Study Guide Test 1: Chapters 1 – 3

 Test Structure
o The test will consist of 25 multiple-choice questions, as well as 3 - 4 short answer
questions. The test will function as your answer sheet, so please make sure to put
your name on it. You will not need a calculator for this test.
o All questions will cover things we have discussed in class. I suggest reviewing
your notes, slides, and the textbook to fill gaps in understanding.
o Short answer questions are not intended to be essays. In addressing a question,
you should:
 1) make a point (e.g., I think that…),
 2) provide some reasoning for your point (e.g., I think this because…), and
 3) don’t write too much. Length does not necessarily equal quality and
more length can be detrimental if you contradict yourself or state
something that is objectively incorrect. This is a fine line to walk, as you
need to show me that you understand the question and your answer.
o YOU DO NOT NEED TO KNOW SPECIFIC DEFINITIONS! I am not going to
ask for verbatim definitions. Memorization, as far
 I will not, for example, ask, “What is the textbook definition of financial
statement auditing?”
 I may, however, ask, “What, in your words, is the definition of financial
statement auditing and what role does it play in society?” Some
understanding of a textbook definition is certainly helpful, but by no
means necessary to score full points.
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 Chapter 1 – Auditing and Assurance Services
o Define information risk and explain how the financial statements auditing process
helps reduce this risk.
Information risk is the possibility that a company’s important information is
inaccurate or incorrect. The financial statement auditing process helps to reduce this
risk by having and auditor examine said company’s financial statements to make sure
that the information in those statements is credible and correctly reported.
Information risk is the probability that the information circulated by a company will
be false or misleading. Preparers and issuers of financial information may benefit
from providing false, misleading, or overly optimistic information. CEOs reduce this
risk by demanding timely, relevant, and reliable information through complexity,
remoteness, time sensitivity, and consequences.
o Define and contrast financial statement auditing, attestation, and assurance
services.
 Understand the relationship between financial statement auditing,
attestation, and assurance.
 Understand how they are different (i.e., contrast) with respect to provided
services.
Financial statement auditing is when a single auditor examines a company’s financial
statements to make sure the information is accurate and correct to provide the company
with credibility. Attestation is taking this information from the financial statements and
comparing them with an already agreed engagement of a company’s internal system.
Assurance services are the process an auditor goes through of expressing their opinion on
the company’s financial statements accuracy and correctness.
Financial Statement Auditing is the examination of an entity's financial statements and
accompanying disclosures by an independent auditor. The purpose of a financial
statement audit is to add credibility to the reported financial position and performance of
a business.
Attestation is when the assertions are embodied in a company's financial statements, we
refer to the attestation as auditing. Assurance is This potential conflict of interest between
information providers and users, along with financial statement frauds such as those of
Enron and Theranos, leads to natural skepticism on the part of users. Thus, they depend
on information professionals to serve as independent and objective intermediaries who
will lend credibility to the information. Financial Statement Auditing is
o Describe and define the assertions [1] that management makes about recognition,
measurement, presentation, and disclosure [2] of the financial statement and
explain why auditors use them as the focal point of the audit. [1] Assertion is
defined as a confident and forceful statement of fact. [2] Disclosure is defined as
the action of making new or secret information known. *
 Know these well. Know their definitions and know when they might apply
to given financial statement accounts (also a Chapter 3 concept).
The assertions management makes regarding their financial statements is key in why
auditors use them as the focal point of the audit. This is because the financial
statements are factual proof of a company’s performance. With that being said
company’s wanting to show to the world that they have good performance and as a
result return good profit. The way to show this is through their financial statements.
As a result, some companies manipulate their financial statements to show that their
company is performing better than it actually is. Because of this auditors focus on
financial statements the most to make sure that what a company is showing is
accurate and correct.
o Define professional skepticism and explain its key characteristics.
Professional skepticism is the mindset of questioning and assessment of evidence.
The key characteristics are identifying the issue, gathering the facts, performing an
analysis, making a decision, and review.
Professional Skepticism is defined in the professional auditing standards as having an
attitude that "includes a questioning mind and a critical assessment of evidence". Its
key characteristics are
 Knowing a simple definition is probably enough to get through anything I
could ask related to this.
o Describe the audits and auditors in governmental, internal, and operational
auditing.
- U.S. Governmental Accountability Office (GAO) (Its audit is the Generally
Accepted Government Auditing Standards (GAGAS)
- U.S. IRS
- State and Federal bank examiners (FDIC)
- SEC Inspectors
- PCAOB Inspectors
 Chapter 2 – Professional Standards:
o Understand the development and source of GAAS (generally accepted auditing
standards).
 Know what the purpose of these are, as well as some of the development
in auditing standards over the years.
The GAAS are standards by which auditors must proceed by when conducting an audit.
The purpose of GAAS is to make sure that the financial statements of a company are
accurate and correct as well as to issue a report on those financial statements
GAAS are auditing standards that identify necessary qualifications and characteristics of
auditors and guide the conduct of the audit examination

o Describe the fundamental principle of responsibilities and how this principle

relates to the characteristics and qualifications of auditors.
 Understand what this principle relates to, as well as what auditors are
responsible for, including the different educational, ethical, and regulatory
requirements that an auditor must comply with prior to beginning the
engagement.
 Understand the difference between independence in appearance and
independence in fact.
The fundamental principles of responsibilities is the professional qualifications of an
auditor by having the capabilities to perform an audit as well as complying with ethical
requirements and maintaining professional skepticism during an audit.
The fundamental principle of responsibilities relates to the personal integrity and
professional qualifications of auditors. The principle addresses the following
responsibilities of auditors:
- Having appropriate competence and capabilities to perform the audit
- Complying with relevant ethical requirements
- Maintaining professional skepticism and exercising professional judgment throughout
the planning and performance of the audit

o Describe the fundamental principle of performance and identify the major

activities performed in an audit.
 Understand the importance of relative assurance and materiality to the
audit.
 Understand the auditors’ responsibilities with respect to the four
subcategories of performance:
 Planning and supervision
 Materiality
 Risk assessment
 Audit evidence
o Understand the idea of sufficient vs. appropriate evidence,
and how both relate to control risk.
The fundamental principle of performance is the criteria for performing an audit. The
major activities of performing an audit are identifying the problem, gathering the facts,
performing an analysis, making a decision, and review.
The fundamental principle of performance sets forth general quality criteria for
conducting an audit. The performance principle states that:
- The auditor plans the work and properly supervises an assistants
- Determines and applies appropriate materiality level or levels throughout the audit
- Identifies and assesses risks of material misstatement, whether due to fraud or error,
based on an understanding of the entity and its environment, including the entity's
internal control
- Obtains sufficient appropriate audit evidence about whether material misstatements
exist, through designing and implementing appropriate responses to the assessed risks

o Understand the fundamental principle of reporting and identify the basic contents
of the auditors’ report.
 Understand the auditor’s output, including the broad sections of the
auditor’s report. No need for rote memorization of an actual report; that
said, I expect you to understand the categories of an audit report,
including:
 Title
 Addressee
 Opinion on the Financial Statements
 Basis for Opinion
 Critical Audit Matters
 Other
 Key to this principle is understanding the four basic audit reports and
when they should/shouldn’t be issued:
 Unmodified (Unqualified) opinion – when an auditor states that a
company’s financial statements are accurate and correctly
presented
 Modified (Qualified) opinion – when an auditor states that a
company’s financial statements are presented fairly except for one
specific issue
 Adverse opinion - when an auditor states that a company’s
financial statements are not accurate or correctly presented
 Disclaimer – when an auditor states they have no opinion
regarding a company’s financial statements
Reporting is criteria used to determine the measurement, recognition, presentation,
and disclosure of information in a company’s financial statements.
o Regulatory Bodies and Accounting Oversight
 Understand who regulates the audits of non-issuers, issuers, governmental
entities, and international audits, including some of the backdrop for
changes in regulation (e.g., PCAOB, AICPA, etc.).
 Understand how the PCAOB enforces audit quality for issuers, including
their use of standards, inspection, and enforcement.
 The PCAOB is the public company accounting oversight board, and the AICPA is the
American institute of certified public accountants.
 Chapter 3 – Engagement Planning and Audit Evidence:
o List and describe the pre-engagement activities that auditors undertake before
beginning an audit.
 Acceptance/Continuation Decision
 Communication with Predecessor Auditor, including why and how this is
supposed to happen (think Apollo shoe case).
 Compliance with Independence and Ethics
 Engagement Letters: including, what their purpose is, in terms of defining
responsibility for the audit, fee schedules, timing, etc.
The pre-engagement activities that auditors undertake before beginning an audit are
first, performing procedures towards the acceptance or continuation of an audit client
relationship. Next, determining compliance with ethical requirements. Lastly, reach
an agreement with the client about the terms and conditions of the audit engagement.
o Understand the importance of planning to the audit engagement.
 Broad definition and purpose of an audit plan
 Specifically, factors the auditor considers when developing an
audit plan.
 Audit Staffing Considerations
 Typical audit staffing
 IT auditors
 Specialists (both client- and auditor-side)
 Internal Auditors, including the factors that lead to reliance on
internal audit work (competence and objectivity).
o Define materiality and explain its importance in the audit planning process.
 Understand what materiality is, as well as how it varies between accounts
and different risks.
 Understand how materiality guides the entire audit, from planning to
performance, to reporting.
 Understand how materiality can be calculated, although I will not actually
require you to do this on the test, so a cursory knowledge of which types
of things can be used is probably good.
Materiality is the importance of an amount, transaction, or discrepancy within a
company. It is important within the audit planning process because in an audit it can
lead to why a company performs the way they do and why certain things are done the
way they within the company which is reflected on a company’s financial statements.
This can result in possible material misstatement on financial statements.
o List and describe the eight general types of audit procedures for gathering
evidence. (You do not need to memorize these, but should be able to pick them
apart from each other, if given a definition or example…)
 Inspection of records and documents – Examination of reports and records
 Vouching vs. Tracing
Vouching – inspection of document evidence supporting a
financial transaction
 Tracing – following a transaction back to the source
document
 Inspection of tangible assets – examination of a company’s assets
 Observation – the act of observing something to gain information
 Inquiry – the act of asking for information
 Confirmation – the act of confirming something
 Recalculation – the act of changing numbers to get a different outcome
 Reperformance – the act of performing something again
 Analytical Procedures – the process of finding potential problems within
financial records

o Define what is meant by the proper form and content of audit documentation.
 Purpose of audit documentation
 Permanent vs. current file
 How long audit documentation must be retained, including how soon it
must be finalized after the audit report release date.

The proper form and content of audit documentation refers to the records or documentation of
procedures that auditors performed, the audit evidence that they obtained and the conclusion that
makes by them based on the evidence obtained. Internal control documents that auditor prepare
in Microsoft word, excel or other application is the example of audit documentation. Another
example that describes audit documentation would be the working paper that auditor prepares to
document and test depreciation expenses.