ACG4632 Study Guide for Final Exam The regular final exam is comprehensive but more than 50 of the points on the exam will pertain to topics that were covered after the second midterm some memorization regarding auditor independence issues may be necessary EXAM 1 MATERIAL Chapter 1 An Introduction to Assurance and Financial Statement Auditing 1 the Lemons Dilemma in class Be sure to understand the issues involved Information asymmetry and the role of auditing assurance services We talked about Information asymmetry means that the 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 between the manager and the absentee owner If both parties seek to maximize their self interest the manager may not always act in the best interest of the owner Lemon Dilemma Think about selling your used car You will undoubtedly have more information about your used car than someone purchasing it this represents information asymmetry You may want to purchase an inspection to 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 2 Differences among Audit Attest and Assurance engagements Auditing is a 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 interested users Attest services 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 The subject matter of attest services can take many forms including prospective information analyses systems and processes and even the actions of specified parties Note that financial statement auditing is a specialized form of an attest service The three types of attest engagements are 1 Examination 2 Review 3 Agreed Upon Procedures Assurance services are independent professional services that improve the quality of information or its 2 context for decision makers To summarize assurance services can capture information improve its quality and enhance its usefulness for decision makers 3 Concepts of Materiality and Risk and why they are relevant to an audit Materiality is the magnitude of an omission or misstatement of accounting information that in the light of surrounding circumstances makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement A common rule of thumb is that total aggregated misstatements of more than about 3 to 5 percent of net income before tax would cause the financial statements to be materially misstated The auditor provides no assurance that immaterial misstatements will be detected Audit risk is the risk that the auditor may unknowingly give a clean opinion on financial statements that are materially misstated implies some risk that a material misstatement could be present in the The auditor s standard report states that the audit provides only reasonable assurance that the financial statements do not contain material misstatements Reasonable assurance financial statements and the auditor will fail to detect it The auditor controls the level of audit risk by the effectiveness and extent of audit work conducted D The risk that an auditor will mistakenly issue a clean opinion on financial statements that are materially misstated cannot be driven to zero Ever 4 Understand what audit evidence is and relevance reliability trade off A major concept involved in auditing is evidence regarding management s assertions Audit evidence consists of the underlying accounting data and any additional information available to the auditor whether originating from the client or externally Once the auditor has obtained sufficient appropriate evidence that the management assertions can be relied upon for each significant account and disclosure the auditor has reasonable assurance that the financial statements are fairly represented Relevance refers to whether the evidence relates to the specific management assertion being tested Reliability refers to the diagnosticity of the evidence Simply can a particular type of evidence be relied upon to signal the true state of the account balance or assertion being examined Understand the relation between sample size and materiality as well as the relation 5 between sample size and desired level of assurance I love to test students on conceptual relationships such as these To deal with the problem of not being able to examine every transaction the auditor uses 1 His or her knowledge about the transactions and or 2 A sampling approach to examine a subset of the transactions Many times the auditor is aware of items in an account balance that are more likely to contain misstatements based on previous audits understand of the client s internal control system or knowledge of history When the auditor has no special knowledge about which particular transactions or items may be misstated he or she uses sampling procedures that increase the likelihood of obtaining a sample that is representative of the population of transaction or account items 3 You can think of materiality as the fineness of the auditor s filter A lower materiality amount requires the auditor to use a finer filter in order to detect smaller errors and it takes more work to create a finer filter Similarly as the desired level of assurance increases for a given materiality amount the sample size necessary to test an assertion becomes greater Understand the major phases of the audit the order of them and what types of 6 activities of activities what be performed in each of the major phases Don t memorize lists but try to understand the structure here Client Acceptance Continuance Professional standards require that public accounting firms establish policies and procedures for deciding whether to accept new clients and retain old clients This is to minimize the likelihood that an auditor will be