9.401 Auditing

Chapter 5Chapter 5

Audit Responsibilities and ObjectivesAudit Responsibilities and Objectives

Auditor’s Responsibility…..

To accumulate evidence to determine if the To accumulate evidence to determine if the f/s are fairly stated in accordance with f/s are fairly stated in accordance with GAAP in all material respects, GAAP in all material respects,

and to issue an appropriate reportand to issue an appropriate report

Managements’s Responsibility….. Adopting sound accounting policiesAdopting sound accounting policies Maintaining adequate internal controlMaintaining adequate internal control Generating financial statements. Still mgmt Generating financial statements. Still mgmt

responsibility even if:responsibility even if: Auditor provided bookkeeping servicesAuditor provided bookkeeping services Auditor prepared f/sAuditor prepared f/s Auditor offered suggestionsAuditor offered suggestions

Auditor vs. Management

When auditor and management disagree on When auditor and management disagree on a material issue:a material issue: If management capitulates, issue clean If management capitulates, issue clean

opinionopinion Auditor can’t force management to alter Auditor can’t force management to alter

financial statementsfinancial statements If management refuses, auditor must If management refuses, auditor must

qualify opinionqualify opinion

Auditors and Errors

ErrorsErrors=unintentional misstatements of f/s=unintentional misstatements of f/s

• Mistake in gathering or processing dataMistake in gathering or processing data• Incorrect estimate from oversight or Incorrect estimate from oversight or

misinterpretation of factsmisinterpretation of facts• Mistake in application of GAAP relating to Mistake in application of GAAP relating to

amount, classification, presentation or amount, classification, presentation or disclosuredisclosure

Auditors seek reasonable, not absolute, assurance Auditors seek reasonable, not absolute, assurance that f/s contain no material errors….that f/s contain no material errors….

Why not provide absolute assurance? Can’tCan’t because: because:

Use of samplingUse of sampling Auditors use judgment, which is fallibleAuditors use judgment, which is fallible F/S contain estimatesF/S contain estimates Audit evidence is persuasive, not Audit evidence is persuasive, not

conclusiveconclusive Internal control has limitationsInternal control has limitations

Won’tWon’t because prohibitive costs exceed because prohibitive costs exceed benefitsbenefits

Auditors and Fraud

Employee FraudEmployee Fraud

=usually theft of assets from company=usually theft of assets from company Management FraudManagement Fraud

=intentional misstatement of f/s, usually to =intentional misstatement of f/s, usually to deceive stakeholdersdeceive stakeholders

Auditors and Fraud

Auditors have less responsibility towards Auditors have less responsibility towards fraud because:fraud because: Object of concealmentObject of concealment Can be hard to find if:Can be hard to find if:

Employees are colludingEmployees are colludingManagement is overriding internal Management is overriding internal

controlscontrols

Auditors and Fraud Auditors must be alert to factors increasing Auditors must be alert to factors increasing

consider the risk of misstatements:consider the risk of misstatements: means and opportunity means and opportunity

(eg. Weak internal controls, areas of judgment (eg. Weak internal controls, areas of judgment or complexity, dominant mgmt, decentralized or complexity, dominant mgmt, decentralized org)org)

motive motive (eg. High expectations, financial problems, (eg. High expectations, financial problems,

bonuses, IPO’s)bonuses, IPO’s) mgmt character and engagementmgmt character and engagement

(eg. Aggressive, dishonest, evasive)(eg. Aggressive, dishonest, evasive)New client, assets subject to misappropriationNew client, assets subject to misappropriation

Auditors and Fraud If risk of fraud is high:If risk of fraud is high:

Be critical of accounting policiesBe critical of accounting policies Use more experienced personnelUse more experienced personnel Close supervisionClose supervision Do more work, more effective procedures, Do more work, more effective procedures,

and closer to year end (=nature, timing and closer to year end (=nature, timing and extent)and extent)

Consider withdrawing from engagementConsider withdrawing from engagement

Throughout Audit Exercise professional scepticismExercise professional scepticism

Assume good faith of managementAssume good faith of management Be aware that management could be Be aware that management could be

dishonestdishonest Be alert to red flags which call Be alert to red flags which call

management good faith into questionmanagement good faith into question

Red Flag Examples: Handwritten records usually computerizedHandwritten records usually computerized Evasive, uncooperative managementEvasive, uncooperative management Unrealistic time deadlines set by mgmtUnrealistic time deadlines set by mgmt Limitation in scope imposed by mgmtLimitation in scope imposed by mgmt Conflicting or unsatisfactory evidenceConflicting or unsatisfactory evidence Unsupported or unusual transactions, Unsupported or unusual transactions,

particularly close to year endparticularly close to year end Fewer confirmation responses than expected Fewer confirmation responses than expected

or significant differences foundor significant differences found

What to do when red flags appear:

Perform additional work to confirm or dispel Perform additional work to confirm or dispel suspicions.suspicions.

If suspicions are confirmed:If suspicions are confirmed: Talk to appropriate level of mgmtTalk to appropriate level of mgmt Talk to audit committeeTalk to audit committee Consider effect on rest of auditConsider effect on rest of audit Consider effect on evidence already Consider effect on evidence already

gatheredgathered Consider if you should resign from audit-Consider if you should resign from audit-

consult a lawyerconsult a lawyer

Auditors and Illegal Acts Auditors are less likely to find illegal acts Auditors are less likely to find illegal acts

than errors:than errors: May not be directly related to auditMay not be directly related to audit Auditor may be unaware of lawsAuditor may be unaware of laws Detecting violations may be outside of Detecting violations may be outside of

auditor’s expertise, question of lawauditor’s expertise, question of law May be concealedMay be concealed

The more the illegal act has a “direct effect” The more the illegal act has a “direct effect” on f/s, the greater the auditor’s responsibilityon f/s, the greater the auditor’s responsibility

Auditors and Illegal Acts Auditors should at minimum:Auditors should at minimum:

Identify laws whose violation affects f/sIdentify laws whose violation affects f/s Ask management about policies designed Ask management about policies designed

to prevent illegal actsto prevent illegal acts Obtain written representation from mgmtObtain written representation from mgmt

If auditor DOES discover an illegal act:If auditor DOES discover an illegal act: Inform mgmt and audit committeeInform mgmt and audit committee Consider effect on f/s and audit reportConsider effect on f/s and audit report Consider effect on audit evidence, mgmt Consider effect on audit evidence, mgmt

good faithgood faith

How to perform an audit Financial statements are made up ofFinancial statements are made up of

Account Balances, which are made up ofAccount Balances, which are made up of

TransactionsTransactions The financial statements contain implied The financial statements contain implied

management assertions. Auditing these management assertions. Auditing these assertions leads to objectives which can be assertions leads to objectives which can be balance related (when auditing account balance related (when auditing account balances) or transaction related (when balances) or transaction related (when auditing transactions)auditing transactions)

Management Assertions Existence or OccurrenceExistence or Occurrence

Assets, liabilities and equities exist and that Assets, liabilities and equities exist and that a transaction occurred that pertains to the a transaction occurred that pertains to the entityentity

CompletenessCompleteness There are no unrecorded assets, liabilities There are no unrecorded assets, liabilities

or transactionsor transactions Ownership or Rights and ObligationsOwnership or Rights and Obligations

Assets of the company is owned by entity Assets of the company is owned by entity at given date, liabilities represent at given date, liabilities represent obligationsobligations

Existence

Completeness

Ownership

Management Assertions

Valuation or MeasurementValuation or Measurement Assets or liabilities recorded at appropriate Assets or liabilities recorded at appropriate

carrying value; transactions recorded in proper carrying value; transactions recorded in proper amount and allocated to proper periodamount and allocated to proper period

Presentation and DisclosurePresentation and Disclosure An item is disclosed in accordance with GAAPAn item is disclosed in accordance with GAAP

Valuation

Presentation

Assertions and ObjectivesMgmt AssertionMgmt Assertion Balance ObjectiveBalance Objective Transaction ObjectiveTransaction Objective

ExistenceExistence ExistenceExistence Occurrence Occurrence (=existence+ownership)(=existence+ownership)

CompletenessCompleteness CompletenessCompleteness CompletenessCompleteness

Valuation/Valuation/

MeasurementMeasurement

Valuation/Valuation/

MeasurementMeasurement

AccuracyAccuracy

CutoffCutoff TimingTiming

OwnershipOwnership OwnershipOwnership

Presentation/Presentation/

DisclosureDisclosure

Presentation/Presentation/

DisclosureDisclosure

ClassificationClassification

Detail tie inDetail tie in PostingPosting

Which assertions are violated?1) According to the company books, there are 25

delivery vans but your physical count reveals that they only have 20.

2) The company forgot to record on their financial statements that they will likely have to pay a settlement of two million dollars in connection with a civil lawsuit.

3) The company has several accounts receivable from customers who have declared bankruptcy.

4) The company does not show the breakdown between current and non-current assets and liabilities on the financial statements.

Which assertions are violated?5) A non-profit organization often receives sizable cash

donations but only issues receipts if the donor requests them. It is possible that some cash is pocketed by the employees.

6) The company calculates amortization on their machinery using an estimated useful life of 60 years, which seems unreasonably long given the probability of technological obsolescence.

7) The company failed to include in their financial statements an inventory shipment received immediately before year end.

8) The inventory of a second hand clothing store is recorded on their financial statements, when it is actually inventory on consignment.

Which assertions are addressed by these procedures?

1) You send out confirmations to accounts receivable customers recorded in the company books.

2) You check to see that the inventory you counted in the warehouse is recorded in the company books.

3) You recalculate the amortization of prepaid insurance.

4) You request that the company’s major suppliers send you a copy of your client’s statement of account that you will check with your company’s records.

Which assertions are addressed by these procedures?

5) You compare the ratio of the allowance for doubtful accounts to accounts receivable with the ratio of prior years.

6) You check sales invoices after the year end to see if the inventory selling price was higher than its original cost.

7) For each investment, you check if the amount of dividend revenue earned from portfolio investments corresponds with dividends declared according to the “Dividend Record Guide”.

8) You check to see if the level of sales returns recorded after the year end seems to be normal.

Phases of Audit PlanningPlanning

Obtain knowledge of businessObtain knowledge of business Understand internal control and assess riskUnderstand internal control and assess risk

Tests of ControlsTests of Controls Analytical procedures and substantive tests Analytical procedures and substantive tests

of balancesof balances Complete audit and issue reportComplete audit and issue report