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ACCT 4301 (Latest 2025) Exam 1 Review Test
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Why is there a demand for audit services? Auditing is demanded because it plays a valuable role in monitoring the contractual relationships between the entity and its stockholders, managers, employees, and debt holders. Certified public accountants have been charged with providing audit services because of their traditional reputation of competence, independence, objectivity, and concern for the public interest. As a result, they are able to add credibility to information produced and reported by management to outside parties. How does information asymmetry and conflicts of interest between managers and investors rest in the demand for auditing? In this setting, the managers serve as agents for the owners (who are sometimes referred to as principals) and fulfill a stewardship function by managing the corporation's assets. Accounting and auditing play important roles in this principal- agent relationship. We first explain the roles of accounting and auditing from a conceptual perspective. Then we'll use an analogy involving a house inspector to illustrate the concepts. First, it is important to understand that the relationship between an owner and manager often results in information asymmetry between the two parties. Information asymmetry means that the manager generally has more information about the "true" financial position and results of operations of the entity than does the absentee owner.
The owner likely will be willing to invest more in the business and to pay the manager more if the manager can be held accountable for how he or she uses the owner's invested resources. As the amount of capital involved and the number of potential owners increase, the potential impact of accountability also increases. The auditor's role is to determine whether the reports prepared by the manager conform to the contract's provisions. Thus, the auditor's verification of the financial information adds credibility to the report and reduces information risk, or the risk that information circulated by a company's management will be false or misleading. Reducing information risk potentially benefits both the owner and the manager. How does the audit function mitigate the problem that exists between managements and outside stakeholders (e.g., investors and lenders) Audits add credibility to the financial statements Pre-2002 Environment Economic boom led to more, more, more society; explosion of scandals Accounting firm's competition for business increased and audit fees are forced to be lowered What is auditing? A systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users.
Self-Regulation of auditing profession Government Regulation In 2002, Congress passed the Sarbanes-Oxley Public Company Accounting Reform and Investor Protection Act Post-Sox 2002 End of "self-regulation" for public company audits Created Public Company Accounting Oversight Board (PCAOB)
- Inspection of audits - audit deficiencies of firms are made public Rotation of lead audit partners (every 5 years)
- Trade off between experience/expertise and independence Audit firms must make additional reports to both audit committee and public regarding internal controls (improve information quality) More serious penalties for those found negligent or involved in cover-ups (e.g., audit document retention) Banned many non-audit services for financial audit clients (improve auditor independence)
Audit committee has to select auditors and pre-approve non-audit services
- Audit committee is the "client" instead of management Why does the audit only provide "reasonable" assurance and not "absolute" assurance regarding the fairness of financial statements. The phrase "reasonable assurance" implies that even when the auditor does a good job, there is some risk that a material misstatement could be present in the financial statements and the auditor will fail to detect it. SEC Securities and Exchange Commission Oversees formulation of accounting processes Oversees formulation of audit procedures for public companies PCAOB Public Company Accounting Oversight Board Issues auditing standards for audits of public companies
Auditor's Responsibility The auditor of a company is responsible for
- Gathering a sufficient amount of evidence in order to provide reasonable assurance that management has processed/reported transactions, account balances and disclosures in a manner that is free of Material misstatement Reasonable assurance is a high, but not absolute level of assurance Management's Responsibility A company's management is responsible for
- Recording transactions made during a period (i.e., quarter, year)
- Account Balances that get reported at the end of a period based on recording transactions
- Disclosures The financial statements and footnotes are the responsibility of management
Who are considered covered members when applying independence rules?
- An individual on the attest engagement team
- An individual in a position to influence the attest engagement
- A partner, partner equivalent, or mater who provides more than 10 hours of non attest services to the attest client within any fiscal year.
- A partner or partner equivalent in the office in which the lead attest engagement partner or partner equivalent primarily practiced in connection with the attest engagement
- The firm, including the firm's employee benefits plan
- An entity whose operating, financial, or accounting policies can be controlled by any of the individuals or entities described above or by two or more such individuals or entities if they act together. Financial Interest of Auditors Rule prohibits covered members to have direct or material indirect financial interest in the audited company (e.g., investments and/or loan to client) Direct - ownership (stock and/or partnership), control over client entity, or beneficially owned through an intermediary (have control and/or authority to supervise or participate in intermediary's investment decisions Indirect (material) - financial interest that is owned through an investment vehicle, estate, or trust (no control or authority to supervise or participate in intermediary's investment decisions)
- Rule requires that if audit team member has intention to work for the client, needs to immediately remove him/herself from engagement
- Rule requires that if employee of client goes to work for audit firm, member can't be on the attest engagement Family Relationships Immediate family
- Follow same independence rules of the covered member with a few exceptions
- Cannot work for the audited company in a key position or have financial interest in the audited company (other non-key positions are okay)
- Material financial interests - independence impaired when CPA is aware of the interest Close Relatives (parents, siblings, or nondependent children)
- Covered member is aware of the close relative's material financial interest
- Financial interest enables close relative to exercise significant influence
- Close relative in key position
Common Non-Audit Services Banned for Public Companies and Which Non-Audit Services are allowable
- Bookkeeping
- IS design and implementation
- Appraisal or valuation services
- Actuarial services
- Internal audit outsourcing services
- MGMT functions
- Broker or dealer, investment adviser, or investment banking services
- Legal services
- Expert services Firms may provide tax services to audit clients (unless services involve aggressive interpretations of applicable tax laws) Audit committee has to pre-approve other nonaudit services What is Professional Skepticism? an attitude that includes a questioning mind and a critical assessment of audit evidence.. In exercising professional skepticism in gathering and evaluating evidence, the auditor should not be satisfied with less-than persuasive evidence because of a belief that management is honest"
International Auditing and Assurance Standards Board (IAASB) International Accounting Standards Board (IASB) PCAOB auditing standards must be followed on all financial statement audits performed in the U.S. (T/F) False, only public companies An independent audit adds value to the communication of financial information because the audit: a. Confirms the exact accuracy of management's financial representation b. Lends credibility to the financial statements c. Guarantees that financial data are fairly presented d. Assures the readers of financial statements that any fraudulent activity has been corrected b. lends credibility to the financial statements The organization responsible for setting auditing standards for U.S. privately-held companies is ASB
Which of following best describes the general character of the section of the "Principles Underlying An Audit of Financial Statements" titled "Performance"? a. Description of the competence, independence, and professional care of persons performing the audit b. Criteria for the content of the auditor's report on financial statements and related footnote disclosures c. Criteria for audit planning and evidence gathering d. The need to maintain an independence of mental attitude in all matters relating to the audit c. Criteria for audit planning and evidence gathering What level of assurance do auditors provide that immaterial misstatements will be detected? None Principles Underlying An Audit - ASB Purpose Responsibilities Performance Reporting Purpose (Principles Underlying an Audit - ASB)
The independent auditor's objective is to obtain sufficient appropriate evidential matter to provide him or her with a reasonable basis for forming an opinion.
- professional judgement is evaluating the reasonableness of accounting estimates
- in the great majority of cases, the auditor has to rely on evidence that is persuasive rather than convincing What are the evidence requirements that the auditor needs to satisfy in order to complete with auditing standards to render an opinion? Persuasiveness of audit evidence given a particular audit objective (i.e., assertion)"
- Sufficiency (amount)
- Appropriateness (quality) Reliability - Can this evidence be relied upon to signal the true state of an assertion?
- source independence, effectiveness of internal controls, auditor's direct knowledge, original documents, etc.
Relevance - Is the audit evidence relevant to the assertion being tested? Management Assertions Assertions are expressed or implied claims/representations made by Management in the financial statements Also serve as "audit objectives" for audit work Management Assertions About Transactions/Disclosures During the Year
- Occurence
- Completeness
- Authorization
- Accuracy
- Cutoff
- Classification
- Presentation Management assertions about transactions typically refer to items on the income statement.
Classification Assertion Transactions/events get recorded to the proper accounts Assets, liabilities, and equity interests have been recorded in proper accounts Presentation Assertion Properly aggregated or disaggregated or described Accuracy/Valuation/Allocation Assertion All assets, liabilities, and equity interests are appropriately valued and recorded Management Assertions About Account Balances/Disclosures at the financial statement date
- Existence
- Rights and Obligations
- Completeness
- Accuracy/Valuation/Allocation
- Classification
- Presentation
Existence Assertion Assets, liabilities, and equity interest exist Rights and Obligations Assertion Company holds or controls the rights to assets, and liabilities are the obligations of the company Account Balance vs. Transaction Assertions Generally, Account Balance Assertions = B/S Accounts Transaction Assertions = I/S Accounts What is the difference between accuracy and valuation? Accuracy is clerical (numbers) Valuation involves management's judgements and estimations
