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CHAPTER 1: AN INTRO TO ASSURANCE AND FINANCIAL STATEMENT AUDITING

LO1.2: The Demand for Auditing and Assurance

Public company is a company that sells its stocks or bonds to the public, giving the public a valid
interest in the proper use of the companys resources
Managers serve as agents for the owners (principals) and fulfill stewardship function by managing
the corporations assets
o The initial demand for auditing comes from the agent not the principal
Information asymmetry: manager generally has more information about the true financial position
and results of operations of the entity than does the absentee owner
Because their goals may not coincide, there is a natural conflict of interest b/w the manager and the
absentee owner
o If both seek to maximize their self- interest, the manager may not always act in the best interest
of the owner
o Manager is responsible for reporting the results
o Manager is accountable to owner
The Role of Auditing
o The owner 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/she uses the owners invested resources
o As the amount of capital involved and the number of potential owners increase, the potential
impact of accountability also increases
o Auditors role is to determine whether the reports prepared by the manager conform to the
contracts provisions
o Auditors verification of the financial info adds credibility to the reports and reduces information
risk ( the risk that info circulated by a companys mgmt. will be false or misleading
o Auditing is demanded because it plays a valuable role in monitoring the contractual relationships
b/w the entity and its stockholders, managers, employees, and debt holders
o Certified public accountants have been charged with providing audit services b/c of their
traditional reputation of competence, independence, objectivity, and concern for the public
interest...able to add credibility
Management Assertions and Financial Statements
o Financial statement assertions are mgmt.s expressed or implied claims about info reflected in the
F/S
o Assertions are central to auditing...they are the focus of the auditors evidence collection efforts
o One main task for an auditor is to collect sufficient appropriate evidence that mgmts assertions
are correct
o Table 1-2
Lists all of the mgmt. assertions that auditors focus on
Divided into 3 aspects of information: transactions, account balances, and presentation and
disclosure
Transactions: CACACO
Occurrence
Completeness
Authorization
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Accuracy
Cutoff
Classification
Account balances: CREV
Existence
Rights and Obligations
Completeness
Valuation and Allocation
Presentation and Disclosure: COCA
Occurrence and rights and obligations
Completeness
Classification and understandability
Accuracy and valuation

LO1.3:

The evaluation of evidence to determine whether information has been recorded and presented in
accordance with a predetermined set of criteria, together with issuance report that indicates the
degree of correspondence

LO1.4: Auditing, Attest, and Assurance Services Defined

Auditing: 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 interest users
o Well planned and thorough approach for conducting an audit
o Auditor must objectively search for and evaluate the relevance and validity of evidence
o Auditor compares the evidence gathered to mgmts f/s asserting in order to assess the degree of
correspondence b/w those assertions and established criteria
o Generally accepted accounting principles usually serve as the basis for evaluating mgmts
assertions in the context of a f/s audit
o Communication will vary depending on the type and purpose of the audit, and the nature of the
auditors findings
Attestation: occur when a practitioner is engaged to issue...a report on subject matter, or an assertion
about subject matter, that is the responsibility of another party
o Not limited to economic events or actions
o Subject matter can take many forms, including prospective information, analyses, systems and
processes, and even the actions of specified parties
o f/s auditing is a specialized form of an attest service
Assurance: are independent professional services that improve the quality of info, or its context, for
decision makers
o Extending auditors activities to assurance services allows reporting not only on the reliability
and credibility of information but also on the relevance and timeliness of that information
o Making good decisions requires quality information...can be financial or nonfinancial
o Relates to improving the quality of info or its context
Can improve quality through increasing confidence in the infos reliability and relevance
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Context can be improved by clarifying the format and background with which the
information is presented
o Independence: objectivity of the service provider
o Professional services: implies the application of professional judgment and due care by the
provider
o Can include almost any service provided by accounting professionals that involves capturing
info, improving its quality, or enhancing its usefulness for decision makers

LO1.5: Fundamental Concepts in Conducting a Financial Statement Audit

An Overview of the Financial Statement Audit Process


o Auditor gathers evidence about the business transaction that have occurred and about the account
balances into which the transactions have accumulated
o Auditor uses the evidence to compare the assertions contained in the financial statements to the
criteria used by mgmt. in preparing them (ex: GAAP)
o The auditors report communicates to the user the degree of correspondence between the
assertions and the criteria
Conceptual and procedural details of a f/s audit build on 3 fundamental concepts:
o Materiality: amount by which a set of f/s could be misstated w/out affecting the judgment of
reasonable people
Auditors first task in planning an audit is to make a judgment about just how big a
misstatement would have to be before it would significantly affect users judgments
Info is material if omitting it or misstating it could influence decisions that users make on the
basis of the financial info of a specific reporting entity
Helps determine the nature, timing, and extent of audit procedures
A common rule of thumb: total (aggregated) misstatements of more than about 3 to 5% of
income before tax would cause the f/s to be materially misstated
o Audit Risk: the risk that the auditor expresses an inappropriate audit opinion when the f/s are
materially misstated
Audit provides only reasonable assurance that the f/s do not contain material misstatements
reasonable assurance implies some risk that a material misstatement could be present in the
f/s and the auditor will fail to detect it
Auditor plans and conducts the audit to achieve an acceptably low level of audit risk
The auditor controls the level of audit risk through the effectiveness and extent of the audit
work conducted
The more effective and extensive the audit work, the lower the risk that a misstatement
will go undetected and that the auditor will issue an inappropriate report
Auditor can check everything but there is chance the f/s might still contain material
misstatements
Auditors only offer reasonable not absolute assurance
o Evidence regarding mgmts assertions audit evidence
In arriving at an opinion, auditor must have audit evidence relating to mgmts assertion
Consist of the underlying accounting data and any additional information available

Once the auditor has obtained sufficient appropriate evidence that the mgmt. assertions can
be relied upon for each significant account and disclosure, the auditor has reasonable
assurance that the f/s are fairly presented
Sufficiency: the quantity of evidence
Appropriateness: whether the evidence is relevant and reliable
o Relevance: evidence relates to the specific mgmt. assertion being tested
o Reliability: the diagnosticity of the evidence...can a type of evidence be relied upon to
signal the true state of the account balance or assertion being examined

LO1.6: Sampling: Inferences Based on Limited Observations

Testing every transaction is costly, especially if the company is a large one


Auditor selects a subset of transaction and accounts to examine
o Based on past audits, understanding of the clients internal control system, or knowledge of the
clients industry, is aware of items in an account balance that are more likely to contain
misstatements
o Uses random sampling procedures that increase the likelihood of obtaining a sample that is
representative of the population of transactions or account items
There is an inverse relation b/w sample size and materiality
o Auditor must collect more evidence to have reasonable likelihood of detecting smaller errors
There is a direct relation b/w sample size and desired level of assurance
o As the desired level of assurance increases for a given materiality amt, the sample size necessary
to test an assertion becomes greater

LO1.7: The Audit Process

Three stages in the accounting process that take place in the preparation of financial statements:
internal controls are implemented to ensure appropriate capturing and recording of individual
transactions, which are then collect into ending account balances
Evidence that relates directly to ending account balances is usually the highest quality, but also the
costliest, evidence
Major Phases of the Audit
o Client Acceptance/Continuance:
Professional stds. Require that public accounting firms establish policies and procedures for
deciding whether to accept new clients and to retain current clients
Purpose: to minimize the likelihood that an auditor will be associated with clients who lack
integrity
If an auditor is associated with a client who lacks integrity, the risk increases that material
misstatements may exist and not be detected by the auditor
For a new client, the auditor must confer with previous auditors and the auditor must
frequently conduct background checks on top mgmt.
The knowledge gathered in this phase provides valuable understanding of the entity and its
environment, thus helping the auditor to assess risk and plan the audit
o Preliminary Engagement Activities:
3 activities:
Determine the audit engagement team requirements
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o
o

Ensure the independence of the audit team and firm


o Members who have audit and industry experience, whether specialists are needed,
and make sure members are free from prohibited relationships that might threaten
objectivity
Establish an understanding with the client regarding the services to be performed and the
other terms of the engagement
o Includes considerations as timing of the audit and expected audit fees
Begins by updating his/her understanding of the entity and its environment
Includes the nature of the entity and the industry in which it operates, how it measures its
own performance, and the quality of its internal control
Plan the Audit:
Make preliminary assessment of the clients business risk and determine materiality
Assess the risk relating to the likelihood of material misstatements in the f/s
Should take into account the auditors understanding of the entitys internal control if the
client is a public company
Outcome: written audit plan that sets the nature, extent, and timing of the audit work
Consider and Audit Internal Control:
Helps auditors assess risk and identify areas where f/s might be misstated
Audit Business Processes and Related Accounts:
Auditors usually organize audits by grouping f/s accounts according to the business processes
that primarily affect those accounts
Auditor applies audit procedures to the accounts in order to obtain audit evidence about
mgmts assertions relating to each account and reduce the risk of undetected material
misstatement to an appropriately low level
For public company clients, the audit of internal control is done in an integrated way with the
f/s audit
Complete the Audit:
Auditor must obtain sufficient appropriate evidence in order to reach and justify a conclusion
on the fairness of the f/s
Auditor assesses the sufficiency of the evidence and obtains additional evidence where
deemed necessary
Auditor also addresses a number of issues, including the possibility of undisclosed contingent
liabilities, such as lawsuits, and searches for any events subsequent to the balance sheet date
that may impact the f/s

LO1.8: Evaluate Results and Issue Audit Report

Final phase in the audit process is to evaluate results and choose the appropriate audit report to issue
o The auditors report/ auditors opinion: main product/output of the audit
Communicates the auditors findings to the users of the f/s
o Auditor determines if the preliminary assessments of risks were appropriate in light of the
evidence collected and whether sufficient evidence was obtained
o Auditor then aggregates the total uncorrected misstatements that were detected and determines if
they cause the f/s are materially misstated and explains the nature of the misstatement
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o If the uncorrected misstatements are judged to be material, the auditor will request that the client
correct the misstatements.
If the client refuses, the auditor issues an opinion that clearly indicates that the f/s are
materially misstated and explains the nature of the misstatement
If the uncorrected misstatements are insignificant enough that they do not cause the f/s to be
materially misstated, or if the client is willing to correct the misstatements, the auditor issues
and unqualified report
The unqualified audit report is most common
o Free of material misstatements
o Auditor does not find it necessary to qualify his/her opinion abt the fairness of the f/s
o Audit clients are almost always willing to make the adjustments necessary to receive a clean
opinion
o Introductory Paragraph: indicating which f/s are covered by the report, that the stmts. Are the
responsibility of mgmt., and that the auditor has a responsibility to express an opinion
o Scope Paragraph: communicates to the users what an audit entails...emphasizes the fact that the
audit provides only reasonable assurance that the f/s contain no material misstatements...also
discloses that an audit involves an examination of evidence on a test basis, and assessment of
accounting principles used and significant estimates, and an overall evaluation of f/s
presentation...expresses the auditors judgment that the audit provides a reasonable basis for the
opinion to be expressed in the report...how the audit was conducted
o Opinion Paragraph: concerns the fairness of the f/s based on the audit evidence
o Fourth Paragraph contains explanatory language
o Concludes with the manual or printed signature of the CPA firm providing the audit and with the
date of the report.
The audit report date indicates the last day of the auditors responsibility for the review of
significant events that have occurred after the date of the f/s
Audit must be done in accordance with applicable standards, the auditor must be independent, there
must be no significant limitations imposed on the auditors procedures, and the clients f/s must be
fee of material departures from GAAP...if any one of these condition is not met, the auditor issues a
report that appropriately conveys to the reader the nature of the report and the reasons why the report
is not unqualified
Qualify report: when auditor considers misstatements are material and the client refuses to correct
the misstatements...explains that the f/s are fairly stated except for the misstatement identified by the
auditor
Adverse opinion: issued when the misstatement is considered so material that it pervasively affects
the interpretation of the f/s...indicates that the f/s are not fairly stated and should not be relied upon
Audit report represents the culmination of the audit process and is the way the auditor communicates
his/her opinion abt a clients f/s with outside parties