CHAPTER 1 Information Asymmetry Generally the manager has more information about the financials than does the absentee owner This arises the agent principal problem o Conflict of interest o Managers do not always work in the best interest of the owners o Auditors help decrease the information risk risk that info is misleading for the principal Example of information risk Buying a house Seller will make assertions of renovations or soundness of the house but could always be lying Buyer can hire a house inspector as a third party to minimize their information risk inspector auditor Lemmon Dilemma Used car example You know more information about your used car then a buyer will this creates information asymmetry seller may charge more than they should You may want to purchase an inspection so you can reduce the cost of information If buyers cannot spot the quality difference though as is often the case in the real world there will be only one market for all used cars and buyers will be ready to pay only the average price of a good car and a lemon This result when bad quality pushes good quality from the market because of an information gap is known as adverse selection Role of Auditing Assurance Purpose of Financial Statement Audits To provide financial users with an opinion by the auditor that the financial statements are presented fairly Does not provide complete assurance but enhances confidence of investors Auditors can show the public the quality of a public company s financial statements Differences between Audit Attest Assurance 1 Audit Systematic process of objectively obtaining and evaluating evidence about economic actions and events and to establish criteria and communication between results Internal control Compliance Operational Forensic Specific attestation specific testimonies on accounts 2 Attestation Engaged to issue a report on subject matter that is the responsibility of another party Reporting on nature of quantity of inventory stored in a warehouse Not subject to economic events therefore more broad than Audit High level of assurance more rigorous Attest engagements are broken up in to 3 types Examination Review Agreed upon Procedures 3 Assurance Independent professional services that improve the quality of information or its context for decision makers CPA risk advisory ElderCare WebTrusts SysTrusts Pertains to relevance and timeliness Auditing and attestation is a ized form of assurance services Most broad Materiality and Risk Audit Risk The risk that the auditor may give a clean report and unknowingly fail to appropriately modify their opinion on a misstated financial statement o Depends on the likelihood it has a misstatement and how diligent the auditor is Materiality Magnitude of omission or misstatement of accounting information that could change a person s decision who is relying on this information o Must be relevant to the buyer s decision Relevance and Reliability Evidence assists the auditor in evaluating the management s financial statement assertion whether it be from the client or external evidence of accounting data Relevance Is the information related to the specific assertion being tested Reliability Can the information be relied upon to signal the true state of assertion being tested Sample Size Materiality Assurance Levels Many auditors may use 1 his or her own knowledge from previous audits or 2 samples that will obtain information that can examine a subset of a transaction Sampling increases the likelihood of obtaining a sample representative of the transactions There is an INVERSE relationship between sample size and materiality There is a DIRECT relationship between sample size and level of assurance o Example If an auditor assesses materiality for an account to be small a larger sample will be needed than if materiality were a larger amount This is because the auditor must gather more evidence to have a reasonable likelihood of detecting small errors o Lower materiality requires a finer filter to find a small error Look harder for 5 vs 5m o Desired level of assurance increases the sample size becomes greater Phases of an Audit Client Acceptance Continuation Confer with the previous auditor of a client to check the integrity of a client Background checks on top management Gather evidence that will help assess the risk of the audit Then establish and understanding with the client of what will be performed expected fees timeliness Preliminary engagement activities 1 Determine the audit team requirements 2 Ensure independence of auditors Make sure the team is knowledgeable of the industry Plan the Audit Ratio analysis to detect special accounts Must consider the entity s internal controls Outcome written audit plan nature and timing of audit Consider and audit internal controls Look at the reliability of financial reporting effectiveness of operations compliance with laws Considered entity s board of directors management and other personnel to provide reasonable assurance regarding Audit business processes and related accounts Determine procedures necessary to reduce risk that may be affected by business process purchasing and revenue process Ex Obsolete inventory the auditor could gather evidence to determine if the inventory on hand is properly valued Complete audit Evidence is evaluated Consider contingent liabilities such as lawsuits Evaluate results and issue report Determine is sufficient evidence was collected Take all misstatements and see if they materially effect the financial statements If material auditor request they correct it If they refuse to correct it auditor will express their opinion of a misstated report If they correct it auditor will issue an unqualified clean report Structure of Report Title line must include the word Independent and report is addressed to stockholders Includes o Intro which financial statements responsibility of management express opinion o Scope explains what an audit entails and belief of reasonableness o Opinion Presented fairly in all material respects o Explanatory referring to internal controls references controls o Name of audit firm o Date of the report Unqualified Clean opinion NO misstatements most common Qualified Scope limitation everything is fair except Adverse Client refuses to fix the misstatement pervasively effects interpretation of financials o Financial statements are NOT fairly stated and should not be relied upon Notes Expectation Gap Public views auditors as collecting all the