Audit Exam 3

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Audit Exam 3
2011-05-03 13:43:33
auditing reporting standards cycle

Audit Final exam flash cards...covers Audit of the inventory & production cycle, audit of the finance & investment cycle, audit of cash balances, completing the audit, legal liability, reports on audited financial statements
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  1. Inherent risks in production cycle
    Complexity in applying cost flow assumption (e.g. dollar value LIFO)

    susceptibility to theft

    lower-of-cost-or-market (LCM) valuation

    effects on gross profits
  2. key documents in production cycle
    bill of materials (prenumbered)

    Job cost sheet (prenumbered)

    labor cost distribution

    materials requisition (pre numbered)

    routing sheet

    sales forcast

    time cards/job tickets
  3. Key functions in production cycle
    stores control (raw materials)

    production (WIP)

    Warehouse (finished goods)

    payroll accounting

    inventory accounting (costing; overhead allocation)
  4. Production cycle: Control considerations
    • Production runs are authorized
    • Raw materials are counted and inspected
    • As production takes place, materials and labor quantities are summarized
    • All inventory items are accounted for
    • Use of transfer tickets
    • Count/inspect the items and compare quantities
    • Cost accounting dept. reviews
  5. Production cycle: Test of Controls
    • Observe separation of duties
    • Vouch costs to labor and materials reports
    • -Time tickets
    • -receiving reports
    • -transfer tickets
    • Check for proper authorizations
    • Examine review of cost reports
  6. Production Cycle: Substantive procedures
    • Physical observation of inventory count
    • Tests of pricing and compilation (using client's cost flow assumption)
    • Tests of compilation (extensions, footings, tracing)
    • Analytical procedures
    • ---excessive inventory
    • ---slow moving inventory
  7. "it will always be necessary for the auditor to....
    ....make, or observe, some physical counts of inventory and apply appropriate tests of intervening transactions"
  8. Production Cycle: Inventory Cutoffs
    • Verfity cutoffs for purchases and sales
    • -examine receiving reports and vendor invoices occurring around year-end (purchases)
    • -examine bills of lading and sales invoices copies (sales)
    • -Consider terms of purchases and sales (FOB shipping point; FOB destination)
    • -Agree to inclusion/exclusion from inventory at balance sheet date
  9. Production cycle: Fraud Red Flags
    • Watch for uncontrolled access to inventory
    • Focus on high-dollar items that are easily marketed
    • Be unpredictable when taking test counts
    • Be skeptical of large differences between counts and inventory records
    • Be alert for damaged inventory
    • Follow up on unusual interplant transfers
  10. Inherent risks of Finance and Investment Cycle
    • Lease Accounting
    • Loan covenants
    • Related party TRX
    • Complex TRX
    • Impairment of assets
  11. Basic Audit approach to Finance and Investment cycle
    • Carryforward schedules of account changes
    • Analysis of current period activity
    • Evaluation of Controls concurrent with application of substantive procedures
    • Audit of related accounts simultaneously
    • Evidence gathering for all trx above materiality threshold
    • Confirmation with outside parties
  12. Finance and Investment Cycle: Control Considerations
    • Transactions authorized by BOD
    • Documentation
    • -Investments in securities
    • -PP&E
    • -Bonds and notes payable
    • -Stockholders Equity
    • Cash Receipts/disbursements
  13. Finance and Investment Cycle: Control Procedures
    • Physical controls:
    • securites CUSIP numbers recorded
    • securities recorded in client's name
    • securities held by independent custodian
    • access to safe deposit box requires more than one employee
    • Physical items periodically compared to detail records

    • Separation of duties:
    • trx authorized by BOD
    • external custodian has custody of stock and bond certificates

    • Performance Reviews:
    • compare current investing and cycle trx data against prior year and expected
    • Compare revenue and expenses against org. stds. or expectations
    • Compare trx on monthly stmt to cash receipts/disbursements
  14. Finance and Investment Cycle: Substantive Tests

    Interest Bearing Liabilites
    • Agree to beginning balance and confirm with holders or makers
    • Loan/bond Proceeds
    • -Vouch to cash receipts
    • -recalculate discount/premiums
    • -confirm liability amount, examine note

    • Loan Payoff
    • -recaluclate interest expense and accrual
    • -recalculate premium or discount amortizations
    • -recalculate gain/loss on early retirement
    • -verify cash disbursements

    • Interest Payments
    • -recaculate interest expense

    • Search for unrecorde liabilites
    • -inquiry of mgmt
    • -bank confirmations
    • -unusual amounts of interest expense
    • -large receipts of cash during the year

    • Ensure Debt covenants are satisfied
    • -inspect loan agreements
    • -consider going concern
    • -ensure proper presentation and disclosure
  15. Finance and Investment Cycle: Substantive Tests

    Stock Holder's Equity
    • Paid-in Capital
    • Agree balances to prior year documentation
    • Examine issuances an repurchases of Capital Stock

    • Retained Earnings
    • Agree beginning balances with prior year documentation
    • Verify the appropriateness of prio-period adjustment treatment
    • Trace net income/loss to income statement
    • Ensure that dividends are properly authorized by BOD
  16. Auditing Investments: Substantive procedures
    • Agree beginning balances to prior year documentation
    • Review Client's policies and procedures
    • Purchases of Investments
  17. Registrar
    updates records based on info from transfer agent
  18. Trustee
    • similar to registrars and transfer agents
    • can handle ownership of bonds
  19. Transfer Agent
    • an intermediary that handles company bonds and stocks
    • tracks securities owners for payment of interest and dividends
  20. Auditing Investments: Substantive Procedures

    Sales of investments
    • Vouch to broker's advice, cash receipts records and board minutes
    • Recalculate gain or loss on sale
    • Read minutes for sales of investments and trace to recording
    • Trace cash Receipts to cahs receitps journal and bank stmt
  21. Trouble spots in audits of investments
    • Valuation of Investments
    • Propriety, effectiveness, and risk disclosure of derivative securites used as a hedge
    • Determination of the FV of derivatives and securities
    • Determination of significant influence relationship for equity method investments
  22. Auditing Investments: Substantive Procedures

    Verify dividend revenue
    • Review stocks held by client for dividend pmts (Moody's, Standard and Poor's)
    • If securities held by broker review monthly statements for dividends
    • Trace Dividend receibed to cash receipts records
  23. Auditing FV Measurements
    • Mgmt's responsibility
    • Market based values preferred
    • If not available, use assumptions market would have used
    • If not known, mgmt can use its own assumptions if no contrary data
  24. Accrued Liabilities
    • Examples: Interest, property taxes, wages, income taxes
    • Not normally invoiced or evidenced by receipt of goods
    • More difficult to detect unrecorded accruals
  25. Auditing Accrued Liabilites and Prepaid Expenses
    • Agree balances to prior year workpapers
    • Verify payments
    • Examine underlying agreements
    • Recalculate
    • Search for unrecorded accruals (cash disbursements at year end)
    • Analytical procedures
  26. Auditing PPE
    • Agree balances to prior year documentation
    • Purchases of PPE
    • Expenditures subsequent to acquisition
    • Disposals of PPE: recalculate G(L), trace to and from Board minutes
    • Loopk for unrecorded disposals
    • Depreciation Expense
    • Leased Assets: verify proper treatement (capitalized fv. operating), ensure disclosure in footnotes is appropriate
  27. Types of Cash Accounts
    • Genearl Cash account
    • Restricted Cash Account
    • Imprest Payroll account
    • Branch cash account: transfer excess to general---leave @ particular balance
    • Imprest petty cash fund
    • Cash equivalents (3 months or less)
  28. Strong internal controls for cash
    • Dual custody of cash at all times
    • Lockbox arrangements
    • Fidelity bonds for employees
  29. Cash collections and Disbursements:
    Key control activities
    • Information processing
    • Voucher packet matched prior to cash disbursement authorization
    • Deposits reconciled to amounts credited to AR subsidiary ledger
    • Bank Reconciliation

    • Physical controls
    • Deposit cash and checks daily and intact
    • lock box accounts
    • EDI transactions
    • Dual custody over cash
    • Unused checks secured
    • Check imprinting machine; authorized signature

    • Segregation of Duties
    • separate custody, authorization, recording, execution

  30. Audit evidence in MGMT reports and data files
    • Cash receipts journal
    • Cash disbursements journal
    • Bank reconciliations
    • canceled checks
    • Bank statements
  31. Audit of Cash
    • Cash on Hand
    • count simultaneously with other liquid assets
    • Count in presence of client employee
    • Undeposited receipts
    • ---trace to cash receipts journal
    • ---vouch to subsequent deposit in bank statement

    • Cash on Deposit
    • audited mainly through the clients's bank reconciliation
  32. Standard Bank Confirmation
    In addition to corroborating cash and loan balances, a standard bank confirmation inquiry requests information about contingent liabilites and secured transactions
  33. Check Kiting
    • Kiting is a fraud that occurs by reporting cash simultaneously in two different bank accounts
    • Objective is to overstate cash
    • A schedule of interbank transfers is useful in detecting kiting
  34. Proof of Cash
    • A proof of cash is used when controls over cash are weak or when fraud is suspected
    • It essentially combines 2 bank reconciliations, reconciling all trx that occurred during the period to the client's cash receipts journal and cash disbursement journal
  35. Fraud detection procedures for cash
    • count petty cash twice in one day
    • examine endorsements on canceled checks
    • audit genearl journal entries
    • retrieve customer checks
    • use marked coins and currency
    • measure deposit lag time
    • examine documents (bank stmts) for alteration
    • covert surveillance
  36. Cutoff Tests: Primary Concerns
    Assets & Revenues: risk of overstatement

    Liabilites and Expense: risk of understatement
  37. For cutoff tests, record...
    • Last invoice issued
    • last bill of lading
    • last receiving report
    • last check issued
    • last deposit ticket
  38. Cutoff tests: Analytical procedures
    • comparison of year-end balances & ratio analysis
    • review of year-end activity
  39. Purpose of loan covenants
    to protect the lender from the borrower substantially weakening the borrower's financial position.
  40. Sales Revenue and Sales Returns

    What is the BS account and transaction cycle?
    • BS= Receivables
    • TC= Revenue/collection
  41. Dividend and Interest Revenue

    What is the BS account and transaction cycle?
    • Bs= Receivables, Investments
    • TC= Financie/investment
  42. Gain or Loss on Asset Disposals

    What is the BS account and transaction cycle?
    • BS= PPE, Receivables, Investments
    • TC= Acquisition/Expenditure
    • Finance/ Investment
  43. Cost of Goods Sold

    What is the BS account and transaction cycle?
    • BS= Inventories
    • TC= Production
  44. Interest Expense

    What is the BS account and transaction cycle?
    • BS= Liabilites
    • TC= Acquisition/ Expenditure
    • Finance/ Investment
  45. Inquiry of a Client's Lawyer concerning LCAs
    Obtain mgmt description & evaluation of litigation, claims, and assessments (LCAs)
  46. Request corroboration of LCAs from client's outside counsel (inquiry letter)
    • Lawyer's refusal to respond is a scope limitation (assess severity)
    • Lawyer's inability to evaluate potential outcome is an uncertainty
    • Laywer's assessment that accounting is not in accordance with SFAS No. 5 is a GAAP departure

    ***Lawyer is required to indicate whether response is limited in any way.
  47. Contingent Liability Procedures
    • Inquiries of mgmt about possibility of unrecorded/undisclosed contingencies
    • Review of current and previous RAR's and or regulatory reports
    • Review of minutes of BOD and stockholder meetings
    • Analysis of legal expenses, invoices & stmts
    • Attorney's letters
    • Examine letters of credit/credit lines
  48. Loss Contingency
  49. Gain Contingency
    Disclose if sure beyond reasonable doubt
  50. Auditing Accounting Estimates
    Auditor's responsibility
    • Evaluate reasonableness
    • Consider subjective and objective factors
  51. Auditing Accounting Estimates
    • Complexity and Subjectivity of estimation process
    • Availability and reliability of relevant data
    • Degree of uncertainty
  52. Management Representations
    (public and nonpublic)
    Among other things, written represenations are intended to confirm in writing mgmt representations made to the auditor, either explicitly or implicitly, during the engagement; to indigate and document the continuing appropriateness of these representations; and to reduce the possibility of misunderstandings concerning the matters represented.
  53. Ordinary negligence
    lack of due care
  54. Gross negligence
    serious departure from standard on due care
  55. Constructive Fraud
    failure to check up on something where you know fraud exist
  56. If a client sues under common law, what must be present to prove ordinary negligence?
    • Auditor accepted duty of care
    • Auditor breached that duty
    • Plaintiff suffered loss or damages
    • Casualty- plaintiff relied on report
  57. If client sues under tort law, they must show
    ordinary negligence
  58. Third party primary beneficiaries and forseen beneficiaries suing under tort law must show
    ordinary negligence, gross negligence, or fraud
  59. Third party foreseeable beneficiaries suing under tort law must show
    atleast gross negligence or fraud
  60. Regulation S-K
    Governs nonfinancial information (disclosures)
  61. Regulation S-X
    Governs Financial information
  62. Under common law, ____ must show burden of proof
  63. Form 10-K annual report, must be filed within
    90 days of registrant's year-end
  64. Form 10-Q quarterly report must be filed within
    45 days of registrants quarter end
  65. Form 8-k Specified events, must be filed within
    15 days of event

    ***Exception: change of composition of BOD or change of auditors must be filed within 5 days of event
  66. Proportianate liability
    permits defendent to be held liable only in proportion to their fault in creating the accident
  67. Foreseeable parties
    include creditors, investors, or potential investors wose decisions normally rely on audited financial statements and opinions on those financial statements
  68. Foreseen Parties
    auditors are liable is they are aware that their opinion and financial statements are to be used by some third party
  69. Primary beneficiaries
    third parties for whose primary benefit the audit or other accounting service is performed
  70. Joint and Several Liability
    2 or more people are liable with respect to the same liability
  71. The Private Securities Reform Act of 1995
    Defendent Provisions
    • Modified "joint & several" liability for peripheral defendents---established "proportianate"
    • Created "safe harbor" for forward looking info
    • Codified scienter pleading and proof requirements and strengthened rules of loss causation
    • Eliminating bounty payments to plaintiffs, banning plaintiff referral fees, and limiting "professional plaintiffs" to 5 class actions every 3 years
    • prohibited RICO from being used in civil cases involving securities fraud
    • Auditors' responsibilities for detecting and reporting fraud mirro AICPA Stds
  72. The Private Securities Reform Act of 1995
    Plaintiff Provisions
    • Limited attorney's fees to a "reasonable" amount of the recovery
    • Prohibited defendants for destroying documents & computer records once a complaint was filed
  73. Racketeer influenced & corrupt organizations act (RICO)
    • Intended to curtail movement of organized crime into legitimate business
    • Private parties, such as stockholders, can bring civil suits that include treble damages & attorney's fees
  74. Sarbanes-Oxley Act of 2002
    Accounting Provisions
    • Established PCAOB
    • Prohibits auditors from offering 9 types of consulting services to audit clients
    • Requires public accounting firms to rotate lead or reviewing partners from client assignments every 5 years
  75. Sarbanes-Oxley Acto of 2002
    Corporate Responsibility
    • Requires CEOs & CFOs to certify financial reports, forfeit profits & bonuses when earnings are restated due to securities fraud
    • Prohibits executives from selling company stock during blackout periods; requires insiders to report all company stock trades within 2 days
    • Prevents executives from receiving company loans unavailable to outsiders
    • Requires companies to disclose immediately material changes in financial condition
  76. Unqualified opinion
    Favorable: financial stmts taken as a whole present fairly the financial position, results of operations, and CFs in all material respects in conformity with GAAP

    • 1. Lack of consistent application of GAAP
    • 2. Departure from promulgated accounting procedures with which auditor agrees
    • 3. reports involving other auditors
    • 4. Emphasis on a matter, including uncertainties
    • 5. Substantial doubt about going concern
  77. Qualified Opinion
    Favorable, with Qualification: "Except for" the effects of particular matters

    • 1. Scope limitation (moderate materiality)
    • 2. GAAP departure (moderate materiality)
  78. Adverse Opinion
    Unfavorable: financial stmts do not present fairly the financial position results

    1. GAAP Departure (high materiality)
  79. Disclaimer
    Neither favorable nor unfavorable: auditor does not express an opinion on the financial position

    • 1. Scope limitation (high materiality)
    • 2. lack of auditor independence
  80. Dating Auditor's report
    Shouldn't be dated early than the date on which the auditor has obtained sufficient appropriate audit evidence to support the opinion
  81. Piecemeal Opinions
    Piecemeal opinions should not be issued, since the purpose of an audit is to render an opinion on the financial statements taken as a whole
  82. Where should the explanatory paragraphs be placed?
    1. Change in accounting principles
    2. Uncertainty
    3. Going concern matter
    4. Explanation of departure from unqualified opinion
    5. All other explanatory paragraphs
    • 1. after opinion paragraph
    • 2. after opinion paragraph
    • 3. after opinion paragraph
    • 4. before opinion paragraph
    • 5. no required placement (judgement)
  83. Comparitive Financial Statments
    Continuing Auditor:
    • Auditor's report covers 2 or more periods
    • Report on prior period may be "updated" (vs. "reissued")
    • Report on each period should be considered separately
    • New info in current year may necessitate a different opinion on prior year
    • Format: change in explanatory paragraph ( date of previous report, type of opinion issued, event that caused opinion to differ, stmt that auditor's opinion is different from previously issued)
  84. Auditor's consideration of an Entity's ability to continue as a going concern
    Fundamental Requirements:
    • To evaluate on every audit whether there is "substantial doubt" about going concern issue for a "reasonable" period of time (up to 1 year from most recent balance sheet date)
    • To consider the adquacy of mgmt's financial stmt disclosure of the going concern issue
    • To include an explanatory paragraph when auditor concludes there is "substantial doubt" (auditor's judgement)
  85. Financial Statement disclosures
    Substantial Doubt Disclosures:
    • The principal conditions leading to substantial doubt
    • The possible effects on the entity
    • Management's evaluation of the situation and its plan to overcome
    • Possible discontinuance of operations
    • Management's plans
    • Recoverability of assets & classification of accounts
  86. Securities Act of 1934 (10b and 18)
    Plaintiff/ defendent
    • Plaintiff: materially false or misleading financial stmts
    • damage or loss
    • reliance on false or misleading financial stmts

    • Defendant: same as 1933
    • acted in good faith
    • no knowledge of false stmts
    • doesn't constitute scienter
    • plaintiffs lack of reliance
    • expiratiopn of statute of limitations
  87. Securities ACT of 1933
    • Plaintiff: material false, misleading, or incomplete financial stmts
    • Damage or loss

    • Defendent: due diligence
    • no errors (or atleast not material)
    • Plaintiff purchased securites after issuance of earnings statement covering 12 months following effective date of registration stmt
    • Statute of limitations has expired
    • Plaintiff knew of false or misleading info
  88. Property, Plant, & Equipment and Intangible Assets

    • Recorded PP&E exist
    • All PPE are recorded (completeness)
    • PPE are owned (rights)
    • Repairs and maintenance expense does not include items that should have been capitalized (completeness)
    • Freight-in is included as part of purchase and added to equipment costs (valuation
    • Purchased Goodwill is properly valued (valuation)
    • Goodwill is not impaired (valuation)
    • Capitalized intangible costs relate to intangibles acquired in exchange transactions (existence)
    • Amortization and depreciation expenses are properly allocated (valuation)