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Auditing
A Risk-Based Approach To Conducting A Quality Audit
10th edition
Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg
CHAPTER 16
ADVANCED TOPICS CONCERNING COMPLEX AUDITING
JUDGMENTS
Copyright © 2016 South-Western/Cengage Learning
LEARNING OBJECTIVES
1.
2.
3.
4.
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
Assess whether misstatements, including prior-period
misstatements, are material
Describe audit considerations for long-term liabilities
involving significant subjectivity
Describe audit considerations for merger and acquisition
activities, including restructuring
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LEARNING OBJECTIVES
5.
6.
7.
Describe audit considerations for assessing management’s
fair value estimates and related impairment judgments,
including goodwill impairment judgments
Describe audit considerations for financial instruments
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
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THE AUDIT OPINION FORMULATION
PROCESS
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LEARNING OBJECTIVE 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
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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
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LEARNING OBJECTIVE 2
ASSESS WHETHER MISSTATEMENTS,
INCLUDING PRIOR-PERIOD MISSTATEMENTS,
ARE MATERIAL
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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
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EVALUATING 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
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EVALUATING MISSTATEMENTS
Considerations regarding selective
correction of misstatements
Considering misstatements in the
statement of cash flows
Regulatory guidance concerning
materiality judgments
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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
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LEARNING OBJECTIVE 3
DESCRIBE AUDIT CONSIDERATIONS
FOR LONG-TERM LIABILITIES INVOLVING
SIGNIFICANT SUBJECTIVITY
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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
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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
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LEARNING OBJECTIVE 4
DESCRIBE AUDIT CONSIDERATIONS
FOR MERGER AND ACQUISITION
ACTIVITIES, INCLUDING RESTRUCTURING
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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
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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
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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
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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
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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
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AUDIT PROCEDURES FOR
RESTRUCTURING CHARGES
Review current and proposed financial accounting
standards
Review the detail developed by company in determining
its estimate, including:
• Identification of specific assets to be disposed of
• Number of people to be terminated
• Union contracts on termination
• Planned severance pay
Review specific steps taken
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AUDIT CONSIDERATIONS FOR
RESTRUCTURING CHARGES
Review and Independently test estimates by reviewing:
• Contracts
• Appraisals for property or estimates from investment bankers
• Severance contracts
Mathematically test the estimates
Develop an overall conclusion on reasonableness of
liability and appropriateness of accounting used by client
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LEARNING OBJECTIVE 5
DESCRIBE AUDIT CONSIDERATIONS
FOR ASSESSING MANAGEMENT‘S FAIR VALUE
ESTIMATES AND RELATED IMPAIRMENT
JUDGMENTS, INCLUDING IMPAIRMENT
JUDGMENTS
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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
FASB hierarchy of inputs in assessing fair value
• 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
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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
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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
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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
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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
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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
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LEARNING OBJECTIVE 6
DESCRIBE AUDIT CONSIDERATIONS
FOR FINANCIAL INSTRUMENTS
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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
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AUDITING HEDGES
Understand the product
Identify relevant risks and
related controls
Understand the accounting
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LEARNING OBJECTIVE 8
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
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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
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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.
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IMPORTANT FEATURES OF INTERNAL
AUDIT
Independent and objective
Assurance and consulting activity
Systematic and disciplined approach
Risk management, control, and corporate
governance
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IMPORTANT ACTIVITIES OF INTERNAL
AUDIT
Assurance: Objective examination of evidence to
provide independent assessment on governance,
risk management, and control processes
Consulting: Advisory and related client service
activities
• Nature and scope are agreed with the client
• Add value and improve an organization’s governance, risk
management, and control processes without the internal
auditor assuming management responsibility
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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
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IIA CODE OF ETHICS
Integrity
Objectivity
Confidentiality
Competency
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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
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