Chapter 5 Lecture Notes

Audit documentation should: con't (don't need to memorize)

F. Be sufficient to show that standards of fieldwork have been followed. G. Enable a reviewer with relevant knowledge and experience to: a. Understand the nature, timing, extent, and results of the procedures performed, evidence obtained, and conclusions reached. b. Determine who performed the work and the date such work was completed, as well as the person who reviewed the work and the date of such review. H. For audits of public companies, the PCAOB adds additional documentation requirements for "significant findings or issues," actions taken to address them, and the basis for the conclusions reached.

Other information that the auditor may use as audit evidence includes

minutes of meetings; confirmations from third parties; industry analysts' reports; comparable data about competitors (benchmarking); controls manuals; information obtained by the auditor from such audit procedures as inquiry, observation, and inspection; and other information developed by, or available to, the auditor that permits the auditor to reach conclusions through valid reasoning.

Audit documentation has three functions:

(1) to provide principal support for the representation in the auditor's report that the audit was conducted in accordance with GAAS; (2) to aid in the planning, performance, and supervision of the audit; and (3) to provide the basis for the review of the quality of the work by providing a written documentation of the evidence supporting the auditor's significant conclusions.

Under current auditing standards, management assertions fall into the following categories:

1. Assertions about classes of transactions and events for the period under audit 2. Assertions about account balances at the period end 3. Assertions about presentation and disclosure

Assertions about account balances at the period end:

1. Existence—assets, liabilities, and equity interests exist. 2. Rights and obligations—the entity holds or controls the rights to assets, and liabilities are the obligations of the entity. 3. Completeness—all assets, liabilities, and equity interests that should have been recorded have been recorded. 4. Valuation and allocation—assets, liabilities, and equity interests are included in the financial statements at appropriate amounts, and any resulting valuation or allocation adjustments are appropriately recorded.

Assertions about presentation and disclosure:

1. Occurrence and rights and obligations—disclosed events, transactions, and other matters have occurred and pertain to the entity. 2. Completeness—all disclosures that should have been included in the financial statements have been included. 3. Classification and understandability—financial information is appropriately presented and described, and disclosures are clearly expressed. 4. Accuracy and valuation—financial and other information is disclosed fairly and in appropriate amounts.

Assertions about classes of transactions and events for the period under audit:

1. Occurrence—transactions and events that have been recorded have occurred and pertain to the entity (sometimes referred to as validity). 2. Completeness—all transactions and events that should have been recorded have been recorded. 3. Authorization—all transactions and events have been properly authorized. 4. Accuracy—amounts and other data relating to recorded transactions and events have been recorded appropriately. 5. Cutoff—transactions and events have been recorded in the correct accounting period. 6. Classification—transactions and events have been recorded in the proper accounts.

Three types of analytical procedures:

1. Trend analysis - the analysis of changes in an account over time 2. Ratio analysis - the comparison, across time or to a benchmark, of relationships between financial statement accounts 3. Reasonableness analysis - involves forming an expectation using a model Because it forms an explicit expectation, reasonableness analysis typically forms a more precise expectation than trend or ratio analysis.

Audit documentation should: (don't need to memorize)

A. Demonstrate how the audit complied with auditing and related professional practice standards. B. Support the basis for the auditor's conclusions concerning each material financial statement assertion. C. Demonstrate that the underlying accounting records agreed or reconciled with the financial statements. D. Include an audit program (or set of audit programs) for the engagement. E. Set forth in reasonable detail the auditing procedures that the auditor believed necessary to accomplish the objectives of the audit.

Factors that influence reliability

A. Independent source outside the entity. Evidence obtained by the auditor from an independent source outside the entity is usually viewed as more reliable than evidence obtained solely from within the entity. B. Effectiveness of internal control. The more effective the entity's internal control, the more assurance it provides about the reliability of audit evidence. C. Auditor's direct personal knowledge. Evidence obtained directly by the auditor is generally considered to be more reliable D. Documentary evidence. Audit evidence is more reliable when it exists in documentary form E. Original documents. Audit evidence provided by original documents is more reliable than audit evidence provided by photocopies or facsimiles

Types of evidence:

A. Inspection of records or documents - examining internal or external records or documents B. Inspection of tangible assets - physical examination of the assets C. Observation - looking at a process or procedure being performed by others D. Inquiry - Inquiry consists of seeking information from knowledgeable persons E. Confirmation - a direct written response to the auditor from a third party (the confirming party) F. Recalculation - consists of checking the mathematical accuracy of documents or records

The nature of the evidence refers to the form or type of information, which includes accounting records and other available information.

Accounting records include the records of initial entries and supporting records, such as checks and records of electronic fund transfers; invoices; contracts; the general and subsidiary ledgers, journal entries, and other adjustments to the financial statements that are not reflected in formal journal entries; and records such as work sheets and spreadsheets supporting cost allocations, computations, reconciliations, and disclosures.

Activity Ratios

Activity ratios indicate how effectively the entity's assets are managed. Only ratios related to accounts receivable and inventory are discussed here because for most wholesale, retail, or manufacturing companies these two accounts represent the assets that have high activity. Activity ratios may also be effective in helping the auditor determine if these accounts contain material misstatements.

OWNERSHIP of Audit documentation

Although the auditor owns the audit documents, they cannot be shown, except under certain circumstances, to outside parties without the entity's consent

Appropriateness of Audit Evidence

Appropriateness is a measure of the quality of audit evidence. Evidence is considered appropriate when it provides information that is both relevant and reliable.

Auditor reaches a conclusion based on the evidence -

Audit Report

Management assertions about components of financial statements -

Audit procedures

Provide evidence on the fairness of the financial statements -

Auditor reaches a conclusion based on the evidence

Coverage Ratios

Coverage ratios provide information on the long-term solvency of the entity. These ratios give the auditor important information on the ability of the entity to continue as a going concern.

Types of evidence cont.

G. Reperformance - the independent execution by the auditor of procedures or controls that were originally performed by company personnel H. Analytical procedures - evaluations of financial information through analysis of plausible relationships among both financial and nonfinancial data. I. Scanning is the auditor's exercise of professional judgment to review accounting data to identify significant or unusual items to test. This includes searching for large and unusual items in the accounting records (e.g., nonstandard journal entries), as well as reviewing transaction data.

Gross Profit Percentage

If this ratio varies significantly from previous years or differs significantly from industry data, the entity's financial data may contain errors. Numerous errors can affect this ratio

Medium Reliability:

Inspection of records and documents Confirmation Analytical procedures Scanning

High Reliability - auditor has direct knowledge

Inspection of tangible assets Reperformance Recalculation

Inventory Turnover and Days of Inventory on

Inventory turnover indicates the frequency with which inventory is consumed in a year. The higher the ratio, the better the entity is at liquidating inventory. This ratio can be easily compared to industry standards. The days of inventory on hand measures how much inventory the entity has available for sale to customers.

Inventory Turnover and Days of Inventory on Hand Calculations

Inventory turnover: COGS/Invent Days of inventory on hand: 365 days/Invent turnover

Current Ratio

It includes all current assets and current liabilities and is usually considered acceptable if it is 2 to 1 or better. Generally, a high current ratio indicates an entity's ability to pay current obligations. However, if current assets include old accounts receivable or obsolete inventory, this ratio can be distorted.

Quick Ratio Calculated as

Liquid assets/current liabilities The quick ratio includes only assets that are most readily convertible to cash

Financial Statements-

Management assertions about components of financial statements

Low Reliability - requires further corroboration by the auditor

Observation Inquiry

Profit Margin Calculated as

Profit Margin: Net income/Net sales

Profitability Ratio

Profitability ratios indicate the entity's success or failure for a given period. A number of ratios measure the profitability of an entity, and each ratio should be interpreted by comparison to industry data.

Audit procedures -

Provide evidence on the fairness of the financial statements

Short-Term Liquidity Ratios

Short-term liquidity ratios indicate the entity's ability to meet its current obligations. Three ratios commonly used for this purpose are the current ratio, the quick ratio, and the operating cash flow ratio.

Sufficiency of Audit Evidence

Sufficiency is the measure of the quantity of audit evidence

ARCHIVING and RETENTION

The Sarbanes-Oxley Act and the PCAOB standards require that audit documentation be retained for seven years from the date of completion of the engagement, as indicated by the date of the auditor's report (or the date that fieldwork is substantially completed

Gross Profit Percentage Calculated as

The gross margin percentage ratio is generally a good indicator of potential misstatements GP %: GP/Net sales

An auditor must consider:

The nature of audit evidence. The sufficiency and appropriateness of audit evidence.

Operating Cash Flow Ratio

The operating cash flow ratio uses the cash flows as opposed to assets to measure short-term liquidity. It provides a longer-term measure of the entity's ability to meet its current liabilities. If cash flow from operations is small or negative, the entity will likely need alternative sources of cash, such as additional borrowings or sales of assets, to meet its obligations.

Receivables Turnover and Days Outstanding in Accounts Receivable

The receivables turnover ratio indicates how many times accounts receivable are turned over during a year. However, the days outstanding in accounts receivable may be easier to interpret because this ratio can be compared to the entity's terms of trade.

Relevance

The relevance of audit evidence refers to its relationship to the assertion being tested.

Reliability

The reliability of evidence refers to whether a particular type of evidence can be relied upon to signal the true state of an assertion.

Times Interest Earned

The times interest earned ratio indicates the ability of current operations to pay the interest that is due on the entity's debt obligations. The more times that interest is earned, the better the entity's ability to service the interest on long-term debt. Times interest earned: Net income + interest exp/interest exp

Receivables Turnover and Days Outstanding in Accounts Receivable Calculated as

These two ratios provide information on the activity and age of accounts receivable. Receivables turnover: credit sales/receivables Days outstanding in AR: 365 days/receivables turnover

Return on Assets

This ratio indicates the return earned on the resources invested by both the stockholders and the creditors. Return on assets: Net income/total assets

Debt to Equity

This ratio indicates what portion of the entity's capital comes from debt. The lower the ratio, the less debt pressure on the entity. If the entity's debt to equity ratio is large relative to the industry's, it may indicate that the entity is too highly leveraged and may not be able to meet its debt obligations on a long-term basis. Debt to Equity: ST debt + LT debt/ SH's equity

Return on Equity

This ratio is similar to the return on assets ratio except that it shows only the return on the resources contributed by the stockholders. Return on equity: Net income/SH's equity

Quick Ratio

Thus, inventories and prepaid items are not included in the numerator of the quick ratio. The quick ratio may provide a better picture of the entity's liquidity position if inventory contains obsolete or slow-moving items. A ratio greater than 1 generally indicates that the entity's liquid assets are sufficient to meet the cash requirements for paying current liabilities.

Profit Margin

While the gross profit percentage ratio measures profitability after cost of goods sold is deducted, the profit margin ratio measures the entity's profitability after all expenses are considered. Significant fluctuations in this ratio may indicate that misstatements exist in the selling, general, or administrative expense accounts.

Operating Cash Flow Ratio Calculated as

cash flow from operations/current liabilities The operating cash flow ratio measures the entity's ability to cover its current liabilities with cash generated from operations

Current Ratio Calculated as

current assets/current liabilities

Audit report -

financial statements

The Nature of Audit Evidence -

the form or type of information