Who are the parties involved in the financial reporting model?
Reporting Entity
CPA
F/S reader
What are the five components involved in the financial reporting model?
Financial reporting framework, F/S, accountant's report, evidence, professional advice
Audit of F/S
provides reasonable assurance or positive assurance
Why is it necessary to have a CPA in the financial reporting process?
Accountants protect against both error and fraud
Compilation of Financial Statements
no (or little) assurance, independence is not required
basically makes financial statements look pretty
Review of F/S
looks at records and compare but not to the extent of an audit
provides moderate assurance, independence needed, "negative" assurance report
What are the reasons a CPA provides credibility to the financial reporting process?
-They bring expertise
-They are an outside 3rd party
-They want to protect their reputation
What is the role of the CPA in the financial reporting process?
They attest to what management asserts
What are the three responsibilities of management that cannot be shared?
-Financial statements
-Development and maintenance of the internal control system
-Prevention and detection of fraud
What are the two major types of financial frameworks?
General purpose or special purpose
General purpose framework
intended for a general audience (GAPP, IFRS)
Special purpose framework
intended for a audience with specialized informational needs (RAP, cash basis, OCBA, GAS)
What is the relationship between GAAP and FASB?
GAAP is established by the Financial Accounting Standards Board (FASB) while FASB has the defacto authority to set the accounting standards acceptable to the SEC
What is the recording process?
Includes:
-Economic event occurs
-Books of original entry
-General ledger
What is the reporting process?
Includes:
-General ledger
-Financial statements
Board of accontancy
-State agency who has oversight on the accounting profession in their jurisdiction
-control licenses
-Determine acceptable practices for accountants in their jurisdiction
American Institute of Certified Public Accountants (AICPA)
- Our professional organization who looks out for the interests of the accounting profession
- Maintain a code of conduct which has been widely adopted
- Voluntary membership
State Society of CPAs
State version of AICPA
Financial statement audit
are F/S in accordance with GAAP?
- CPA must be independent from client
- Exclusive major franchise of CPAs
Compliance audit
are rules, regulations, policies, etc. being followed?
operational audit
are activities effective and efficient?
forensic audit
did a fraud occur?
Internal vs. external audit
External audit is done primarily for the benefit of third parties
Internal audit is done primarily for the benefit of management and the BOD.
how is an audit beneficial to the entity being audited in a borrowing situation?
It can reduce the amount of interest you pay because the information risk decreases
Information risk
the risk that the information being used to set business risk is faulty
what are the causes of information risk?
remoteness of information, biases and motives of the provider, voluminous data, complex exchange transactions
What are some means to reduce information risk?
- Lender varifies information directly
- Lender imposes some of the risk on borrower
- Info is audited by an independent party
Why the lender provides options to the borrower?
To allow the borrower to choose what loan they want the lender doesn't care what they choose
What are some of the factors that provide F/S readers assurance of quality performance by the auditor?
- Expertise
- Independence
- Legal liability
- Code of conduct
- Oversight
- Peer review
- Quality controls
What are implicit assertions?
Implied or inferred from FS but NOT directly stated
What are explicit assertions?
Things that are directly stated
What activity does management assertions about transactions and events concern?
If transactions are being properly reported
What are the five management assertions about transactions and events?
Occurrence
Completeness
Accuracy
Cutoff
Classification
T&E: Occurrence
The events really happened
T&E: completeness
All the events that should be included are
T&E: Accuracy
The events are recorded without error
T&E: cutoff
The events belong in this time period
T&E: classification
The events belong in this account
What activity does management assertions about balances concern?
If the account balances are fairly-stated
What are the four management assertions about balances?
Existence
Rights and obligations
Completeness
Valuation and allocation
Balances: Existence
The items really exist
Balances: Rights and Obligations
The entity has the right to receive the benefits from the item or has the obligation to satisfy claims
Balances: Completeness
all items which should be listed are
Balances: Valuation and allocation
all items are properly valued
What activity does management assertions about presentation and disclosure concern?
Are the F/S complete and transparent?
Presentation and Disclosure: occurrence and rights and obligations
items listed on the F/S represent historical events that belong to the entity
Presentation and Disclosure: Completeness
Everything that should be on the F/S (including disclosure) is included
Presentation and Disclosure: Classification and understandability
items in the F/S are properly described in a clear fashion
Presentation and Disclosure: Accuracy and valuation
items listed on the F/S are properly valued without error
What are the management assertions as defined by the PCAOB?
Existence
Completeness
Rights and Obligations
Valuation
Presentation and Disclosure
What is the definition of the I/C system?
a process, implemented by management, designed to provide reasonable assurance about 1) reliability of financial reporting 2) compliance with applicable laws and regulations, and 3) effectiveness and efficiency of operations
What are the general objectives of the I/C system?
1) reliability of financial reporting 2) compliance with applicable laws and regulations, and 3) effectiveness and efficiency of operations
Why is management concerned about establishing a solid I/C system?
Inadequate controls might violate the Foreign Corrupt Practices Act and impose possible legal sanctions on members of management
Why are the auditors interested in the client's I/C system?
They must meet 2nd Standard of Fieldwork - GAAS
What are the five elements of the I/S system?
The control environment
Management's risk assessment
The accounting information and communication system
Control Activities
Monitoring
What is the control environment?
All the internal and external factors that influence internal controls
What is Management's assessment of risk?
identify and assess the risks relevant to the I/C objectives.
What is the accounting, information, and communication system?
- Identify and record all valid transactions
- Record transactions in a timely fashion
- Properly classify transactions
- Properly value transactions
- Disclose properly additional information about transactions in the F/S
What are control activities?
procedures/policies are designed to accomplish the objectives
Control activities should meet these control objectives:
- Authorization and approval
- Validity of Source documents
- completeness
- recording accuracy
- safeguarding assets
- segregation of duties
- reconciliation and other independent checks
What is monitoring?
Management's process that assesses the quality of the internal control's performance over time.
What factors affect or are part of the control environment?
- Management's philosophy and style
- Organizational structure
- Management's control methods - budgeting and variance analysis
- Personal policies
- External reviews
What is the purpose of management's assessment of risk? How frequently should this be undertaken?
it gives an effective internal control system and it is an on-going process so risks must be continually assessed
What is the purpose of the communication system of the I/C system?
to initiate, record, process, and report the entity's transactions and to maintain accountability for the related assets
What are the objectives of the accounting portion of the communication system?
using relevant, quality information that is communicated both internally and externally as necessary to support the proper functioning of internal controls
What is the purpose of the monitoring system?
allows for continual evaluation and upgrading essentially making a feedback loop which suggests the system could be improved
What are some common elements of the monitoring system?
-Management assessment of risks
-External audit's assessment
-Internal auditing department
-affected departments
-employee suggestions
-customer complaints
What are two necessary elements of fraud?
deception and misrepresentation
What are two major types of fraud?
Earnings management and misappropriation of assets
Describe the fraud triangle and its components.
-Motivation or incentive
-Opportunity
-Rationalization
What is tip of the iceberg theory?
the fraud is bigger than it looks (magnitude)
What is the cockroach theory?
The fraud is more numerous than it looks (multitude)
What is the potato chip theory?
Behavior becomes additive (extra money is easy to get use to, and risk of detection is reassessed downward)
What is the rotten apple theory?
Fraud corrupts others (Tone at the top - if management is doing it, why shouldn't I?)
What is the low hanging fruit theory?
Fraudsters tend to diversify (useful for detection - focus on more detectable frauds)
What is the traitor in the midst theory?
Fraudster does not focus on corporate goals but has become a free agent looking out only for self (fraudster becomes less and less a team player and loses respect for the entity, value as an employee is limited)
What is the addition by subtraction theory?
Should an organization hold on to a good employee who is committing fraud?
What two things are necessary to enact a zero-tolerance policy on fraud?
- Well-defined statement of expectations on ethical behavior
- Continual, proactive search for fraud known to employees
- Make sure rules are known by everyone to not risk wrongful termination
Unmodified opinion
The F/S present fairly IAWGAPP
Unmodified opinion with emphasis-of-a-matter
The F/S present fairly IAWGAPP but there is something you need to know
Qualified opinion
The F/S present fairly IAWGAPP except for uncorrected misstatements or unaudited portions
Adverse opinion
The F/S do not present fairly IAWGAPP
Disclaimer
Unable to determine if the F/S present fairly IAWGAPP. F/S must be considered unaudited
How is materiality defined?
An error or omission that would affect the decision of an informed person
What information is considered immaterial?
essentially no reader of F/S really cares
What information is considered material?
affects the decision of those using a specific set of accounts but not someone using the entire set of financial statements
What information is considered highly material?
misstatement is so large or affects so many accounts that any decision using the financial statements would be affected
What are some of the qualitative factors of materiality?
- Actions not measurable but important in implication
- Nature of misstatements
- Scope limitations
- Covenant violations and changes in trends
What is the general format of an audit report?
- Report title
- Report addressed
- Introductory paragraph
- Management's responsibilities
- Auditor's responsibilities
- Scope paragraph
- Opinion paragraph
- Name of CPA firm
- Audit report date
- Explanatory paragraph
Why is the standard unmodified audit report the most common type of report?
it is what management and auditor wants
What are the five reasons for an unmodified opinion with an emphasis-of-a-matter?
1. split responsibility
2. Departure from an accounting principle
3. Lack of consistency
4. Going concern
5. Emphasis of a matter
What is split responsibility?
another auditor is involved if willing to accept then no worries and if not then issue emphasis-of-a-matter report
What is departure from an accounting principle?
GAAP was not used in one area due to UNUSUAL circumstances but the alternative reporting aligns with economic reality
What is lack of consistency?
previous financial statements used a different set of acceptable accounting methods
What is going concern?
reporting entity may not continue to exist in the near future
What is emphasis of a matter?
anything that the auditor thinks that the readers of the financial statements should know. Generally, the information is already in F/S but the auditor is emphasizing the information for the readers.
What are the two types of qualified opinions?
-Scope limitation
- Violations of GAAP
What are the three types of violations of GAAP?
- use of accounting principles that are not GAAP
- inadequate disclosure
- Accounting changes with which the auditor does not agree
What does the adverse opinion express to the F/S reader?
the F/S are not presenting fairly IAWGAPP and are unreliable
What may be implied by the issue of an adverse opinion?
some kind of fraud is present
When must a disclaimer of opinion be issued?
used when the auditor is unable to collect sufficient evidence to support an opinion
When is a disclaimer of opinion not allowed to be issued?
when the auditor is unwilling to issue the appropriate opinion