ADVANCED TOPICS CONCERNING COMPLEX AUDITING JUDGMENTS

1. AuditingA 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

2. Learning Objectives • 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

3. Learning Objectives • 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

4. THE AUDIT OPINION FORMULATION PROCESS

5. 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

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

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

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

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

10. EVALUATING MISSTATEMENTS Considerations regarding selective correction of misstatements Considering misstatements in the statement of cash flows Regulatory guidance concerning materiality judgments

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

12. Learning objective 3 Describe audit considerationsfor long-term liabilities involving significant subjectivity

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

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

15. Learning objective 4 Describe audit considerationsfor merger and acquisitionactivities, including restructuring

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

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

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

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

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

21. Audit procedures for restructuring charges

22. Audit Considerations for Restructuring Charges

23. Learning objective 5 DESCRIBE AUDIT CONSIDERATIONSFOR ASSESSING MANAGEMENT‘S FAIR VALUEESTIMATES AND RELATED IMPAIRMENT JUDGMENTS, INCLUDING IMPAIRMENT JUDGMENTS

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 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

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

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

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

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

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

30. Learning objective 6 DESCRIBE AUDIT CONSIDERATIONSFOR FINANCIAL INSTRUMENTS

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

32. Auditing hedges Understand the product Identify relevant risks and related controls Understand the accounting

33. 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

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

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.

36. Important Features of internal audit Independent and objective Assurance and consulting activity Systematic and disciplined approach Risk management, control, and corporate governance

37. Important activities of internal audit

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

39. IIA Code of ethics

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