Auditing Theory

According to PCAOB standards, the auditor has a responsibility to plan and perform the
audit to obtain reasonable assurance about whether the financial statements are free of
material misstatement, whether caused by error or fraud. PCAOB standards also
require the auditor to state whether, in his or her opinion, the financial statements are
presented in conformity with GAAP and to identify those circumstances in which such
principles have not been consistently observed in the preparation of the financial
statements of the current period in relation to those of the preceding period.

According to PCAOB standards, the auditor has a responsibility to plan and perform the
audit to obtain reasonable assurance about whether the financial statements are free of
material misstatement, whether caused by error or fraud. PCAOB standards also
require the auditor to state whether, in his or her opinion, the financial statements are
presented in conformity with GAAP and to identify those circumstances in which such
principles have not been consistently observed in the preparation of the financial
statements of the current period in relation to those of the preceding period.

According to PCAOB standards, the auditor has a responsibility to plan and perform the
audit to obtain reasonable assurance about whether the financial statements are free of
material misstatement, whether caused by error or fraud. PCAOB standards also
require the auditor to state whether, in his or her opinion, the financial statements are
presented in conformity with GAAP and to identify those circumstances in which such
principles have not been consistently observed in the preparation of the financial
statements of the current period in relation to those of the preceding period.

According to the PCAOB, AICPA, and the IAASB, an auditor has a responsibility to
obtain reasonable assurance that the financial statements are free of material
misstatement.

The IAASB is the audit standard setter for international audit standards, not the PBAOB.

Auditing the financial statements is considered a form of attestation. The company’s

management is responsible for preparing the financial statements, establishing sound
accounting policies, and good internal controls

The objective of the ordinary audit of financial statements is the expression of an

opinion on the fairness with which they present, in all material respects, financial
position, results of operations, and its cash flows in conformity with GAAP. The auditor
has a responsibility to obtain reasonable assurance that the financial statements are
free of material misstatements, not all misstatements. The company’s management is
responsible for preparing the financial statements in conformity with GAAP and
establishing/maintaining sound internal controls.
The verifier, also called a ‘knower,’ helps bridge the trust gap between the promiser and
the truster

The video lesson shows that in the step by step illustration, the market begins to
converge in terms of price and quality in period 3.

The video lesson shows that during phase 1, sellers offer their product on both selling
price and grade (i.e. quality).

The video lesson shows in the step by step illustration, when phase 2 begins, the rules
change and grade quality will be available to the market only after trading has been
completed. Asking prices continue to be available before trading.

In the video, it is revealed that in period 5, seller 1 engaged in strategic

misrepresentation by offering a high price of $11.25 for a low-quality grade product.

The video lesson shows that in the step by step illustration, the verifier or auditor is
added in to the game during phase 3.

The video lesson shows that in the step by step illustration, seller 3 benefits by being
able to sell 2 units by bidding the most for the auditor and having the auditor verify their
quality grade (medium) in conjunction with their price.

In the market game: debriefing video, the outcome of this specific illustration was that
when buyers and seller both knew price and quality grade in advance, market forces
moved towards the medium grade quality of production.

The market game debriefing video discussed that sometimes the highest quality grade
is too costly and as a result, society may trade at a grade other than the highest quality,
such as medium quality in the market game illustrations

The video shows that a recent estimate of the base rate of fraud is much higher, nearly
8% per year in U.S. companies.

The video lesson gives several examples of ‘verifiers’ in society, such as financial
statement auditors, Underwriters Laboratory, Consumer Reports, etc.

The video lesson shows that in the real world, the promiser pays the auditor to verify the
financial statements, and the auditor issues a report back to the promiser

As discussed in the lesson video, the 1994 study by Kinney and Martin showed that
overall, audit-related adjustments showed an overwhelmingly negative effect on pre-
audit net earnings and net assets and that the average aggregate audit-related
adjustment reduced earnings and assets by 2 to 8 times the minimum amount that
would materially misstate the financial statements.
As discussed in the lesson video, the 2011 study by Minnis showed that overall, audited
firms have a significantly lower cost of debt (roughly 69 basis points lower interest rate,
on average).

As discussed in the lesson video, the 2011 study by Minnis showed that lenders place
more weight on audited financial information in setting the interest rate. This is
consistent with lenders viewing audited information as more reliable information.

As discussed in the lesson video, the 2011 study by Minnis showed that overall, audited
firms have a significantly lower cost of debt (roughly 69 basis points lower interest rate,
on average) and that lenders place more weight on audited financial information in
setting the interest rate.

As discussed in the lesson video, the 2011 study by Minnis showed that overall, only
5,932 firms out of 25,784 firms chose to get an audit. This is about 23% of privately held
firms in the study's sample.

As discussed in the lesson video, the 1994 study by Kinney and Martin showed that
overall, audit-related adjustments showed an overwhelmingly negative effect on pre-
audit net earnings and net assets.

Which of the following is true about Phase 2 of the market game step-by-step
illustration?

- The video lesson shows in the step by step illustration, when phase 2 begins, the
rules change and grade quality will be available to the market only after trading
has been completed

In which phase of the market game step-by-step illustration shown in the lesson videos does the
verifier (i.e. the auditor) come into play?

- The video lesson shows that in the step by step illustration, the verifier or auditor is added in
to the game during phase 3.

The video lesson shows that in the step by step illustration, seller 3 benefits by being able to sell 2
units by bidding the most for the auditor and having the auditor verify their quality grade (medium) in
conjunction with their price.

The market game: debriefing video discussed that sometimes the highest quality grade is too costly
and as a result, society may trade at a grade other than the highest quality, such as medium quality
in the market game illustration

The video lesson shows that in the real world, typically the promiser pays the auditor to verify the
financial statements, and the auditor issues a report back to the promiser.
The video lesson shows that in light of audited financial statements, the truster will be willing to pay a
higher price than they otherwise would pay because of the verified financial statements.

The video lesson mentions the opposite: auditors tend to develop larger materiality thresholds than
investors. This makes it difficult for auditors to put themselves "into the shoes" of investors when
judging what audit adjustments are in fact material.

directionally motivated reasoning more likely after some extensive searching has occurred and the
decision maker begins to really hope the next one is "the one"

Motivated reasoning often occurs subconsciously, which makes it relatively hard for auditors and
others to adjust for any bias it causes.

The video lesson mentions that what the auditor expects and what the auditor observes factors into
their risk assessment:

 If they typically observe what they expect to observe, assess low risk
 If they typically observe something different from what they expect to observe, assess high
risk

A risk neutral buyer will be willing to spend no more than the expected value of the Maserati, which
is $50,000