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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
Copyright © 2016 South-Western/Cengage Learning 16-3
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
Copyright © 2016 South-Western/Cengage Learning 16-4
THE AUDIT OPINION FORMULATION PROCESS
Copyright © 2016 South-Western/Cengage Learning
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
Copyright © 2016 South-Western/Cengage Learning 16-6
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
Copyright © 2016 South-Western/Cengage Learning
ASSESS WHETHER MISSTATEMENTS,INCLUDING PRIOR-PERIOD MISSTATEMENTS,
ARE MATERIAL
LEARNING OBJECTIVE 2
Copyright © 2016 South-Western/Cengage Learning 16-8
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
Copyright © 2016 South-Western/Cengage Learning 16-9
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
Copyright © 2016 South-Western/Cengage Learning 16-10
EVALUATING MISSTATEMENTS
Considerations regarding selective correction of misstatements
Considering misstatements in the statement of cash flows
Regulatory guidance concerning materiality judgments
Copyright © 2016 South-Western/Cengage Learning 16-11
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
Copyright © 2016 South-Western/Cengage Learning
DESCRIBE AUDIT CONSIDERATIONSFOR LONG-TERM LIABILITIES INVOLVING
SIGNIFICANT SUBJECTIVITY
LEARNING OBJECTIVE 3
Copyright © 2016 South-Western/Cengage Learning 16-13
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
Copyright © 2016 South-Western/Cengage Learning 16-14
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
Copyright © 2016 South-Western/Cengage Learning
DESCRIBE AUDIT CONSIDERATIONSFOR MERGER AND ACQUISITION
ACTIVITIES, INCLUDING RESTRUCTURING
LEARNING OBJECTIVE 4
Copyright © 2016 South-Western/Cengage Learning 16-16
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
Copyright © 2016 South-Western/Cengage Learning 16-17
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
Copyright © 2016 South-Western/Cengage Learning 16-18
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
Copyright © 2016 South-Western/Cengage Learning 16-19
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
Copyright © 2016 South-Western/Cengage Learning 16-20
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
Copyright © 2016 South-Western/Cengage Learning 16-22
AUDIT CONSIDERATIONS FOR RESTRUCTURING CHARGES
Copyright © 2016 South-Western/Cengage Learning
DESCRIBE AUDIT CONSIDERATIONSFOR ASSESSING MANAGEMENT‘S FAIR VALUE
ESTIMATES AND RELATED IMPAIRMENT JUDGMENTS, INCLUDING IMPAIRMENT JUDGMENTS
LEARNING OBJECTIVE 5
Copyright © 2016 South-Western/Cengage Learning 16-24
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
Copyright © 2016 South-Western/Cengage Learning 16-25
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
Copyright © 2016 South-Western/Cengage Learning 16-26
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
Copyright © 2016 South-Western/Cengage Learning 16-27
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
Copyright © 2016 South-Western/Cengage Learning 16-28
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
Copyright © 2016 South-Western/Cengage Learning 16-29
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
Copyright © 2016 South-Western/Cengage Learning
DESCRIBE AUDIT CONSIDERATIONSFOR FINANCIAL INSTRUMENTS
LEARNING OBJECTIVE 6
Copyright © 2016 South-Western/Cengage Learning 16-31
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
Copyright © 2016 South-Western/Cengage Learning 16-32
AUDITING HEDGES
Understand the product
Identify relevant risks and related controls
Understand the accounting
Copyright © 2016 South-Western/Cengage Learning
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
LEARNING OBJECTIVE 8
Copyright © 2016 South-Western/Cengage Learning 16-34
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
Copyright © 2016 South-Western/Cengage Learning 16-35
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.
Copyright © 2016 South-Western/Cengage Learning 16-36
IMPORTANT FEATURES OF INTERNAL AUDIT
Independent and objective
Assurance and consulting activity
Systematic and disciplined approach
Risk management, control, and corporate governance
Copyright © 2016 South-Western/Cengage Learning 16-38
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
Copyright © 2016 South-Western/Cengage Learning 16-40
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