Copyright © 2016 South-Western/Cengage Learning ADVANCED TOPICS CONCERNING COMPLEX AUDITING...

Copyright © 2016 South-Western/Cengage Learning

ADVANCED TOPICS CONCERNING COMPLEX AUDITING JUDGMENTS

CHAPTER 16

AuditingA Risk-Based Approach To Conducting A Quality Audit

10th edition

Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg

Copyright © 2016 South-Western/Cengage Learning 16-2

LEARNING OBJECTIVES

1. Discuss the nature and types of complex judgments that permeate audit engagements and identify complex audit judgments based on a review of a company’s financial statements

2. Assess whether misstatements, including prior-period misstatements, are material

3. Describe audit considerations for long-term liabilities involving significant subjectivity

4. Describe audit considerations for merger and acquisition activities, including restructuring


LEARNING OBJECTIVES

5. Describe audit considerations for assessing management’s fair value estimates and related impairment judgments, including goodwill impairment judgments

6. Describe audit considerations for financial instruments7. Describe the activities of an internal audit function, assess

the quality of the client’s internal audit function, and determine the effect of a client’s internal audit function on the financial statement audit


THE AUDIT OPINION FORMULATION PROCESS

Gramling,Audrey

Be sure to update with new diagram


DISCUSS THE NATURE AND TYPES OF COMPLEX JUDGMENTS THAT PERMEATE AUDIT ENGAGEMENTS AND

IDENTIFY COMPLEX AUDIT JUDGMENTS BASED ON A REVIEW OF A COMPANY‘S FINANCIAL STATEMENTS

LEARNING OBJECTIVE 1


COMPLEX AUDITING JUDGMENTS

• Whether a misstatement is sufficiently material to merit a qualified audit report • Whether the client’s accounting position can be

justified• Whether the client’s estimates are appropriate• Obsolescence of inventory• Allowance for doubtful accounts• Pension and warrantyobligations• Tax provisions


ASSESS WHETHER MISSTATEMENTS,INCLUDING PRIOR-PERIOD MISSTATEMENTS,

ARE MATERIAL



EVALUATING MISSTATEMENTS

• Subjective differences between auditor and client• Gather appropriate evidence incorporating relevant

information about correctness of account balance• Auditor should be able to defend accuracy of that

estimate• Aggregating and netting misstatements• Evaluate each misstatement individually• Consider the aggregate effect of all misstatements



• Intentional misstatements• Possibility of being fraudulent or a violation of

applicable laws• When detected• Reconsider level of audit risk for client• Consider revising nature, timing, and extent of audit

procedures• Evaluate whether to resign from audit engagement



Considerations regarding selective correction of misstatements

Considering misstatements in the statement of cash flows

Regulatory guidance concerning materiality judgments


METHODS TO ASSESS MATERIALITY OF MISSTATEMENTS

• Rollover method: Focuses on materiality of current-year misstatements and reversing effect of prior-year misstatements• Allows misstatements to accumulate on balance sheet

• Iron curtain method: Focuses on assuring that year-end balance sheet is correct• Does not consider the impact of prior-year uncorrected

misstatements reversing in later years• Dual approach: Uses iron curtain and rollover methods

to determine whether a misstatement is material


DESCRIBE AUDIT CONSIDERATIONSFOR LONG-TERM LIABILITIES INVOLVING

SIGNIFICANT SUBJECTIVITY



LONG-TERM LIABILITY ACCOUNTS WITH A HIGH RISK OF MATERIAL MISSTATEMENT

Warranty reserves - Adjust the estimate of the liability for changes in:

•Product•Nature of the warranty•Sales volume•Average cost of repairing products under warranty

Pension obligations

Other postemployment benefits

•Postretirement benefits, other than pensions•Must be identified and measured by the company•Accounting treatment conceptually same as pensions


AUDIT CONSIDERATIONS FOR PENSION OBLIGATIONS AND OTHER POSTEMPLOYMENT BENEFITS

• Management’s Specialist• Determining whether actuarial firm hired by

management is independent, capable, and objective• Evaluating appropriateness of actuarial firm’s work as

audit evidence• Auditor’s Specialist• Hiring an actuarial specialist to assist the audit team in

auditing pension obligations• Skeptically questioning significant assumptions


DESCRIBE AUDIT CONSIDERATIONSFOR MERGER AND ACQUISITION

ACTIVITIES, INCLUDING RESTRUCTURING



VALUING THE ASSETS AND LIABILITIES OF AN ACQUISITION

• Pricing issues in acquisitions:• Made via stock rather than cash• In which final price is contingent on:• Value of assets received • Future performance of the acquired company or division

• Requires bringing all identifiable tangible and intangible assets and liabilities on the books at fair market value• Intangible assets valued at the net present value of future

cash flows associated with the asset


VALUING GOODWILL

• Goodwill: Excess of the purchase price over the fair market value (FMV) of the acquired company’s:• Tangible assets• Identifiable intangible assets• Liabilities

• U.S. accounting standards require that for public companies goodwill be specifically identified with an operating segment or a reporting unit


AUDIT CONSIDERATIONS FOR VALUING IDENTIFIABLE ASSETS AND LIABILITIES• Gather independent evidence• Evaluate the qualifications of any specialists to

ascertain that individuals are:• Certified• Experienced• Reputable

• Determine if management-hired specialists are sufficiently independent of management• Review methodologies used by specialists


AUDIT CONSIDERATIONS FOR VALUING IDENTIFIABLE ASSETS AND LIABILITIES• Situations requiring reliance on a specialist• Assets acquired and liabilities assumed in business

combinations and assets that may have been impaired• Valuation of environmental liabilities, and site clean-up

costs• Actuarial calculation of liabilities associated with

insurance contracts or employee benefit plans


MEASURING RESTRUCTURING CHARGES

• If an organization makes a decision to restructure operations and develops a plan for restructuring• The plan often includes severance pay for employees

and disposal of property• If such charges are not calculated correctly, then they

can be used to fraudulently manipulate income


AUDIT PROCEDURES FOR RESTRUCTURING CHARGES


AUDIT CONSIDERATIONS FOR RESTRUCTURING CHARGES


DESCRIBE AUDIT CONSIDERATIONSFOR ASSESSING MANAGEMENT‘S FAIR VALUE

ESTIMATES AND RELATED IMPAIRMENT JUDGMENTS, INCLUDING IMPAIRMENT JUDGMENTS



FAIR VALUE ESTIMATE

Price received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date

•Level 1 - Quoted prices for identical items in active, liquid, and visible markets such as stock exchanges

•Level 2 - Observable information for similar items in active or inactive markets

•Level 3 - Unobservable inputs to be used in situations where markets do not exist or are illiquid

FASB hierarchy of inputs in assessing fair value


ACCOUNTING FOR GOODWILL IMPAIRMENT

• Impairment • Occurs when changed circumstances cause estimated

future cash flows of an asset to fall below asset’s book value

• Goodwill impairment• Decrease in value of goodwill, measured by comparing

fair value of reporting entity with carrying value of entity• If fair value is less than carrying value, goodwill is

presumed to have been impaired


REPORTING UNIT AND OPERATING SEGMENT

• Reporting unit: Acquired segment or operating segment to which the goodwill from acquisition is assigned• Tests for goodwill impairment are performed at

reporting unit level• Operating segment: A component of an organization• Is a profit center and has discrete financial information• Results are reviewed regularly for purposes of

performance assessment and resource allocation


ASSESSING GOODWILL

Determine the reporting unit, which is usually an operating segment

Provides separate accounting

Is managed as a separate segment

Could be easily separated from the company


TESTS FOR GOODWILL IMPAIRMENT

• Facilitated if organization:• Develops a price for acquired organization that is

based on a capital budgeting model• Defines clearly a reporting unit for which goodwill is

associated• Organization keeps records that show progress of

reporting unit subsequent to acquisition


IMPAIRMENT TEST

• Reporting unit is the combined organization• Current fair value estimated by examining the current

market capitalization of the stock• Reporting unit is a separate subunit of the

organization• Consider following sources of information• Negotiations to sell the reporting unit• Current profitability of the reporting unit• Projected cash flows compared with cash flow projections made at

the time of acquisitions • Strategic plans for using the assets


DESCRIBE AUDIT CONSIDERATIONSFOR FINANCIAL INSTRUMENTS



FINANCIAL INSTRUMENTS

• Represent financial agreements between a party (issuer) and a counterparty (investor) based on one of the following • Underlying assets• Agreements to incur financial obligations or make

payments• Range in complexity from a simple bond to

complicated agreements containing puts or options


AUDITING HEDGES

Understand the product

Identify relevant risks and related controls

Understand the accounting


DESCRIBE THE ACTIVITIES OF AN INTERNAL AUDIT FUNCTION,ASSESS THE QUALITY OF THE CLIENT’S INTERNAL AUDIT FUNCTION, AND DETERMINE THE EFFECT OF A CLIENT’S

INTERNAL AUDIT FUNCTION ON THE FINANCIAL STATEMENT AUDIT



INTERNAL AUDIT ACTIVITIES

Provide assurance on financial statement-related items

Evaluate effectiveness of operations and related controls

Investigate concerns of fraud

Evaluate the effectiveness of internal control processes

Perform operational audits

Evaluate the organization’s compliance with laws, regulations, and company policies

Perform information systems and security audits


INTERNAL AUDITING - DEFINITION BY INSTITUTE OF INTERNAL AUDITORS (IIA)• Internal auditing is an independent, objective

assurance and consulting activity designed to add value and improve an organization’s operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes.


IMPORTANT FEATURES OF INTERNAL AUDIT

Independent and objective

Assurance and consulting activity

Systematic and disciplined approach

Risk management, control, and corporate governance


IMPORTANT ACTIVITIES OF INTERNAL AUDIT


FUNCTIONS OF INTERNAL AUDITORS

• Assisting in the review of the effectiveness of internal controls over financial reporting as part of the Sarbanes-Oxley requirements• Providing an independent viewpoint on major

accounting issues• Providing feedback on the efficiency of operations

and compliance with company and regulatory policies


IIA CODE OF ETHICS


EFFECT OF INTERNAL AUDIT’S WORK ON THE EXTERNAL AUDIT

• In making judgments about the effect of the internal auditors’ work on external audit procedures, external auditors consider:• Risk of material misstatement of the assertions related

to financial statement amounts• Degree of judgment involved in planning and

performing the procedures and evaluating the audit evidence• Objectivity of internal auditors• Competence of internal auditors

Copyright © 2016 South-Western/Cengage Learning ADVANCED TOPICS CONCERNING COMPLEX AUDITING...

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