But if you know those 15 formulas, you're protecting yourself because it is a basic analytical procedure that is used in auditing and that they mentioned quite a bit in the exam, not only in multiple choice, but they've had simulations on ratio analysis, got to know these formulas
before you do the next class. Make sure you do the five. Questions that I've assigned, get those five answers. And then I'll look to see you in the next class, either. Welcome back to our discussion on audit evidence. I assigned some questions that I wanted you to get answered before coming to this class.
So let's start by reviewing these questions. Number one on auditor, most likely would apply analytical procedures in the overall review stage of an audit. And remember. Analytical procedures are required in the review stage. So why would they do analytical procedures in the review stage is today to enhance the auditor's understanding of subsequent events?
No, it's not about understanding subsequent events B identify auditing procedures, omitted by the staff accountants. No, that's not why we're doing and little procedures in the final review stage D says evaluate the effectiveness of internal control activity. Oh, that would come much earlier in the audit process than the review stage.
No, it's see, we're using analytical procedures in the review stage to determine whether additional audit evidence may be needed. In other words, it's one final check. We are testing one, one final time. The validity of the conclusions that we've reached, we're evaluating in that review stage, the overall financial statement presentation.
And we're evaluating whether the evidence that we have gathered is adequate to support our opinion. It's just that final check. Did we gather enough evidence to support our opinion, to support our opinion? Do we need to gather more evidence, one final check, the review stage and analytical procedures help in that analysis.
Number two, auditor's try to identify predictable relationships when applying analytical procedures, relationships involving transactions, from which of the following accounts most likely would yield the highest level of evidence. Did you notice B allowance for bad debts, C accounts receivable, D accounts payable or all balance sheet accounts?
A interest expense is the only income statement account. And that's the answer. Income statement accounts answer a more predictable. They give you more predictable results. Why? Because income statement items are measured over a period of time where balance sheet accounts are measured at a given point in time.
That's the difference? Income statement items are always measured over a period of time. So the results more predictable, better for analytical procedures. Number three, which of the following activities is an analytical procedure. An auditor would perform in the final overall review stage of an audit to ensure that the financial statements are free from material misstatements.
What did you notice? A reading minutes of meetings and be obtaining a legal letter and D ensuring that the representation letter signed by management is in the audit file. A B and D are not analytical procedures. The only analytical procedure that's in the answer is C comparing current year's financial statements with those prior years for overall presentation.
That's the only analytical procedure that's mentioned in the answer is sick. Number four in auditing accounts payable, an auditor's procedures, most likely would focus primarily on management assertion of what completeness answer C. Remember, what we're worried about with liabilities is they could be understated, not everything's recorded.
That's what we're worried about with liabilities and what we're worried about with expenses. These are things that could be understated. Maybe not all liabilities have been recorded. Maybe not all expenses have been recorded. We want to really focus in on completeness where with assets, with revenues, we're worried about overstatement.
But it's accounts payable is a liability. So we would focus on completeness. Number five in evaluating the adequacy of the allowance for doubtful accounts, an audit, most likely reviews, the aging schedule for receivables to support the assertion of what valuation, and allocation answer be.
Because remember accounts receivable will be reported on the balance sheet net of the allowance account. So we test the agent's schedule to determine whether the allowance account is, has been properly calculated because that's going to finally work into the valuation of net receivables on the balance sheet.
What that's all about is valuation and allocation.
We know that in general, there are two types of. Substantive tests, there's analytical procedures, which we've talked about, and there are tests of details. And I bring this up because there are two substantive tests of details that you have to know very well that you have to be comfortable with in particular, because these two substantive tests of details are very heavily tested.
What I'm talking about is vouching and tracing. Sometimes they call it retracing. But you have to be comfortable with these concepts and these substantive tests, because they're so heavily tested in the exam. When you do your homework, you'll see so many questions mentioned vouching and tracing. So if you look in the viewer's guide, you'll see the outline of a little house and you'll notice in the seller of the house, there's the original authorization and approval of a transaction.
And then as you go up the house, you go through the source documents. The books of original entry, the subsidiary ledgers, the general ledger, the trial balance. And then finally in the attic of the house or the financial statements, that's our little house of GAAP there. Just remember this when you're vouching, when you're vouching, you starting in the attic with the financial statements and you're going back through the trial balance, the general ledger, the subsidiary ledger, the book's original entry, the source documents all the way back to the seller.
All the way down to the seller, to the original authorization and approval of the transaction. That's the direction you're going. You're going from the attic down to the seller. And when you're vouching, you're testing for existence. Now that you find an asset in the attic, you find an asset in the financial statements, and now you want to see if it can find the original, the source documents.
Does this asset really exist? You're testing for existence or occurrence and. What you're really trying to test for is overstatements. Can I, could I find an asset in the balance sheet in the attic and I can't find any supporting documentation for it. I think that's ever happened. Of course it has, is piece of land on the balance sheet.
And I can't find, any deeds, any source documents, because they made it up when you're vouching you're testing for existence or occurrence. And what you're looking for is overstatements. Generally speaking. And this might seem silly, but the V in vouch is like a little arrow pointing down. That's the direction you're going.
You're going down the house. Now, when you're tracing you going up, when you're tracing, you start in the seller in the original authorization approval and you go up the house through the source documents, the books of original entry, the subsidiary ledgers, the general ledger of the trial balance all the way up to the attic, the financial statement.
When you're tracing, you're testing for completeness. In other words, I find all the supporting documentation say for a liability, and I can't find the liability in the attic, in the financial statements I'm testing for completeness. And what I'm basically looking for when I'm tracing is understatements.
What does it management would like to understate, perhaps liabilities expenses, again, management. Bias could be to overstate assets or revenues. Their bias could be to understate expenses or liability. So when you're tracing, you're going up the house and this could be stretching a point, but the T in trace that the cross of the bar that crosses the T if you bend it just a little bit, it's a little, it's like an arrow pointing up.
You're going up the house. You're testing for completeness, looking for understatements, liabilities expenses, things that could be understated. Now remember as long as you're within the confines of that house, up and down the direction makes perfect sense. When you're bouncing, you're going down the house.
When you're tracing you going up the house, as long as you're within the house. Now when you get outside the house, it's a little different. If I find an asset in the financial state, And then I go to the factory to find the actual asset. You can't really think of it as opera down, right? Because I'm outside the house.
Now, if I find an asset in the financial statements and I go to the factory floor to see if I can find the equipment and the serial numbers, that's about you. I'm testing for existence. Hey, there's an asset here on the financial statements. Go to the factory, show it to me, show me the serial number. I'm going from the house to the actual asset.
Again, he's not really up or down, is it? But that's Bouchon. Testing for existence. Same thing. The other way, if I find an asset in the factory, on the factory floor and then I go with and show it to me in the financial statements, whereas it, in the financial statements, I'm testing for completeness, I'm looking for understatements I'm tracing.
So just remember if I go from the financial statements to the assets, the actual assets, I'm vouching testing for existence or occurrence. If I go from. The assets themselves to the financial statements, I'm tracing testing for completeness. So it's not really up or down. Now, there are a couple of transaction cycles that I want to get back to a couple of transaction cycles that are very heavily tested in internal control and also evidence.
And it's very important when you go in the exam in terms of audit evidence to know cold, the flow of documents in these transaction cycles. So let's look at a couple of them. There are three big ones. The exam really likes a lot. Let's start with the purchases accounts payable side. We've been through it before.
Remember it all starts in the user department. The user department fills out a store's requisition, got to know the flow of documents. Use the department. The department that's using the raw material. If they need material that you fill out a store record stores, requisition the store room. When they run out of goods, fills out a purchase requisition.
Then the purchasing department, they've got a set. They're going to fill out a purchase order. All right. So the user department, if they need material fills out a storage requisition, a store room, when the store room needs raw, more raw material fills out a purchase requisition. The purchasing department fills out a purchase order.
The receiving department, when the goods come in, fills out what you know are receiving report. The accounts payable department gets the vendor invoice and then combines it with the store, the purchase requisition, the purchase order, the receiving report, and it makes out a voucher package updates. The accounts payable master file.
Records the transaction in the cash disbursements journal, the treasury department makes out and mails the check. We keep custody in one pair of hands cancels, the voucher package, and then the general accounting department updates the general ledger. So again, I say in terms of audit evidence, make sure that flow of documents we've gone from the.
Store requisite store's requisition to the purchase requisition to the purchase order to the receiving report, to the voucher package, to the canceled check to the general ledger. So let's keep in mind, we're within the house of GAAP. So if you are going from the per the purchase order to the receiving report, to the accounts payable, master you're tracing, you're testing for completeness, right?
Cause you're going up the house. On the other hand, if you go from the general ledger back to the accounts payable, master back to the receiving report, back to the purchase order, you are going down the house, your bouncing you're testing for existence or occurrence memorize that flow of documents.
Another transaction cycle, the exam likes a lot is the sales accounts receivable cycle. The sales accounts receivable cycle all starts in the sales department. The sales department gets. The customer purchase order and fills out a sales order. Again, the sales department, after they get the customer purchase order fills out a sales order, the credit department approves credit.
So now it makes it an approved sales order. The shipping department ships the goods and fills out a bill of lading, a bill of lading, a shipping document. The billing department prepares the sales invoice post the transaction in the sales journal, the accounts receivable department. Posts the transaction into the customer's account updates.
The accounts receivable master in general, accounting, potent posts is transaction to the general ledger. So once again, what you want to focus in on what you want to memorize is the flow of documents. Memorize them. We've gone from the sales order to the bill of lading, to the sales invoice, to the sales journal, to the accounts receivable, master the general ledger.
So once again, where within the house of GAAP. So if you're tracing, you could be going from the bill of lading to the sales invoice, to the accounts receivable master. You'd be testing for completeness, looking for understatements. If I'm vouching, I'm going from the account receivable master back to the sales invoice, back to the bill of lading, back to the sales order testing for existence or occurrence, looking for overstatements, as long as you're within that house of GAAP, the direction up or down makes sense.
And then finally the cash receipts cycle. How does the cash receipts cycle look we've been through it before all starts in the mail room. Somebody opens up the daily mail, gets the checks that come in. They fill out a daily remittance listing. So the mail room fills out a daily remittance listing.
Then the cashier, there is a cashier. It could be the treasurer, either one, the cashier or the treasurer. Makes the deposits. We keep custody in the same hands. We always say we always separate authorization, recordkeeping, and custody. So the treasurer or the cashier makes the deposits daily and fills out a deposit summary.
The internal audit staff does a bank reconciliation, the account receivable department updates the account receivable master and records. The transaction in the cash receipts journal. General accounting updates, the general ledger. So once again, what you want to focus in on is that flow of documents. If I go from the deposit summary to the account receivable master I'm tracing, I'm going up the house testing for completeness.
If I go from the general ledger back to the account receivable, master back to the deposit summary, I'm vouching I'm testing for existence or occurrence. You'll find that is flow. These transaction cycles come up in the exam in multiple choice and even in simulations and knowing this flow of documents and knowing the direction you're flowing for vouching and tracing will always make a big difference.
Always be important in that exam. Make sure you take the time to study that flow of documents and just know them cold. Now, before you do the next class, You'll see, there are nine questions that I'd like you to answer, and I will look to see you in the next class, keeps studying
welcome back. That I have assigned nine questions for you to have finished before coming to this class. So let's start by going over those nine questions. First in number one. They say in testing the existence assertion for an asset, an auditor or a narrowly works from what? We know that if we think in terms of that house, the house of GAAP, when we're testing for existence, we're going down those members, as long as you're within that house, then the direction will work.
When you're going down the house you're bouncing. You're testing for existence, looking for overstatements, generally speaking, when you're going up the house you're tracing and you're testing for completeness. So as long as you're within the confines of that house, that direction will work. And since we're testing for existence, the answer of course is see we're vouching.
We want to go from, see the accounting records down the house, starting with the accounting records, on the roof. All the way down the house into the, down towards the seller, back to the supporting documentation and the original authorization testing for existence. Answer C number two in determining whether transactions have been recorded.
Now we're testing for completeness. Aren't we? So they're asking if we're testing for completeness. Where the transactions have been recorded, whether anything has been omitted, which racing we're going up, the house, the direction of the audit testing should be from what, from the bottom of the house from answers.
See again, the original source documents. We start from the original source documents. We find all the documentation for say a liability. Why isn't it in the records? We trace it to the records make we trace it to the financial state. Make sure it's being reported. Make sure that nothing's been omitted testing for completeness.
Number three, an auditor selects a sample from the file of shipping documents to determine whether invoices were prepared. This test is performed to satisfy the audit objective of what? If I'm going from the shipping documents, the bill of lading too. The invoice. If I'm going to the vendors invoice, am I going down the house?
Am I going up the house? I'm going up? I'm going from the bill of lading shipping documents up the house to the billing department that prepares the invoice. If I'm going up the house, I'm tracing, I'm testing for completeness and the answer is big. Number four, an auditor selected items for test counts while observing a client's physical inventory, the auditor then traced the test accounts to the client's inventory listed this procedure.
Most likely obtained evidence concerning management's assertion of what? Now were outside the house. Remember? Now we're not within the, within that house of generally accepted accounting principles and not within that house, with the financial statements at the roof all the way back to the original authorization and the seller when it, in that house anymore.
And once you're outside the house, it's not, don't think of it as really up or down here. We're going from, test counts to the records. We're going from the assets, basically from the factory floor to the record. Remember if you're going from the factory floor to the records for completeness, and the answer is bait.
That's tracing. When you find assets on the factory floor, in this case, a test account, and you want to see if they're in the records, you're testing for completeness. It's not really up or down, but that's tracing. Now. If you went from the records, if you found assets in the financial statements and then went to the factory floor to see if you could find them now, that's vouching.
You're testing for existence. Hey, I found some assets that are being reported. Go to the factory and say, where are they? Show me the serial numbers. It's not really up or down. So just remember if you go from assets to records, you're tracing testing for completeness. If you go from the records right directly to the assets, you're Boucher testing for existence, you have to get used to that.
You're outside the confines of the house. Now. Number five. Which of the following is a substantive test that an auditor most likely would perform to verify the existence and valuation of accounts payable. If we're testing for existence right away, we think of vouching. So you go, let's go to C makes sense.
The voucher would we, if we want to test for existence and value and evaluation of accounts payable, would we vouch selected entries in accounts payable? Back to the purchase orders and the receiving reports. Yes. That's how you test for existence. You're going to start with accounts payable and then vouch back to the receiving reports and the actual purchase orders to test for existence and ultimately valuation, whether accounts payable is overstated and the answer.
Is sick. And I want to mention that this would be true, whether it's, a paper environment we know with a paper audit trail or an electronic environment, this information has to be there. When there's the, one of the problems with an electronic environment is that there's no natural audit trail.
There's no paper trail. Then the documentation has to be built into the system. It still has to be an audit trail. This information. Even if it's not in paper form, reading, receiving reports, purchase orders would have to be there so important to have documentation controls in an electronic environment, in any environment, but in electronic environment it's essential that it's built into the system because there's not a natural paper audit trail, number six, which are the following procedures, would an auditor most likely perform in searching for unrecorded liability.
Unrecorded liabilities. If we're looking for unrecorded liabilities, how about a, what I trace? And of course your initial thought is unrecorded, liabilities. I'm looking for understatements. And generally when you're looking for understatements, you're tracing right. When you're bouncing, you're looking for overstatements, generally speaking.
You're in the exam and you go I'm going to search for unrecorded liabilities. Generally I'm worried that liabilities are understated. You'd want to trace. So of course the answer is right there for you trace, it says trace a sample of accounts payable entries recorded just before year end.
Now wait a minute. If these accounts payable entries were recorded just before year end, then it's, how are you testing for unrecorded liabilities? If you're starting with accounts, people that were recorded just before year end, it doesn't make any sense like this can't be the answer, even though you think I'm testing for, I'm looking for an understatement in liabilities.
I'm going to trace, but that doesn't make sense because if I start with accounts payable that will recorded just before year end. Then I'm starting with liabilities that have been recorded. I'm looking for unrecorded liabilities. This may strike you as strange, but here we're going to vouch. And the answer is.
See, we're going to vouch a sample of cash disbursements recorded just after year, end back to the receiving reports and the vendor's invoices. The why are we, why is it about, because basically you're going to vouch back to the supporting documentation. You're looking at disbursements right after, right at the beginning of the year, so right after the close of the year, at the beginning of say year two, you find some disbursements vouch back to the receiving reports.
And the invoices. And what you're trying to find is that these payments right after year end the payments at the beginning of the year, to really, when you look back at the supporting documentation or for a liability that should have been recorded in year one. So if this makes sense to you. Yeah. If you vouch, when you're vouching looking for overstatements year two would be overstated.
Year two liabilities really would be overstated because it, the liability should have been recorded in year one. Your one liabilities were understated. They were unrecorded liabilities in year one. They there wasn't proper cutoff. So that's a little bit convoluted there. Again, you're vouching to find really an overstatement in year two liabilities because the liability belongs in year one liabilities were understated because it was unrecorded.
And as I say, they didn't have proper cutoff. So it's they're playing with you there about whether you're looking for overstatements or understatements. In this case, we would vouch number seven, a weakness in internal control over recording retirements of equipment may cause an auditor to this is, I think, is really going to come down to a or D do I want to go from the assets?
To the records or do I want to go from the records to the assets? We'll get we're outside the house now. So in terms of tracing and vouching, can't really think in terms of going up or down here, I want to find out if there's a, if there's a weakness in recording retirements of equipment. So should I go from the assets to the records or should I go from the records to the assets?
A notice is going from the assets to the records. And he says, if I inspect certain items of equipment, In the plant and then trace them back to the accounting records. Will that do it? No, because if I start with the equipment in the plant, obviously the equipment hasn't been retired now, but I'm afraid that equipment's been retired, but it hasn't been recorded.
There's a weakness in recording retirements. So I'm afraid that there's equipment that's been retired and retirement's not reflected in the records. So if I go with a and I start with equipment in the plant, obviously that equipment hasn't been retired. That doesn't make any sense at all. If I go from assets, if I go from assets to records in this case, remember, cause that's tracing assets to records and you're looking for completeness.
You're looking for understatements. We're not looking for an understatement here. We're looking for an overstatement because if there's a weakness in retiring or equipment recording retirement, That means equipment is overstate. We're looking for an overstatement. So we want to vouch. And the answer is D if I select certain items of equipment from the accounting records and try to find them in the plant, and if I can't find them in the planet, it's because they were retired and the retirement wasn't recorded, there was a weakness in recording retirements.
So equipment is overstated of that. Make sense to you. I want to go from the assets. I, excuse me. I want to go from the records now to find the assets on Boucher. I find this equipment in the records go to the plant. I can't find it because it's been retired and the retirement wasn't recorded. So equipment is overstated I'm vouching.
And the answer is D I'm. The purpose of tracing a sample of inventory tags to a client's computerized listing of inventory. Notice we're going from assets to record. So we're tracing, right? We're going from asset. We're not in the confines of the house now where we're outside. That was the confines.
Can't think in terms of up or down, we're going from assets to records. And what is the purpose of that to determine whether the inventory items answer a represented by the tags were included in the listing we're testing for completeness, which racing. That's why we're doing this to determine whether the inventory items answer a represented by the tags are on the listing.
What testing for completeness, which racing number nine, Cooper CPA performs a test to determine whether all merchandise for which the client was billed was received.
The population for this test consists of what? Where do you begin? What is the population you'd start with. If you want to test to see whether all merchandise. For which the client was billed was actually received. The population you'd start with is answer B everything they will build for you start with all the invoices, you'd start with all the invoices.
And then you would vouch back to the receiving reports, right? You're looking for overstatements here. You're looking for an overstatement in accounts payable. So you're vouching. Now you within the confines of the house. You'll go in down the house. So you'd want to vouch, starting with the invoices, back to the receiving reports to see that merchandise was actually received when they've been built.
Now, that all this audit evidence that we're gathering is documented in the work papers and the Workpapers of course are essential. The work papers, support the audit report. The work papers show that the auditor adhered to generally accepted auditing standards and the Workpapers also aid in the conduct of the audit.
And basically the Workpapers are comprised of the permanent file and the current file, the permanent file contains items of continuing audit significance. If the permanent file is that file, you login to the client year in, year out. And as I say, it contains items of continuing audit, significance, articles of incorporation, chart of accounts, internal control, questionnaires, flow charts, items of continuing audit significance.
That's the permanent file you login to the client year in, year out. And then there's the current file, which contains items of current audit significance. A working trial balance accounts receivable confirmations, a letter of audit inquiry to the client's attorney, lead schedule for something like cash supported by 18 bank accounts, items of current audit significance.
Now don't forget that the CPA, the auditor owns the Workpapers CPA owns the Workpapers. However, the Workpapers do contain confidential client information. So the CPA. Needs the client's permission to disclose the information to a third party. Remember that even though the CPA does technically own the Workpapers, it is confidential client information.
So the CPA would need the client's permission to disclose the information to a third party. Now, there are some exceptions, they don't need the client's permission. If it's in response to a subpoena, it's part of a professional practice review, but basically. The client needs, the CPA needs the client's permission to disclose the information to a third party.
It's confidential, glide information, and there's some rules we need to talk about if your client is an issuer, Sarbanes-Oxley, let's not forget that socks. Sarbanes Oxley requires that if you are, your client is an issuer, the CPA has to retain the Workpapers and all supporting documentation that supports the audit report for at least seven years.
At least seven years or there are criminal penalties, very significant. And if your client is a non-issue, you must retain audit documentation for at least five years. And, basically what you're retaining, what the auditor is required to retain is Workpapers sufficient for another veteran auditor to understand the work that was performed.
And in terms of requirements, absolute requirements, the auditor is required to document the Workpapers, all their audit procedures. The nature, the extent, the timing of all their audit procedures, the results of all the audit procedures and the conclusions that the auditor reached regarding that evidence that's what's required.
It's very common sense. The auditor has to document the nature of the extent, the timing of all their audit procedures and the results and the conclusions that were reached. The auditor has to document a reconciliation of the client's accounting records to the financial statements, a couple more rules.
Okay. When do you have to complete the audit work papers? So some rules here. When does the auditor have to complete the work? Workpapers. If your client is a non issuer, you have to complete the work papers no more than 60 days from the audit report release date. No more than 60 days from the audit report release date.
If your client is an issuer, you must complete the work papers. No more than 45 days from the audit report release date and the public company, accounting oversight board standards, the oversight board standards also have another requirement. Then, if there are any changes to the audit documentation after it's been completed, it's a very significant oversight board standard say, Hey, any changes to audit documentation after the work papers has been completed, must be fully documented and you also must keep the original documentation as well.
Now, before you start the next class, I do want you to answer three questions on work papers, and make sure you get those answered. Before you go to the next class and I'll see you then
welcome back. That I assigned three questions that I wanted you to answer before coming to this class. So let's start with those three questions. And number one, they say, which of the following statements is most accurate regarding sufficient and appropriate documentation. D says, audit documentation is the property of the client.
That's not true. The Workpapers are the property of the auditor. The CPA to start with. So that knocks out D C says if additional evidence is required to document significant findings or issues, the original evidence is not considered sufficient and appropriate and therefore should be deleted from the Workpapers.
Of course not all that would be retained. ACE says accounting estimates are not considered sufficient inappropriate documentation. That's not true. What the auditor would have to document is the basis for those tests. Now the answer is B says sufficient and appropriate documentation should include evidence that the work papers have been reviewed.
There's a review of work done at every level. Staff members work is reviewed by supervisors. Supervisors work is reviewed by managers. Managers work is reviewed by partners and all of that is part of sufficient and appropriate documentation. Number two. Which of the following factors most likely would affect an auditor's judgment about the quantity type and content of the Workpapers a says the assessed level of control risk.
That's it, isn't it. If control risk is high, that means there's a high probability that the internal control structure is not working well. And if control risk is high. The auditor is going to have to gather much more evidence to be persuaded much more. That's going to affect certainly the quantity of evidence that's gathered and also the type, because now the auditor's going to need more outside corroboration.
And of course the content as well. So you don't have to go beyond day number three, which of the following factors would least likely affect the quantity and the content of the Workpapers. ACE says the condition of the client's records. No, that would affect the quantity and the type and the content.
Wouldn't it. If the records are a shambles, you're going to need a lot more evidence. You're going to need more outside. Corroboration B says the assessed level of material misstatement. If the assessed level of material misstatement is high, you're going to have to gather a lot more evidence and again, more outside corroboration.
It's going to affect the quantity, the type, and the content C says the nature of the auditor's report. No, that's not the answer that would affect the quantity and the type and the content of the evidence, because you're certainly going to gather a lot more evidence if it's a qualified opinion or an adverse opinion, as opposed to an unmodified opinion.
Now, the answers date, the content of the management representation letter is very unlikely. To affect the quantity, the type or the content of the work papers. It really doesn't have any bearing on it at all. Now we know that we are gathering all this evidence and documenting all this evidence to determine if there are any material misstatements, any errors and fraud in management, assertions, and.
Our audit procedures are going to include tests of controls. Of course, observation inquiry inspection. We re perform some procedures and some substantive tests. And I want to give you a memory tool. So you will easily remember all the substantive tests of details that we might perform. Just remember the word Corvair C O R.
V a I R Corvair. And it'll just give you a handy reference point to remember the substantive tests that are used. Let's go through what it means. The in Corvair is confirmation by confirming accounts receivable. The O in Corvair is observation and inquiry. Now you may say how can observation, which is of course, one of the tests of controls, how can observation be used as a substantive test?
We could. Observe the taking of the ending inventory. For example, how about inquiry? How could inquiry be used as a substantive test? We could inquire about the company's policy on determining obsolete inventory. So observation inquiry can be used as a substantive test are, as retrace, would be is vouch a is analytical procedures.
I is inspect or examine and R is recompute or reconcile. Remember Corvair, you have a quick list of the substantive tests that are used to check out management assertions, and the way your number management assertions is cold. So you're using Corvair, which is. A old classic junk of a car to check out the code.
And one more thing, let's talk about subsequent events. You know what subsequent events are subsequent a subsequent event is an event that occurs after the balance sheet date, after the balance sheet date, but before the company issues their statements, right? That's a subsequent event. It's an event that occurs after the balance sheet date, usually December 31, but before our client issues, the statement.
And it's also important to know how you would search for subsequent events and the way you search for subsequent events. Just remember, you're looking for a miracle. M I R a C L. You're looking for a miracle. M is the management representation letter you're going to have, you're going to be sure to have the management representation letter address, whether or not there've been any subsequent events.
And of course I is acquired. Inquire of management, whether there've been any subsequent events, the R is read minutes of meetings, read minutes of meetings. That's very informative. You could read also interim statements, where the next interim statement, but read minutes of meeting the, a asset or liability valuation changes at the beginning of the year, you want to look at any asset or liability evaluation.
Changes from the end of the year under audit to the beginning of the following year, that would be an indication to see. And miracle is cut off. You want to make sure that you test assets, liabilities, revenues, expenses for proper cutoff, and L is the legal letter in the letter of audit inquiry to the attorney.
You would inquire about any subsequent events. So you want to put that. You want to make sure that's part of your arsenal as well. Corvair, the substantive tests that are used and, miracle how to search for subsequent events and what I'm getting to is that once, Corvair and once, miracle and, management assertions cold, now you're able in any multiple choice or a simulation to determine, what audit procedures.
Sound appropriate. What audit procedures would be appropriate for any given assertion, because that's the position. The exam very often puts you in. You're in a mobile Joyce, and they're asking you, what audit procedures would be appropriate or in a simulation, you may be asked to determine what audit procedures would be appropriate.
So now, just to give you an example, if we had to decide what audit procedures were appropriate, For the management assertion of inventory, just as an example, and you're in the exams, let's say it's a simulation and we have to decide what audit procedures would be appropriate. You could in your scrap paper, just write down management, assertions cold, and then just start thinking about the way you would test each assertion for completeness in cold for completeness.
If it's inventory couldn't you trace. From test counts, you could trace from test counts for inventory to the inventory listing, testing for completeness, going from test counts from the auditor to inventory list. See if there's see if it's listed. See if it's correct testing for completeness, you could.
How about cutoff? You could inspect or examine a sample of inventory transactions before and after year end to determine the proper cutoff classification and understandability, you could examine all disclosures related to inventory to make sure that they're understandable ownership, rights obligations.
You could confirm any. Consigned goods that are held by third party, confirm the balance of consigned board consigned goods held by third parties. Remember those goods still belong to your client. They have ownership rights to that merchandise for valuation, you could inquire about management's policy regarding obsolete inventory.
You could recompute lower of cost of market.
You could do an analytical procedure. You could analyze the change in inventory turnover. If a notorious inventory turnover has gone down, it might indicate there is more obsolete inventory for existence. Now you want to bounce from the records to the assets you would have. You want to bounce from the inventory listing.
To the inventory tab testing for existence, going from the inventory listing to the inventory tab testing for existence, you could observe the taking of the ending inventory, observe the beginning and the ending inventory. I'm not trying to list every possible audit procedure. All I'm saying is that anytime you're in that exam and you're put in a position where you have to decide what audit procedures can be used.
We'll start with Cove, management's assertions. And then think about in terms of Corvair, what substantive tests would be appropriate in that circumstance appropriate for that assertion. And you should be able to answer anything they come up with. And then don't forget subsequent events. It's always relevant to search for subsequent events regarding inventory.
One more time you're looking for a miracle, so you'd want. It's appropriate to have the management representation letter address, whether there were any subsequent events that affected inventory, inquire of management, whether there were any subsequent events that relate to inventory, we'd want to read minutes of meetings, look at any changes in asset or liability valuation.
From the end of the year, to the beginning of the following year test for proper cutoff, send out a legal letter. Asking the client's attorney, whether there have been any subsequent events related to inventory. And let me just also mention that, if it's something like, equipment or fixed assets, not only is it appropriate to apply management assertions in terms of fixed assets, also it's appropriate to think of anything related to fixed assets like accumulated depreciation.
Expand your thinking a little bit. If we're talking about fixed assets, then accumulated depreciation is also relevant. You'd want to apply management assertions to bolt and Corvair, to bolt miracle, to bolt. If it's accounts receivable, what's related to it, allowance for bad debts, all of that is appropriate.
But if you have Corvair and you have miracle and management assertions, you should always be in a position to decide. No, whether audit procedures are appropriate. Now let's think about, cash receipts. If we had to think about audit procedures that we would use for cash receipts. Again, we'd write down cold.
How about completeness? We want to trace right? Wouldn't we trace a sample of cash receipts from the remittance listing to the deposit summary, to the deposit, slips to the cash receipts journal, testing for completeness. Cutoff examine a sample of cash receipts transactions before and after year end to determine proper cutoff classification understandability.
You want to examine any disclosures that are related to cash to the cash balance ownership, rights obligations you'd want to inquire of management. If there were any restrictions on cash valuation. You'd want to reconcile the bank. Cutoff statement. Bank cutoff statement is sent from the bank to the CPA about 30 days after year end.
So you'd want to reconcile the bank cutoff statement existence. Of course you want to vouch, why wouldn't you Boucher sample of cash receipts from the cash receipts journal back to the deposit. Slips back to the deposit summary all the way back to the remittance listing. Again, I'm not trying to list every possibility.
I'm just saying it's a way of thinking. If I'm putting that position in the exam where I've got to think about what audit procedures would be appropriate, I've got Corvair. I know management's assertions. And then I can always look for a miracle that's always relevant. Now, were there any subsequent events that affected cash?
So you have the management representation letter address that you inquire of management. You read minutes of meeting, you look at any change in asset or liability valuation. From the end of the year, to the beginning of the following year, you test for cutoff. You send out a legal letter, always important.
Now regarding cash. I want to go over a couple of terms that you might see. In the exam that affect cash. First time I want to go over is kiting is what kiting is about. What a client can do at year end is write a check from bank account number one and deposit it in bank account. Number two. So we have a client.
We have a client at year end. They write a check from bank account number one, and they don't record it. They don't record it in the check register. It's not recording. The disbursement is not recorded and they deposited bank account number two. And of course, what they're hoping is that in the year end bank statements, the, the cash is going to show up in both places that aren't on the books it'll show up in both places.
Cause they didn't record the disbursements, the disbursement in the cash disbursements journal from bank account number one, but they do record the receipt. And the deposit bank account, number two, they just hope it shows up in both places. That's Katie. And the way to find kiting is for the CPA, for the auditor to do a bank transfer schedule.
That's the way you find it. You do a bank transfer schedule for every transfer in there should be a transfer out. And what you're basically looking for when you do the bank transfer schedule is when you see a transfer in, you see a deposit, you're looking for a deposit that. Is dated earlier than when you find the transfer out the disbursement, that'll tell you there's been kiting.
Anytime you find a deposit, the deposit in bank account, number two, for example, you find the deposit and it's dated earlier than when you find the disbursement in bank account. Number one, how could that be? That would tell you that there's kiting and of course, Kaiden cannot happen. If you have proper separation of duties, you want to separate the person who handles cash from the record keeping and you have the internal audit function.
Do the bank reconciliation. Another term you might see is lapping. Here's how lapping works. Let's say customer number one pays their bill and I steal the money. Customer. Number two, pays their bill. I steal their money. Then costume number three pays their bill. And I use the money from customer number three and I post it the customer number one's account that's lapping customer, honorable number one, pays their bill and I steal it custom.
Number two, pays their bill. I steal it. Then when customer number three pays their bill, I take the cash from customer number three and I post it to customer one's account. So there's a delay. That's how you know, there's lapping when there's a delay between. When the cash was received and when it was posted to the customer's account, now, one way you couldn't find lapping is send out accounts receivable, confirmation on an interim date because customers are going to screen, I paid this bill, why hasn't it been posted to my account?
So he sent out an account receivable confirmation on an interim date that should find lapping. Another thing you might see mentioned in the exam is a lock box. That's a pretty good system with a lockbox. Customers send their payments directly to the bank. And of course, lapping can be stopped with a proper separation of duties.
There's a proper segregation of duties. It's going to be very difficult to do lapping without some sort of scheme where employees collude the proper separation of duties. They shouldn't be lapping. Let's look at a couple of questions. If you look at questioning. Number four, question number four and five are on the same information.
It says the information below was taken from the bank transfer schedule prepared during the audit of Fox company's financial statements for the year ended December 31 year. One assume all checks are dated and issued on December 30th year one. And the first question they want to know. Which of the following checks would indicate hiding what would be hiding here?
Look at check number two Oh two two Oh two. Notice the disbursement date on the books is January 3rd, but on the receiving side on the books, it's December 30th. You see what I mean about how can the receipt, how can the transfer in B before. The transfer out that indicates Kaiden, that's a banter, that's a bank transfer schedule.
So as an auditor, you're looking at that and saying how can they transfer in on the receiving side B before the transfer out on the disbursement side, that would indicate cutting. Look at check four Oh four on the disbursement side, it was on January 2nd for books. And on the receiving side, notice it's on the bank statement December 31.
Now here again. How can you have the transfer in the deposit? December 31 for bank before the disbursement. That's what indicates kiting. And the answer is big checks. Two Oh two and four Oh four Arcadia. Now in question five, they say, which of the following checks would be a deposit in transit? Now it's one Oh one and three Oh three.
If you look at one Oh one, the disbursement was on. December 30th and that's on the disbursement side and on the receiving side, it's on the books December 30th, but it doesn't show up on the bank statement on the receiving side until January 3rd. And it doesn't clear the disbursement bank until January 4th.
So at ERN it's, that's a, that is a deposit in transit on the receiving side that's deposit and transit it. The deposit was written on December 30th. On the disbursement side on the receiving side, it's on the books December 30th, but it doesn't clear that bank until January 3rd. So for the receiving side, that would be a deposit in transit and same thing with three Oh three, the dispersant was on December 31.
Notice doesn't show up on the receiving side per bank until January the following year. So for the receiving side, that's a deposit in transit. Keep studying. Don't fall behind. And I looked to see you in the next class. Welcome back in this class. We're going to talk about governmental auditing. And the first thing I want to say about government, a lot of it is that auditing is auditing.
Whether you're auditing a profit making company or a government program or activity. Auditing is auditing. And don't forget that us generally accepted auditing standards apply to all audits. So it makes perfect sense that generally accepted government auditing standards. That's generally accepted government auditing standards, usually called the yellow book, includes all us generally accepted auditing standards.
So the yellow book.
Gives us the standards, more audits of governmental organizations, programs, activities, functions, and also the yellow book applies to government assistance received by contractors. And also non-profits. Now, as I say, the yellow book includes all of us. Generally accepted auditing standards, but the yellow book does have different points of emphasis and a few different requirements.
For example, the audit requirements for federal financial assistance includes expanded internal control documentation and testing. It includes expanded reporting requirements. Including a formal written report on the consideration of internal control and the assessment of control risk. Also expanded reporting on whether the federal financial assistance was administered according to applicable laws and regulations.
So while the yellow book does include all of us generally accepted auditing standards, as I say, it has different points of emphasis. Different requirements. Let's talk about the different types of audits that can be done in government law. Auditing first, you might see a financial statement audit a financial statement.
Audit is performed according to the yellow book and its purpose is determined. Whether the financial statements are presented fairly in accordance with us GAAP, or maybe even an hoc boa,
the. Audit also includes our report on internal control and compliance with laws and regulations and contractual requirements and grant requirements. It's important to say this, that the yellow book requires a written report on the auditor's understanding of internal control and the assessment of control risk on all audits.
Let me say that again. That's important. The yellow book requires a written report on the auditor's understanding of internal control and the auditor's assessment of control risk on all audits, whereas in U S gas, there's only a written report if significant deficiencies are found in internal control.
So of course the auditor is required to obtain an understanding of the design of internal control. And to determine whether the controls have been implemented. And the auditor has to communicate to Matt, to the management, those in charge of governance, all significant deficiencies noted during the audit, even if they're not material weaknesses and significant deficiencies are also reported to the appropriate legislative and regulatory bodies.
And the yellow book, there's also additional attention given to fraud. And what is called abuse? Abuse is a misuse of authority for gain. Now, the auditor is not required to, search for abuse, but if abuse is detected, it requires further testing. The point is that noncompliance with laws and regulations.
Contractual requirements, grant requirements, or abuse that has a material effect on the financial statements must be reported to management and those in charge of governance. And of course, any written response by the organization is included in the audit report. The auditor is required to report all illegal acts, all illegal acts.
Or possible illegal acts to a top official of the entity and also any oversight body or legislative or regulatory body. The auditor is required to report fraud and illegal acts to the federal inspector general. If management fails to disclose the fraud and illegal acts. Or take remedial action. Now, of course, a management representation letter is required at the end of every audit and the management representation letter is going to state that there have been no violations or possible violations of laws or regulations that should be disclosed in the financial statements that the.
Managing representation letters is going to state that management is responsible for complying with all laws and regulations and the manage representation letters is going to state that management has disclosed to the auditor, all laws and regulations that have a direct material effect on the financial statements.
Let me say a word about compliance audits. A compliance audit is usually done in conjunction with a financial statement audit. And the yellow book requires that the auditor design, the audit to provide reasonable assurance of detecting material misstatements that result from noncompliance, with laws and regulations,
the auditor's opinion on compliance is that the program level. And if you do a financial statement audit, if you do. An audit of a profit-making company. What we're always thinking of as an auditor is the risk of material misstatement. We know the risk of material misstatement it's made up of two other risks.
It's made up of the inherent risk for the particular account and control risk, and risk of material misstatement is made up of inherent risk and control risk. It's very similar with a compliance audit, the risk of non-compliance, it's just a different way of thinking. The risk of non-compliance is made up of inherent risk and control risk.
So if the risk of non-compliance goes up, if inherent risk and control risk is higher than the auditor has to set the detection risk, lower to control the overall audit risk of non-compliance. And in the required manage representation letter in the compliance audit, management's going to state that management has disclosed all instances of non-compliance or that there were no instances of non-compliance.
Okay. Let's talk about the required documentation you are required to document in the work papers, the assessment of. The risk of noncompliance, the procedures that were performed to test the controls and the results and the basis for materiality levels. Now, also in governmental auditing, there are attestation engagements, examinations reviews agreed upon procedures and.
These are performed according to the yellow book and the yellow book incorporates the statements on standards for attestation engagements. It's all incorporated in the yellow book. And if we're talking about an examination, there are expanded requirements on reporting on the effectiveness of internal control and identifying any deficiencies in internal control.
Also reporting on compliance with laws and regulations and contracts requirements and grant requirements. And then finally there are performance audits,
performance audits. The purpose of a performance audit is to provide, findings or conclusions based on evaluating sufficient, appropriate evidence against a particular criteria. The objective of a performance audit is to assist management and those in charge of governance with him, with improving the programs, performance, and operation to achieve the organization's goals effectively and efficiently.
Let me say a few words about the single audit act. The single audit act requires. An audit be performed in accordance with the act for entities that expand federal funds, federal assistance during any fiscal year equal to or greater than $750,000. So they had, again, the single audit act requires an audit be performed in accordance with the act for entities that expend federal funds during the fiscal year.
No federal assistance during the fiscal year equal to or greater than 750,000. Now there are two primary objectives of the single audit act first to audit the entities, financial statements and report on a separate schedule, the expenditures of federal funds in relation to the financial statements. And number two, it's also a compliance audit federal funds expended during the fiscal year for each program.
The single audit act requires additional audit procedures for specific programs, including a separate evaluation of materiality for each program. Materiality is determined for each program and it's using a risk-based approach. The way you determined a major program is by looking at inherent risks. And control risk and detection risk that's to help you determine a major program.
Now what's required in the single audit act, is that the auditor must express an audit opinion or a disclaimer of opinion on the financial statements and the separate schedule of expenditure of federal funds. Yeah. There's noncompliance with the requirements of the federal financial assistance. If there is non-compliance well, if it's material it's qualified opinion, it's very material it's adverse.
Also of course, the auditor is required to report on. Major programs, internal control, and their compliance with laws and regulations. Now to finish your preparation on government law, then make sure you do all the multiple choice in this area. And I think you'll be ready for this area for the exam. I look to see you in the next class.
Welcome back in this class. We're going to begin our discussion on statistical sampling. And how statistical sampling relates to auditing. We know that auditing is all about risk. We've talked about this many times in the course that risk is on a void unavoidable in auditing because we don't examine a hundred percent of the documentary evidence that supports the financial statements.
We always take a risk in auditing and. We've identified very particular types of risks that we take as an auditor. We know that there's control risk. The risk that internal controls are not functioning well. There's inherent risk. The risk that a given account by its very nature could be misstated.
There's detection risk. The risk that an auditor will fail to detect material misstatements. That do in fact exist. And of course the ultimate risk is audit risk. The risk that the financial statements are materially misstated, they're misleading, but the auditor misses it all somehow and gives an unmodified opinion.
That's the ultimate risk that we take audit risk. All right. So let's get to the point. Why do we use statistical sampling and auditing? Because. Statistical sampling allows an auditor to quantify risk, to measure in mathematical terms, the amount of risk that the auditor is taking. Now, generally speaking, there are two types of statistical samples.
There are attribute samples and there's. Variable samples. There's attribute sampling there's variable sampling. When you're attribute sampling, you're testing a population for a certain characteristic, a certain attribute, how many accounts receivable have never filed a credit application? How many accounts receivable have that attribute that characteristic?
And generally we use attribute sampling. To test controls, test compliance and then there's variable sampling. When you take a variable sample, you're estimating the dollar value of a population. And how does that value differ from what's stated in the financial statements. So generally we use variable sampling for substantive testing.
Of details. Now I want to start with some basic concepts. In fact, three basic concepts. The first step in any sampling is to define the population. So let's think about this for a minute. How many populations that you could sample, would you find in a typical set of financial statements? There's the population of accounts receivable.
There's the population of accounts receivable more than $700. There's the population of accounts receivable between four and $800 more than 24 days overdue. There's the population of accounts receivable between a dollar and $2,000 that a more than 90 days overdue. I think you see my point, the amount of populations that you could sample.
In a typical set of financial statements is almost infinite. So that's my point. It's up to the auditor to define in precise terms, the population that's going to be sampled that takes auditor judgment, and it may surprise you, but there's a lot of auditor's judgment being used in a sampling plan. So from the very beginning, Judgment is used because it's up to the auditor's judgment to define the population.
Now, once you define the population, listen carefully, once you to find that population, here's our first major concept. You always assume that population has the properties of the normal curve. I'll say that again. Once you define that population, we always assume that population has the properties.
Of the normal curve. Now, am I saying that all the items in the population, if you plotted them on a graph would form a normal curve? No, not saying that. Listen carefully. What I'm saying is the means the arithmetic means of all the samples you could draw from that population. If you were to plot them on a graph would form a perfect normal curve.
It's called the central limit theorem. It's a huge key to sampling. They want you to find a population? You assume the population has the properties of the normal curve. Not that all the items in the population form a normal curve. No, but the means of all the possible samples you could draw from that population.
If you were to plot them on a graph would form a perfect normal curve. So that's our first major concept that. The auditor has to define the population. And once the population is defined, we assume the population has the properties of the normal curve. And we'll say more about those properties later on second major concept for a sample to be mathematically valid.
The sample has to be an unrestricted random sample. You say that again for sample to be mathematically valid, the sample has to be an unrestricted. Random sample. So the second concept here is randomness. It's a key concept. What does randomness mean? Basically what it means is that every item in the population has an absolutely equal chance to be selected in the sample.
Every item and the population has to have an equal chance to be selected in the sample. In other words, this is the one place. This is the one place in a sampling plan where there can't be any judgment at all. They can't be any judgment in deciding what transactions will be sampled. It has to be an unrestricted random sample.
In other words, you go to a random number generator on a computer, and the random number generator says go to transaction six one nine. So you go to transaction six one nine. Find all the supporting documentation for that transaction. And you audit that transaction, whether it looks interesting, whether it looks boring, whether it looks routine matter, the random number table said sample transaction six one nine.
Will you get all the supporting documentation for transaction 609? And you audit it to its final. Okay. Inclusion. How about this? Let's say the random number table said go to transaction seven one three, and we sit there and we go, I'm at this client every year. And I can tell from that transaction code, that's a very old transaction.
I'm going to have to go to get the supporting documentation for that transaction. I'm going to have to go to the archives, down in the cellar. It's not computerized records that old I'll have to go down to the seller and dig out the paperwork. And I've seen rats down there. The size of a toaster oven.
I don't think I want to do that. So I'll, I think I'll just substitute another transaction. If you substitute another transaction that destroys randomness because now you've added judgment in what items are going to be selected in the sample. Can't be any judgment can't be. Now, if you don't want to get down on the seller and fight huge rats, then call the transaction.
Correct. Or call it an error. No, they can't. They can't support the amount, whatever you've got to make it. The random number table said to sample that transaction. You have to sample that transaction. It's an unrestricted random sample. How about this? Could I sit like a file drawer and go, okay. I've got to, I've got to look at some documentation here.
It'll look at some transactions. So I take a dollar bill out of my pocket. The first serial number is nine. So I count nine invoices in, and then I look at every 10th one after that's called systematic sampling. It is a form of randomness, but it's a weaker form of randomness. It is a form. That's a weaker form of randomness because if the population is in any order, for example, if all the large transactions were at the beginning of the file drawer, it's going to distort your results.
You're your strongest form of randomness is a random number table says, go to transaction 1247. You go to transaction 1247, whether it looks interesting, boring routine doesn't matter, get all the supporting documentation for that transaction and audit it to its final conclusion. But for your sample to be mathematically valid, it has to be an unrestricted random sample.
So that's our second major concept. First major concept. We assume the population, once it's defined has the properties of the normal curve. Second for our sample to map, to be mathematically valid, it has to be an unrestricted random sample. And now our third major concept, variability is very important in a sampling plan and in a population.
Let me illustrate it to you this way. Let's say there was a, just a big barrel of money, a big barrel full of money. And. My boss says, Bob Jay, count the money in the barrel. All we know about the barrel is there's a million pieces of money. That's we don't know where there's nickels, dimes quarters, $5 bills, a hundred dollar bills.
We have no idea. I have no idea what's in there. We just know there's a million pieces of money in the barrel. So Bob I'd like you to count that money in the barrel. So I'm given this job and I think I'm not going to sit here and count a million pieces of money. I'll take an unrestricted random sample of money and I'll project.
The value of the money in the barrel. So let's say if you're with me on this, if you can buy this hypothetical, let's say it's possible to open the top of the barrel, put a blindfold on, and I reach in and take out a hundred pieces of money at random. Just allow me that I can do that. Put a blindfold on. I take out a hundred random pieces of money.
And when I take out a hundred random pieces of money, I pull out a hundred nickels, just nickels. I go, I don't know, maybe the sample wasn't big enough. So I take out another hundred random pieces and another a hundred and another hundred and another a hundred. Finally I've taken out 500 random pieces of money.
And what I've come up with is 500 Nichols. That was just no variability. So I'm going to do in that case is I'm going to say to my boss with a great deal of confidence. We'll say more about confidence later, but I'm going to say to my boss with a great deal of confidence, I think what's in the barrel is a million nickels.
Cause I don't see any variability. I pulled out 500 random pieces of money. I came up with 500 Nichols. I think what you have in the barrel is a million nickels. I think the value of the money in the barrel is $50,000. My boss says I'm not satisfied. Of course they never are. My boss says, all right, Bob, I'll tell you what.
Just humor me, go in and take one more random piece of money. Just one more. And if it's a nickel, I'll buy your results. So I put on my blindfold and I dig into the barrel. I pull out one more random piece of money and it's a million dollar bill. Now. I think you see what just happened there. When that million dollar bill comes out.
Of course, now there is. An enormous amount of variability, right? How many million dollar bills are there? Is this the only one that's possible? Maybe there's only one. We came up with it in sample. Maybe there's one, every 500. You see what each million dollar bill does to the value of the money in the barrel.
It changes everything. What you'd have to do in that case, because. There's such a huge amount of variability. You'd have no choice, but I've got to know how many million dollar bills there are. Is there one? Is this the only one I've got 10 more? The only thing you'd have to do, the only thing you could do in that case is now take samples of thousands of pieces of money.
Maybe tens of thousands to try to see how often a million dollar bill comes up or here's my point. Variability causes uncertainty. The more variability there is in a population. The more uncertainty there is. And generally speaking, the more variability there is in a population, the larger samples have to be, this is what variability does to you causes your samples to be much greater.
Again, how many million dollar bills are there. I'd have to have sample thousands and thousands of pieces of money to try to get an idea. How many times a million dollar bill, how often a million dollar bill is going to come up. I want you to remember that standard deviation is the standard measure of variability.
And we'll say more about that in our next class. I'll see you in our next class. Welcome back in this glass. We're going to continue our discussion of statistical sampling and how statistical sampling relates to auditing. And as you remember, in our last class, we began our discussion with variable sampling.
We use variable sampling to estimate the dollar value of a population. We use variable sampling as part of our substantive testing of details. And in this class, I want to go through a simple variable sample and the results. So here's the information let's say we have done a variable sample and we're going to do what is called a mean per unit.
Projection. That's what we're going to, what we're going to work on a mean per unit projection. So we've done a variable sample and let's say that the population, as we've defined, it has 2000 transactions. We took an unrestricted random sample of a hundred of those transactions and we audited those hundred transactions and our audited value based on our audit of those hundred transactions, the audit value of the sample $25,000.
I'm going to assume that our standard deviation is a hundred dollars. Remember that measures variability, our standard deviation is a hundred dollars. The standard error of the mean is $10. And I'm assuming that the auditor has a 10% tolerable misstatement, which I'll get to later. All right. So let's do our mean per unit projection.
I'm going to take the audit value of the sample. $25,000. I'm going to divide by the a hundred transactions in our random sample that comes out to $250. That's the arithmetic mean of the sample? That was the audited value of the average transaction in the sample. That's the arithmetic mean of the sample $250.
I'm going to multiply that arithmetic mean $250 times the 2000 items in 2000 transactions in the population. And that comes out to $500,000. That's our best estimate of the value of this population. $500,000. That is what is called our point estimate. Now, remember we said in our last class that once we define a population, we assume the population has the properties of normal curve.
So let's put down a normal curve and let's talk about a couple of properties. We put down a normal curve and we're going to put a line right down the middle. So 50% is to the left of the curve. 50% of this is to the right of the curve. And we're going to put our point estimate our best estimate of the value of the population, right in the middle 500,000.
Now, what are the properties of the normal curve? One of the properties of a normal curve is that. 50% of the population falls to the left of the curve. In other words is less than 500050% of the population is to the right of the curve, right to the right of the point estimate more than 500,000.
That's one of the key properties of a normal curve. 50% of the population falls to the left of the point estimate less than 500050% of the population falls to the right of the point. Estimate is more than 500,000 another. Property of a normal curve. If I go one standard deviation to the left and to the right of the point, estimate I will encompass 68% of that curve.
It's one of the properties of a normal curve. If I go one standard deviation to the left and one standard deviation to the right of the point, estimate I will encompass 68% of that curve. So let's do that. Let's do a calculation. How many standard deviations am I going to go to the left and right of the curve.
To the left of the right of the point, estimate one, I'm gonna go once one standard deviation, that's gonna, that's gonna cover 68% of the curve. I take that number standard deviations. One times the standard error of the mean $10 I gave you that comes out to $10 times the number of transactions in the population 2000, and that comes out to plus, or minus $20,000.
Now let's put that on our curve. If I go one standard deviation to the left of the point, estimate that's less than 20,000. So that brings me down to a lower limit of 480,000. If I go one state of deviation to the right of the point estimate that's plus 20,000, that brings me up to 520,000. Now here's what I'm saying.
We are 68% confident. It is 68% probable that the value of this population. Is $500,000 plus or minus $20,000. I'm admitting it could be as low as and 80,000. It could be as high as 520,000 plus or minus 20,000 give or take 20,000. Now the way to express this I'm 68% confident that the value of this population is 500,000 plus or minus 4%.
Very often they will express what is called the precision, your plus minus factor. In terms of a percent of the point estimate, if you take 4% of 500,000, you get 20,000, I am 68% confident. It is 68% probable notice confidence relates to probability. It is 68% probable, therefore I'm 68% confident that the value of this population is $500,000 plus or minus 4% plus or minus 20,000.
I'm admitting it could be as low as four to 80,000. It could be as high as 520,000 plus or minus give or take. 4%. And again, that 4%, that's the actual precision that you calculate it at 68% probability. Now don't confuse that with the auditors
tolerated misstatement,
the auditors tolerated misstatement is plus or minus 10%. The auditors tolerated misstatement that relates to the auditor's judgment about materiality. In other words, we're saying that we're 68% confident that the value of this population is 500,000 plus or minus 4%. If the auditors tolerated misstatement is possibly minus 10%, if you go to the balance sheet and this item accounts receivable, whatever it is.
300,000. There's a problem, right? The auditors is willing to say, if they're within, if I go to the balance sheet, that's within 10%, that's the auditors tolerated misstatement, as long as I'm within 10%, I, that it's not a material problem. But as I say, if the auditor goes to the balance sheet, And sees this accounts receivable, whatever the population is that we were testing is 300,000.
There's a problem. It's way it's off by way more than 10% or the audit, it looks on the balance sheet and sees that accounts receivable is 800,000 it's way beyond 10%, but don't again, don't confuse the auditors tolerable misstatement with the actual precision. We calculate it at 68% confidence, which is.
Plus, or minus 4% another property of the normal curve. If you go 1.9, six standard deviations, almost two, if you go 1.9, six standard deviations to the left and the right of the point estimate you'll encompass 95% of that curve. So let's do that. Let's work out the actual precision at that level.
And I'm going to take the number of standard deviations I need for 95% probability, 1.9, six times the standard error of the mean. $10 that comes out to 19 point 60 times. The items in the population 2000 comes out to plus, or minus $39,200. So let's put it on our curve. If I go 1.9, six standard deviations to the left of the point, estimate that's minus 39,200 brings me down to 460,800.
That's my lower limit. That's the lower limit of that projection. If I go 1.9, six standard deviations to the right of the point estimate that's a plus 39 too. That brings me up to $539,200. That's the upper limit of that projection. So what are we saying? We're saying it is 95% probable. Therefore I am 95% confident member confidence relates to probability.
It is 98% probable, therefore I'm 98% confident that the value this population is 500,000 plus or minus. 39,200 give or take 39,200. I'm admitting I could be off by 39,200 plus or minus 7.8%. Very often. Precision is expressed in terms of a percent of the point estimate you take 7.8% of the 500,000. You get 39 too, but that's what we're saying.
When 95% confident the value of this population is 500,000 plus or minus 7.8%. We're admitting we could be off. By up to 7.8%. Now the auditors tolerable misstatement is plus or minus 10%. You look on the balance sheet and say, it's accounts receivable and it's showing at 540,000. The, with the auditors tolerable misstatement they would, could even allow it up to 550,000 plus 10%.
Because that's what the auditor would consider a material. So again, auditors tolerable, misstatement relates to materiality. Auditor's judgement about materiality. Again, don't confuse that with the actual precision, we calculate at a certain level of probability, a certain level of confidence. All right.
Now, let me show you another way to do the same type of projection. We just went through a mean per unit projection. But there are different ways you can get that point. Estimate. Let me show you a ratio. Estimation is how you do a ratio estimation. Let's say that the audited value of our sample is $8,000.
The book value, there was the audited value of the transactions we took in our sample. Once we've audited, those transactions $8,000, the book value says 10,000 take 8,000. Over 10,000. The ratio is 80%. So if the book value of the population. Is a hundred thousand times, our 80%, our point estimate is 80,000.
That's our best estimate of the real value of that population. 80,000. That's a ratio estimation. How about a difference estimation? Here's a, here's how you do a difference estimation again, we'll assume the book value of our sample is 10,000 and we audit a random sample of transactions are audited value is 8,000.
What's the difference? $2,000. Take that $2,000. Divided by the a hundred random items in our sample. It's a $20 difference per transaction. Now, all you'd have to do is take the thousand items in the population times the difference, the $20 difference from our estimation and that comes out to $20,000. And nodes would be a minus 20,000.
Because the audit value of the sample was less than the book value, audit value, 8,000 book value of those transactions, 10,000, because it was less, this would be a minus $20 for a transaction. Take that minus 20 times a thousand items in the population be a minus $20,000. So what's what is our difference?
Estimation? If the book value of the population is a hundred thousand minus that $20,000. From our difference estimation, our point estimate would be 80,000. Our best estimate of the value of that population would be $80,000. All I'm saying is when you win the exam, make sure the difference between a mean per unit projection, a ratio estimation, or a difference estimation.
Let's talk about stratified sampling. When you stratify a population, all you're doing is dividing a population up into smaller population. That's what it means to stratify, dividing a population into smaller populations. Let me give you an example. Let's say we're going to sample the population of equipment transactions and our client has eleven thousand two hundred eleven thousand two hundred equipment transactions.
Now 11,000 of those transactions are for $500 or less. 200 of those transactions are for $5 million or more. Okay. So that's our situation. We want to sample a population of equipment transactions. Our client has 11,200 equipment transactions, 11,000 of them, $500 or less.
Yeah, a hundred of the transactions, $5 million or more. Now, if I define that as just one population, I think you see the problem. If we just define that as one population of equipment transactions, there's a gigantic amount of variability. Sample sizes are going to skyrocket. So here's what I can do since it's up to the auditor to define the population.
Why can't I define equipment transactions as two populations, I have a population of equipment transactions, 500 or less, and I have another population of equipment transactions, $5 million or more. I have two populations. And what you would find is you have two populations with each population has very little variability.
You would take a small, a much smaller sample out of each. So this is why you stratify population to reduce variability and that results in smaller sample sizes. Now I want to go back to risk, by the way, when I did statistical sampling, I don't know if I ever had a population that had been stratify.
I'm not sure. It was just, it's such a huge. Huge concept to try to reduce variability. You're always looking at a way to to break up those populations to really break. They really get the variability down. So your S your sample sizes can be much smaller. I was stratifying all the time. Now I want to go back to the concept of risk.
We know that there are all kinds of risks and auditing. We've talked about control, risk and inherent risk. And we've talked about audit risk. There are risks in sampling as well. What's the basic risk in a sample. The sample could be wrong. That is possible, right? You're not guaranteed. If you take a random sample.
Even an unrestricted random sample. There's no guarantee it is perfectly representative of what's in the population. It is a perfect representative of what is in the population. No guarantee of that. In other words, you could just pick out an odd selection of items. It's possible. The sample could be wrong.
That's your basic risk with sampling that the sample could be wrong. So here's how we break those risks down. There's the alpha risk with a sample is this that the financial statements are correct. Okay. Here's your alpha risk with sampling? The financial statements are correct. They're fairly stated, but your sample says there's a problem.
Remember the sample is wrong. So what you end up doing is modifying your opinion. That's called the risk of incorrect rejection. You reject the financial statements and you shouldn't have, they were fine. So that's the alpha risk financial statements are fine. Sample says, Oh, there's a material problem.
You modify your opinion. You give a qualified opinion. That's the risk of incorrect rejection. Now of course the beta risk is the opposite. It's the one we're really worried about in the beta risk. The financial statements are materially misstated. Loaded with errors and fraud sample says, everything's fine.
Number the samples wrong. You just get an odd selection of items. Sample says, everything is fine. So you give an unmodified opinion. That's called the risk of incorrect acceptance. That's the risk of incorrect acceptance. Got to know these risks. Also make sure the effect of certain items on sample sizes.
How about variability more variability means what larger sample sizes, less variability means less sample sizes. That's a direct relationship. How about tolerable misstatement? The auditor's tolerable misstatement. If the auditor has a smaller tolerable misstatement you're plus or minus half a percent, generally the samples are larger because there's very little room for error.
So if the auditors' tolerable, misstatement is very small, generally the samples have to be larger. If the auditors tolerable, misstatement is large plus or minus 15%, generally, it's not as tight. You take smaller samples. It's an inverse relationship in our next class. We'll talk about attribute, sampling.
I'll see you then
welcome back. To our discussion on statistical sampling. Now, as we've said, in our prior classes, we use variable sampling, which we've talked about to this point, when we're trying to estimate the dollar value of a population, generally, we use variable sampling when we're doing substantive testing of details.
Now I want to get into attribute sampling when you're attribute sampling, you're testing the population for a particular attribute. A particular characteristic, how many accounts receivable have never filled out a credit application? That's something you don't want. In other words, with an attribute sampling plan, you're looking for an error rate.
You're looking for errors, trying to determine an error rate. And generally you use attribute sampling when you're testing controls, testing compliance. So just to show you a. The simple result of an attribute sampling plan. Let's say that we're testing the population of accounts receivable for that attribute.
How many customers have never filled out a credit application? Let's say in our unrestricted random sample, 7% of the customers never filled out a credit application. That's our point estimate. We're assuming the population has the properties of the normal curve and. Since I want to be 95% confident that's 1.9, six standard deviations.
So I go 1.9, six standard deviations to the left of the point estimate that brings me down to 3%, 1.9, six standard deviations to the right of the point. Estimate brings me up to 11% because the precision that I calculated was plus, or minus 4%. So what we're saying in statistical terms is this. We're 95% confident that the true error rate in the population is 7% plus or minus 4%.
We're admitting it could be as low as 3% high as 11%, but we're 95% confident. It's not more than 11%. That's what we're saying in statistical sampling terms where 95% confident it's 95% probable. That the true error rate in this population is 7% plus or minus 4%. We're admitting it could be as low as 3% high as 11%, but we're 95% confident.
It's not more than 11%. Now let's say the auditor's tolerable error rate. That relates to the auditor's judgment about materiality. If the auditor's tolerable error rate is 12%, then it's fine. Cause we're 95% confident. It's not more than 11%. And the auditor could tolerate up to a 12% error rate in this particular item,
let's go back to sampling risk. We know the basic risk with any sample is that the sample could be wrong. You're not guaranteed with a statistical sample with an unrestricted random sample. You're not guaranteed. To get a perfect represent representation of what's in the population. You could pick out a weird group of items, even at 99% confidence, 99% confidence.
There's a 1% chance that your sample is just wrong. So let's break down the risks with an attribute sampling plan with an attribute sample, the alpha risk. Is that internal controls are effective. Internal controls are effective, but your sample says there's a major weakness in internal control. Remember the samples wrong?
The basic risk is the samples wrong, lead you in the wrong direction. So with the alpha risk, internal control is affected, but your sample says there's a material weakness. So what do you do? You assess control risk too high. That's the risk of under reliance, that's called the alpha risk is the risk of under reliance because you don't rely on internal control and you should have, and the result is you do way too much substantive testing.
Now the beta risk is the opposite with the beta risk. Internal control is not effective. It's not, but your sample says everything is fine. So you assess control, risk too low. That's the risk of over reliance. You rely on internal control when you shouldn't the risk of over-reliance. So the result is you do too little substantive testing.
Now it's always important to know the effect on sample sizes. Let's talk about the effect on sample size from the expected deviation rate, the expected error rate. If the expected error rate is high. You take larger samples, expected error rate is low. You take smaller samples. That's a direct relationship.
If the auditor expects the error rate, you know that the auditor is at this client every year. And if the auditor expects the error rate to be high, generally they take larger samples. If they expect the error rate to be low, they take smaller samples. That's a direct relationship now. Don't confuse that with the tolerable error rate, what the auditor could tolerate.
It's auditor's judgment. If the auditor's tolerable error rate is high, generally it takes smaller samples. It's an inverse relationship. The, if the auditor can tolerate a huge error rate in something, probably an insignificant item in material. So you take smaller samples, but if the auditor's tolerable error rate is low, very tight, it's probably a very important item.
Generally take larger samples. It's an inverse relationship you might see in the exam that they met discovery sampling discovery. Sampling is a type of attribute sample where you want to predetermined probability of discovering one error. That's a discovery sample where you have a predetermined probability of discovering one error.
This is used for critical items. Where you expect the error rate to be very small, how many canceled checks for more than $500,000, we'll have less than four signatures because that's the policy. If it's more than $500,000 is going to have four approved signatures. So I'm going to take a sample of canceled checks more than 500,000.
How many canceled checks for more than $500,000, we're going to have less than four signatures. You would hope that would be none. That's the policy. So I want to see how many have less than four signatures. I expect the error rate to be very small, to be close to zero, but with the discovery sample, I want a predetermined probability of discovering at least one error.
Let's talk about PPS sampling. PPS stands for probability proportionate to size. If you do a PPS sample probability proportional to size. You're using an attribute sample table for a sample for variables. I know it seems odd, but that's what you're doing with a probability proportional to size PPA, a PPS sample.
You want to use an attribute sampling table for a sample for variables. If you look in your viewers guide, you'll see a problem Hill company. It says Hill has. Decided to use probability proportional to size PPS sampling, sometimes called dollar unit sampling in the audit of a client's accounts receivable balances he'll plans to use the following table.
So you have an attribute sampling table here. First column is number of overstatement misstatements, the risk of incorrect acceptance. We know what that is. And we're given a risk of incorrect acceptance of 1%, 5%, 10%, 15% and 20% additional information tolerable misstatement 48,000. The auditor could tolerate risk of incorrect acceptance 20%.
Again, that's the auditor's judgment. What they could risk for incorrect acceptance where, you know, in control in internal controls are bad. Sample says everything is mine. You accept internal control. You assess controllers to low risk of incorrect acceptance. They'll the acceptable risk, but this is 20%.
Number of misstatements allowed one. The book value of accounts receivable 480,000 and this 360 accounts. And they want to know what would be the sample size. What you do is start with the risk of incorrect acceptance. Go to the 20% column. They have a risk of incorrect acceptance of 20% go to the 20% column.
Now what's your number of allowed misstatements one. So go to go under the number of misstatements one. And if you look over onto the 20% column, you see the number three, that's your reliability factor. Your reliability factor is three. So now we can work out the sample size if. You take the tolerable misstatement $48,000 and that's auditor's judgment.
What they could tolerate from misstatement 48,000 divided by that reliability factor three, it comes up to $16,000. That's your sampling interval. Now it's just a matter of taking the book value of all your accounts receivable, 480,000 divided by that sampling interval, 16,000. And you've got a sample size of 30 answer date.
You're using an attribute sampling table to do a sample for variables. Why did they do this? What are some advantages with a PPS sample? The sample size is not effected by variability. It's not effected. The sample size is not effected by variability and you know what normally would be not with the PPS sample.
Also a big advantage of PPS sampling. You can start the sample before the entire population is available. Sometimes that's. Very useful, out in practice where you can start a sample for the entire population is available to you. And also with a PPS sample, the population is automatically stratified.
You get automatic stratification because larger dollar value transactions have a higher probability of being selected in the sample. So there are some advantages to PPS sampling.
Keep studying don't fall behind. And I looked to see when the next class we're going to shift our focus and I want to talk about information technology. When information technology is used in an accounting system, it affects the control activities that are used. It affects the risk assessment that your client would use.
It affects information and communication monitoring the system. And of course it affects the environment. It affects every component of crime, every component. Of internal control was affected by information technology and information technology itself creates some internal control problems. Information technology is a wonderful thing, but when information technology is used in an accounting system, as part of an internal control structure, it creates some internal control problems.
For example, information technology can not by itself. Distinguished between reasonable and unreasonable data. If you tell, a physical payroll clerk, a person to write a payroll, check this week to the janitor for a hundred million dollars, hopefully a clerk would say, now, wait a minute.
That doesn't make any sense. What do you mean a hundred million dollars for, but the janitor for anybody, it doesn't make sense. Information technology by itself. Can't distinguish what's reasonable. What's unreasonable. There, there is a lack of physical traces information technology is processing transactions online in real time without necessarily leaving any physical traces.
So there's no natural audit trail. And perhaps the major problem with information technology is there's a high concentration of duties within information technology. Information technology at times it is doing functions that if it were handled by a person would be incompatible because there was such a high concentration of duties.
So let's talk about the control activities that you would look for. If information technology is part of the accounting system. As far as information technology is concerned and control activities within information technology, there are two broad areas. There are general controls and there are application controls.
Remember that it's either going to be general controls or application controls, general controls refer to the system that's built around it. And perhaps this is obvious, but it should be said any weakness in general controls will have a pervasive effect on the system. Pervasive. You don't want any weakness in general controls.
And again, general controls refer to the system that's built around information technology. First general control is that you'd want to separate information technology from the users of the output. They should be separate information technology from the users of the output information. The information technology by itself should never initiate.
Authorize or approve anything? No. The information technology part of the accounting system should just process activity. Shouldn't be initiating, authorizing, approving anything. It should process transactions. Now they're important general control. They should be procedures to review, test approve and document.
Again, procedures. Part of general group controls would be to have procedures to review, test approve and document. Two things systems and changes to systems programs, and changes to programs. That's essential, documentation controls so important in it. Things get out of control very quickly without strong documentation controls, again for monitoring, but there must be procedures to review, test approve, and document those two things systems and changes to systems programs, and changes to programs.
Another general control is to be sure that your client takes advantage of all hardware and systems, software controls, firewalls, virus protection, anti-hacking software that's part of general controls, access controls. You must restrict access to the hardware, to the master files and to the programs and the documentation.
Again. There must be controls to restrict access to the hardware, to the master files and to the programs and the documentation. And because there is such a high concentration of duties within it, it is essential that there'd be a proper separation of duties within it. The functions that you'd want to separate our Copel C O P a L again, because there's such a high concentration of duties within it, as we said, There, the it department is doing things that in the hands of a single person would be incompatible.
So it's essential. You have a proper separation of duties within it. What you want to separate is copay. Let's go over it. The C would be the control group. The control group is a group of employees that are responsible for internal control within it. That's the control group, a group of employees that will be responsible for internal control within it.
Always computer operators. P is computer programmers a would be analysts, systems analysts, and then L is the librarian function. The librarian keeps the master files, the programs and the documentation. Very important function. Those are the functions you want to keep separate. And then one more, very important general control is to safeguard the assets.
They have to be. Smoke detectors, fire detectors, moisture detectors, and a disaster recovery plan, meaning that you have a copy of important master files off premises. Very important control, important master files should have a copy off premises. And you know why? Because the cost of reconstructing, a machine readable file can be very expensive.
So you want a copy of important master files off premises. Now let's talk about application controls, whether it's an inventory application, whether it's an accounts receivable application, whether it's a payroll application, you want controls built into the, that particular application. And it won't surprise you that application controls come down to controls over input controls during the processing and controls over output.
That's how application controls, breakdown, controls over input controls during processing and controls over output. And it can be very simple controls, record counts, making sure that, the number of records that went into the system are fully accounted for on the output record counts, control totals, knowing, total gross pay.
No total number of employees control totals, all you know, through all through input processing, output hash totals would be a total just use as a control. You could add up all the employees, social security numbers. It's a hash holder. It's it has no other meaning except as a control.
So if you know what all the employee's social security numbers add up to, what that adds up to now, if you were to somehow drop an employee and add an employee, you would catch that, just knowing total employees wouldn't catch that record counts. Wouldn't catch that. But a hashed total, like total social security number would catch it.
You want to use, check digits, check numbers. Is this a valid. Employee number. Is this a valid part number?
Also, you want to use limit and reasonableness checks. As we said, information technology by itself, can't distinguish between reasonable and unreasonable input. So why not build into the system li limit and reasonableness checks so that, if the highest paid employee is the president. And the president, I know it gets a hundred thousand dollars a week.
Why would anybody, why would the payroll system be able to write a check above that amount you put in that absolute limit? And you could do it by employee number. If the employee number indicates a janitor and the highest paid janitor is, I don't know, $800 a week, why should any janitor would that employee number, starting with a certain prefix, why should the payroll department be able to write a check?
Beyond that amount you build in re because it can't distinguish between reasonable and unreasonable data, you build it into the system. Now, before we leave the area of information technology, I also want to, I want to mention that some clients will use a service organization for something like payroll, as part of their system, as part of their internal control, they're using a service organization like ADP or Paychex.
And the service organization may have their auditor, the service organization, auditor perform on a test examination and that test examination reporting on the service organizations controls. And you have to be aware of this because if the exam gets into this, there are two types of reports that you could see from a service organizations, auditor in a type one report, a time a type one report would be a report on.
A description of the service organizations system and the suitability of the design of controls. That's a type one report, a report on management's description of the service organization system and the suitability of the design of controls. All the type one report is saying is whether management's description of the system is.
Fairly presented. That's all the type one report is telling you whether management's description of the system is fairly presented as an auditor. You can not use a type one report as a basis for reducing your assessed level of control risk. Let me say it again. As an auditor, you cannot use a type one report as a basis for reducing your assessed level of control risk with a type two report.
If the service organizations auditor gives you a type two report that has a report on management's description of the service organization system and the suitability of the design and operating effectiveness of controls. Notice the difference in the title in a type two report, it's a report on management's description of the service organizations system and the suitability of the design and operating effectiveness of the controls.
The type two report is a report on whether the controls are suitably designed to achieve control objectives. It's very different. A type two report is a report on whether the controls are suitably designed to achieve control objectives. So if you're an auditor and a service organizations, or auditor gives you a type two report, and you're the audit of the client, you as the auditor of the client can use a type two report.
As a basis to reduce your assessed level of control risk. So as an auditor, if you're given a type two report by the service organization's auditor, you can use a type two report as a basis to reduce your assessed level of control risk. So you want to be aware of that difference between a type one and a type two report.
Welcome back in this class, we're going to discuss professional ethics and in the area of ethics, the exam, primarily tests. The AICPA code of professional conduct, and the code applies to all members of the AICPA when they perform any professional service, not just auditing. And one thing to keep in mind if you depart from the code and I don't recommend it, but if you depart from the code, the burden of proof is on you to justify the departure.
So it's not something I would recommend, but again, basically the code governs the performance of all professional services. And I want to start with the articles. Article number one is on responsibility and it basically establishes that when a CPA, when a member provides any service, not just auditing the CPA has the responsibility to exercise sensitive, professional and moral judgment.
Article number two, public interests establishes that members have the obligation to serve the public interest, not just the client's interest. Number three integrity establishes that when providing any service, a member has to demonstrate a high degree of integrity. What's integrity, honesty, and fair dealing.
That's what integrity is honesty and fair dealing. Article number four. Objectivity and independence. What it's saying is when a member, when a CPA provides any service, they have to maintain their objectivity. What does objectivity mean? No conflicts of interest. And if a member is in public practice, they have to be independent of a client.
If they're going to provide any assurance on financial information, that. If a CPA is going to provide any assurance on financial information, the CPA has to be independent, in fact, independent in appearance. Our objective in an audit is what our objective in an audit is to provide reasonably positive assurance that the financial statements are free of material misstatement, reasonably positive assurance, that the financial statements are free of errors and fraud.
What we do or review what's our objective. To provide limited assurance. We are not aware of any material modifications that should be made for these financial statements to be in accordance with us GAAP. That's called limited assurance. But when we're providing assurance of any kind on financial information, we have to be independent, in fact, independent in appearance.
How about a compilation? No, if you're doing a compilation, you're just compiling numbers that have been given to you by management. Into the form of financial statements, and you're not providing any assurance whatsoever on that information. So you don't have to be independent to do a compilation.
Article. Number five is, do care when a member provides any service, not just auditing any service, a member has to exercise due professional care, meaning that a CPA always has to be acting as a reasonably. Prudent knowledgeable CPA would act under certain under similar circumstances. That's due professional care that when you providing any service, you're always acting as a reasonable prudent, knowledgeable CPA would act under similar circumstances.
Another way to put it. What does due professional care mean? No negligence. Article number six, scope and nature of services just establishes that. A member has to observe the code when they're defining the scope and the nature of any professional service. Those are your six articles. Now the rules clarify and amplify the articles.
Let's start with rule number one, rule one Oh one. You know what? It's going to be on independence. Rule number one, rule one Oh one is asking this question. When is independence impaired, what would cause independence to be impaired? During the period of a professional engagement, the CPA cannot have any, they cannot
have, they can't have any direct financial interest. In the client or be committed to acquire any direct financial interest in the client or a material indirect financial interest in the client. If the CPA has any direct notice, any direct financial interest in the client, one share out of 500 million outstandings, too many, you can't be committed to acquire or have already acquired.
A direct financial interest in the client. If you've done that your independence is gone or you can't, the CPA cannot have a material indirect financial interest in the client. If they have a material indirect financial interest in the client, their independence is gone. Let me ask you this can a CPA own shares in a mutual fund and the mutual fund owns shares with the client.
Would that affect the independence? That's my question. Can a CPA own shares in a mutual fund and the mutual fund owned shares of the client? Would that destroy independence? It could, if the shares in that mutual fund are a material part of the CPA's net worth, then it's a material indirect financial interest in the client.
Independence has gone. The general rule is this. If a CPA owns 5% or less 5% or less in a diversified mutual fund, that whole, that owns shares of their client. That's not considered a material indirect financial interest. Again, if a CPA owns 5% or less of the shares, In a diversified mutual fund that owns shares of their client.
That's not considered a material indirect financial interest. If a CPA owns more than 5% of the shares in a diversified mutual fund that owns shares with their client. And that's a significant part of the CPA's net worth than it is a material indirect financial interest and independence is gone. So remember that if a CPA owns more than 5% of the shares in a diversify, in a diversified mutual fund, they don't share it with the client.
And that's a material. Part of the net worth of the CPA. Independence is gone if they own, if the CPA owns any shares in a non diversified mutual fund, that's holding shares of the client. Independence has gone. It's a strict rule because it has to be. Independence is the bedrock of the profession has to be a very strict rule during the engagement.
The CPA can't be the trustee or executor of an estate that is committed to acquire any direct financial interest or a material indirect financial interest in the client. Independence would be gone
during the period of the professional engagement. The CPA can't have had can't have a material business, investment jointly held business investment with the client, its officers, its principal shareholder. Our principal shareholder would own 10% or more of the stock or independence is impaired.
Again, during the period of engagement, the CPA can't have a material jointly held business investment with a client or its officers or its principal shareholders. Again, that's a material part of the CPA's net worth independence has gone.
During the period of a professional engagement, the CPA can't have alone to, or from the client, its officers, directors, principals, shareholders, independence would be impaired if a CPA, spouse or spousal equivalent or dependent whether or not they're related again, if a CPA, spouse or spousal. Equivalent or dependent, even if you know whether or not related, if the spouse responsible equivalent or dependent violates rule one Oh one, then it's imputed to the CPA.
It's as if the CPA violated rule one Oh one, independence has gone again. It's a very strict requirement. Yeah, it has to be because it's the bedrock of the profession. Independence. If a CPA's parents, sibling, brother or sister. Non-dependent child has a key management position with a client or a financial interest in the client.
That's material to the net worth
independence has gone. Maybe you won't give an adverse opinion. Maybe you just, maybe you'd hesitate giving an adverse opinion to a client because it means your father's going to lose his job. All of a sudden, all of a sudden you have a rooting interest. All of a sudden you might pull a punch.
What's the difference between a qualified and an adverse opinion judgment. So may not, or maybe you'd hesitate to give an adversity onion if it meant that your mother would lose a key management position.
And of course the CPA. Can't serve in any decision-making function for our client. That's the equivalent of management or a policy-making position.
The CPA can't be involved with any litigation or threatened litigation against the client that is material. And of course it would be material. If you're down to litigation, it's material. Let's go to rule one Oh two integrity and objectivity just clarifies that when a CPA provides any service, they maintain their objectivity means what no conflicts of interest
and demonstrates a high degree of integrity. What's integrity, honesty and fair dealing rule two Oh one. Clarifies that when providing any service, the member exercise due professional care, you know what that means? No negligence. You're always acting as a reasonable, prudent, knowledgeable CPA, what act under similar circumstances.
And by the way, part of due professional care is that all engagements have to be adequately planned and supervised staff work. Is reviewed by supervisors. Supervisors work is reviewed by managers. Managers work is reviewed by partners. There is a critical review of work done at any at all levels.
That's a huge part of due professional care rule. Three Oh one confidential client information basically says that the CPA can not disclose. Confidential client information without the consent of the client who owns the work papers. I think you notice the CPA owns the work papers. The CPA owns the work papers, but the CPA can't disclose confidential client information to any third party.
Without the consent of the client. There are exceptions, the CPA could disclose confidential client information without the consent of the client in response to a subpoena. To comply with law or regulations as part of a professional practice review rule three Oh two contingent fees. The CPA cannot charge a fee based on results.
Well, a qualified opinion is going to cost you this, but if you want an unmodified opinion, that's really going to cost you. Of course not. Can't charge a fee based on results. Even a compilation. You can't charge a contingent fee for a compilation. If there's any reasonable chance that the compilation will be used by third parties.
And there, that would almost always be the case that it would be used by third parties. How about a tax return? No, you can't. You can't charge a contingent fee for an original tax return on amended tax return. Even a claim for a refund. Now you can charge based on complexity. You can charge more for a complex return than an easy return.
That's no problem.
You cannot charge a contingent fee for an examination of prospective information. There's a prohibition against contingent fees. Rule five Oh one acts discreditable. Acts discreditable to the entire profession of accounting. Don't commit an act that's discreditable to the entire profession of accounting.
The big one is retention of the client's records and the other one, which is near and dear to all of our hearts. You cannot solicit or disclose CPA Exam AUD questions or answers. These are acts discreditable to the entire profession of accounting. And then finally rule five Oh two advertising and solicitation CPA is allowed to advertise as long as it's not false misleading or deceptive rule five Oh five.
I wanted to mention that to form a Borg organization and name basically establishes that you can not put on your letterhead members, AI, CPA, unless. All owners are members of the AICPA our consulting services. Okay. If you perform consulting services, would that impair independence consulting services or?
Okay. You're still independent because you're just considered an objective advisor just for the benefit of the client. And the work is for internal use only. Now in the next class, there are 12 multiple choice questions. I want you to get done. Get your answers to those 12 questions and then come back and we'll go through them together.
I'll see you there. Welcome back. I hope you did these questions. You have your answers to these questions, and now let's go through them together. Number one, on June 1st year one, a CPA obtained, a hundred thousand dollars personal loan. From a financial institution, client for whom the CPA provided compilation services.
Now, when you do a compilation, you're not required to be independent because you're not providing assurance on financial information. You're just compiling numbers given to you by management into the form of financial statements so far. No problem. The loan was fully secured, considered material to the CPA's net worth CPA, paid the loan in full.
December 31 year one. And then on April 3rd year, two client asked the CPA to audit the financial statements for year two. Is the CPA considered independent with respect to the audit of the client audit of the client's December 31 year two financial statements. He says, yes, they are independent because the loan was fully secured.
That's your relevant? That's relevant. You can't have a loan. To, or from an audit client, whether it's fully secured or not. But notice this loan was paid December 31 year, one was paid in full. So during the period of the audit engagement, there is no loan to a, from the client B says, yes, the CPA is independent because the CPA was not required to be independent at the time the loan was granted.
That's true because at the time the loan was granted. It was compilation services where independence was not required. And again, when the CPA is hired to do audit services, the loan has been paid in full, but bottom line is you can't have a loan to a, from an audit client that would impair independence.
But when this client became an audit client, the loan was paid in full. So no problem. Yes, they're still independent. And the answer is B. Number two, the concept of materiality would be least important to an auditor when considering what ACE says the adequacy of the, of a disclosure of a client's illegal act.
Well, materiality would matter there, right? Whether it was a theft of a hundred million dollars in Barrow bonds or a missing posted stamp. It matters. Materiality does matter with illegal acts B says discovery of a weakness in a client's internal control structural here again, materiality would matter.
Is it internal control over bear bonds or internal control over postage stamps materiality would matter. So that's not the answer they want to know when materiality would be least important. D says the decision whether to use positive or negative confirmation. For accounts receivable. And I know you remember this issue, a negative confirmation, the customer only responds.
If they disagree with the account balance with a positive confirmation, we're asking the customer to respond whether or not they agree now does materiality matter. It does cause we tend to use negative confirmations when there's a lot of accounts, small dollar values, strong internal control. We tend to use positive confirmation.
When we, I have a small number of accounts, large dollar values, materiality matters, weak, internal control. So again, materiality would matter and answer D answer. See the effect of a direct financial interest in a client materiality doesn't matter. One share out of 50 billion. Outstanding is too many.
Materiality is irrelevant and the answer is C. Number three, a CPA is permitted to disclose, use confidential client information without the consent of the client. One says to another CPA firm, if the information concerns suspected tax return irregularities, of course not, you can't disclose confidential client information without the consent of the client, but an exception would be number two.
To a state CPA society, quality control review board. That would be an exception. Answer is B number four, which of the following theory mangement generally would not be permitted under the ethical standards of the profession. A says a referral fee paid by a CPA to obtain a client. That's okay. Be a commission.
For compiling a client's internal use financial statements for internal use only it's a compilation commission would be okay there a contingent fee for representing a client in tax court. I think they want you to just see that contingent fee and all contingent fees are a problem and jumper D but representing a client in a tax court.
That's okay. In other words, you could charge a fee based on the results because it's the taxing authority. That initiated the proceedings, but answers C a contingent fee for preparing an original tax return. An amended tax return. No, it's not allowed answer. See again, complexities. Okay. You can charge a different price based on the complexity of the return, but not a contingent fee.
No, not if you really want to refund. I'll charge you this. No. Number five under the ethical standards of the profession, which of the following positions would be considered a position of significant influence in an audit client a marketing position, C research and development D human resources. Now, it's B policymaking that.
It would be a position of significant influence. Number six, in which of the following situations would a CPA's independence be considered impaired. One says CPA maintains a checking account. That's fully insured by a government deposit insurance agency, FDI C at an audit client, financial institution.
No problem whatsoever. Independence would not be impaired. Number two is CPA has a direct financial interest in that in an audit client. That's a problem. Independence is impaired three CPA owns a commercial building, leases it to an audit client and it's a capital lease. If it's a capital, lease that in substance, this is a loan and you cannot have a loan to a, from an audit client.
Independence is impaired. So independence is impaired with answer B two and three. Number seven, a CPA who is not in public practice is obligated to follow which of the following rules of conduct. If you're not in public practice, you're not worried about independence. You're not worried about contingent fees or commissions, but when you were in, if you're a member what w whether you are in public practice or not, you always.
Exercise, integrity and objectivity always. So you're still under those requirements. Answer B number eight, which of the following statements best describes the ethical standard of the profession pertaining to advertising and solicitation? Sure. You went right to it. Answer, see a CPA can advertise in any manner.
As long as it's not false misleading or deceptive number nine, according to the ethical standards of the profession, which of the following acts is generally prohibited. Again, I bet you went right to an answer B retaining the client's records after the client has demanded their return. That is an act discreditable to the entire profession of accounting.
Number 10
must a CPA in public practice. Be independent. In fact, and appearance when providing the following services, a compilation of personal financial statements, a compilation you're just compiling, providing any assurance whatsoever on that. No independence is not required. Preparation of a tax return.
No, you don't have to be independent to do a tax return compilation of a personal financial forecast. Again, it's compilation. You're not providing any assurance on that whatsoever answers D no straight across the board. No. Number 11. A violation of the profession's ethical standards most likely would have occurred when a CPA.
A says issues, a co an issues, an unmodified opinion on the gear to financial statements. When fees for the year zero audit were unpaid. How about a you're issuing an unmodified opinion on the year two financial statements when fees for the prior year were unpaid.
Yeah, that violates the profession that violates the profession. That in fact, that violates your independence because now you have a rooting interest. Now you have a rooting interest. Maybe you won't give that adverse opinion because you'll never get paid. Company water, business independence would be destroyed by that.
The answer is a and finally number 12. Car CPA is a staff auditor participating in the audit engagement of forte, which of the following circumstances, impairs car's independence
a says during the period of the engagement for it gives car tickets to a football game with $25. No problem. B says car owns stock in a corporation that the client's 401k plan also invests in the fact that the client's 401k plan invest in some stock that you're also holding doesn't that doesn't impair your independence in any way.
It's pretty tenuous C says cars, friend, an employee of another local accounting firm. Prepares the tax return that wouldn't affect your independents in any way. But answer D of course is a problem. Car's sibling is an internal auditor employed by Ford. That's you know, if your parent, if your sibling has a key position with the client, maybe you won't give that adverse opinion because your friend will lose their job.
All of a sudden there's a rooting interest or at least the appearance of a rooting interest. And you have to be independent in fact, and also appearance. I hope you did well on that. Set. Keep studying. I'll see you in the next class.