Principles of Auditing Chapters 5-6

Overall Audit Strategy

Considers those characteristics of the audit which determine its scope, such as industry reporting requirements, client locations, and the basis of reporting followed by the client.

Sufficient vs. Appropriate

Sufficiency is a measure of the QUANtity of audit evidence that should be obtained. Appropriateness is the measure of QUALity of that audit evidence.

Two types of misstatements

misstatements arising from (1) fraudulent financial reporting (Management fraud), and (2) misstatements arising from misappropriation of assets (defalcations).

Three fundamental conditions necessary for the commission of fraud

(1) some type of incentive or pressure; (2) an opportunity to commit the fraud; and (3) an attitude that allows the individual to rationalize the act.

Discussions with Engagement Personnel (PCAOB 314) and (PCAOB 316)

(314) requires that auditors have a discussion with the audit team members about the susceptibility of the client's financial statements to material misstatements, while (316) requires a discussion on susceptibility to fraud.

Materiality (as defined by FASB)

...the magnitude of an omission or misstatement of financial info that, in the light of surrounding circumstances, makes it probable that the judgement of a reasonable person relying on the info would have been changed or influenced by the omission or misstatements.

The process of performing analytical procedures consists of these steps:

1. Develop an expectation of an account (or ratio) balance. 2. Determine the amount of difference from the expectation that can be accepted without investigation. 3. Compare the company's account (ratio) balance w/ the expectations. 4. Investigate ad evaluate significant differences from the expectation.

Audit Evidence

All the info used by the auditors in arriving at the conclusions on which the audit opinion is based.

Analysis of a Ledger Account

Another common type of audit working paper. The purpose of an analysis is to show the changes in an asset, liability, equity, revenue, or expense account during the period covered by the audit.

Engagement Risk

Auditors will consider the reputation of management and the financial strength and credit rating of a prospective client to help assess the overall risk of association with the particular business.

Differences of Opinion

If they are able to do so, the working papers should be revised to reflect their common opinion. If they are not able to reach agreement, the opinion of the partner-in-charge of the engagement will prevail with respect to the content of the auditors' report. However, all other members of the audit team have the right to document in the working papers their disagreement with the ultimate decision.

Audit File

Includes the working papers for a particular engagement and is the principal record of the work performed during the audit. If the auditors are subsequently charged with negligence, the working papers included in the audit file will be a major factor in refuting or substantiating the charge.

Outside and within the client organization...

Info must no be divulged outside the client organization. But it also must not be divulged within the client organization.

Nonroutine transactions

Involve activities that occur only periodically, such as the taking of physical inventories, calculating depreciation expense, and adjusting financial statements for foreign currency gains and losses

Analytical Procedures

Involve evaluations of financial statement info by a study of relationships among financial and non financial data. The auditors can use these relationships to obtain evidence about the reasonableness of financial statement amounts.

Routine transactions

Involve recurring financial statement activities recorded in the accounting records in the normal course of business.

Working Trial Balance

Is a schedule listing the balances of the accounts in the general ledger for the current and previous year and also providing columns for the auditors' proposed adjustments and reclassification's and for the final amounts that will appear in the financial statements. "Backbone" of the entire set of audit working papers.

Internal Control

Is designed to provide reasonable assurance of achieving objectives related to reliable financial reporting, efficiency, and effectiveness of operations, and compliance with applicable laws and regulations.

The Systems Portion of the Audit Program

Is generally organized around the major transaction cycles of the client's accounting system. Audit procedures in the systems portion of the program typically include obtaining an understanding of the controls for each transaction cycle, preparing a flowchart for each cycle, testing the significant controls, and assessing control risk for the related financial statement assertions.

The primary challenge for the auditors

Is identifying any related party transactions that management has not disclosed, because they may be recorded in the accounting records with all other transactions.

Audit Plan

Is more detailed than the audit strategy and includes the nature, timing, and extent of audit procedures to be performed by the audit team members in order to obtain sufficient audit evidence.

The Substantive Test Portion of the Audit Program

Is organized in terms of major financial statement accounts and classes of transactions, such as cash, accounts receivable, sales, inventories, and plant and equipment. Substantive procedures are used to restrict detection risk for these accounts.

Transaction Cycle

Is the sequence of procedures applied by the client in the processing a particular type of recurring transaction. Also called class of transactions.

AICPA AU 230 (PCAOB Auditing Standard No. 3)

Requires that audit documentation provide (1) evidence of the auditors' basis for concluding on the achievement of the audit's overall objectives, and (2) evidence that the audit was planned and performed in accordance with GAAS.

Management is...

Responsible for the fair presentation of financial statements in conformity with generally accepted accounting principles.

Permanent File

Serves 3 purposes: (1) to refresh the auditors' memories on items applicable over a period of many years.; (2) to provide new staff members with a quick summary of the policies and organization of the client; and (3) to preserve working papers on items that show relatively few or no charges, thus eliminating the necessity for their preparation year after year.

Disclosure of related party transactions

Should include the nature of the relationship; a description of the transactions, including dollar amounts; and amounts due to and from related parties, together with the terms and manner of settlement.

Tick Marks

Symbols used by auditors to identify specific steps in the work performed. They provide a very concise means of indicating the audit procedures applied to particular amounts. Should be accompanied by a legend to explain their meanings.

Representation Letter

The CPAs obtain from client officers a written RL summarizing the most important oral representations made by MGMT during the engagement.

Estimation transactions

The activities that create accounting estimates. Have high inherent risk b/c they involve management judgements or assumptions.

Reclassification Journal Entries (RJEs)

The auditors develop these for items that, although correctly recorded in the accounting records, must be reclassified for fair presentation in the client's financial statements.

Adjusting Journal Entries (AJEs)

The auditors draft. Which they recommend for entry in the client's accounting records.

To conduct a satisfactory audit...

The auditors must be given unrestricted access to all info about the client's business.

Reasonable Assurance

The auditors should plan and perform the audit to obtain reasonable assurance that material misstatements, whether caused by errors or fraud, are detected.

AICPA AU 540 (PCAOB 342) requires...

The auditors to determine that (a) all necessary estimates have been developed, (b) accounting estimates are reasonable, and (c) accounting estimates are properly accounted for and disclosed.

Report Release Date

The date the client is granted permission to use the report. Auditors are given 60 days after this date to complete the audit file by assembling a complete and final set of audit documentation.

Audit Risk

The possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated.

Audit Risk

The possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated. Auditors should obtain sufficient appropriate audit evidence to reduce audit risk to a low level in every audit.

Control Risk

The risk that a material misstatement could occur in a relevant assertion and not be prevented or detected on a timely basis by the client's internal control.

Detection Risk

The risk that the auditor's procedures will not detect a material misstatement that exists in a relevant assertion. Also, a function of the effectiveness of the audit procedures performed. If the auditors wish to reduce the level of detection risk, they simply obtain additional appropriate evidence. As a result, DR is the only risk that is completely a function of the sufficiency of the procedures performed by the auditors.

What do the auditors do if they obtain evidence of fraud?

They should evaluate the implications for the audit and communicate their suspicions to an appropriate level of management, at least one level above the level involved. If the fraud involves senior mgmt or material misstatement of the financial statements, the matter should be reported to the audit committee of the board of directors.

Tracing vs. Vouching

Tracing starts at the source documents and finishes with the ledgers (Understatements). While vouching starts at the ledgers and finishes with the source documents (Overstatements).

Engagement Letter

When this is accepted by the authorized client official, it presents an executor contract b/w the auditor and the client. Meeting independence is a requirement.

If new info is added to the working papers...

Whether it is before or after the documentation completion date, documentation should include (1) when and by whom changes were made and reviewed, (2) specific reasons for the changes, and (3) the effect, if any, of the changes on the auditors conclusions.

Reconciliations

Working papers that are used to prove the relationship b/w amounts obtained from different sources. These provide evidence as to the accuracy of one or both of the amounts and are important to the audit of many accounts, including cash, accounts receivable, and inventories.

Examples of Working Papers

Working trial balances, audit programs, correspondence (including e-mail) concerning significant matters, internal control questionnaires, letters or representations obtained from the client and from the client's legal counsel, and returned confirmation forms.

How do the auditors respond to fraud risk? (3 ways)

(1) a modification in approach having an overall effect on how the audit is conducted; (2) an alteration in the nature, timing, and extent of the procedures performed; and (3) performance of procedures to further address the risk of management override of internal control.

Audit program

A detailed plan of the audit procedures to be performed in the course of the audit.

Related Party Transactions

A transaction in which one party has the ability to influence significantly the management or operating policies of the other party, to the extent that one of the transacting parties might be prevented from pursuing fully its own separate interests.

Documentation Completion Date

After the close of this 60-day period, no info may be discarded from audit working papers.

Working Papers

Audit documentation or work papers. The record of the audit procedures performed, relevant audit evidence obtained, and the conclusions the auditors reached.

Common-size financial statements

Financial statements that present each amount as a percentage of some financial statement base.

Lead Schedules

Also called grouping sheets or summary schedules. Are set up to combine similar general ledger accounts, the total of which appears on the working trial balance as a single amount.

Audit Committee

Public companies must establish such a committee within the board of directors to take an active role in overseeing the company's accounting and financial reporting policies and practices. Required by the NYSE, the American Stock Exchange, and NASDAQ.

AICPA AU 210 (PCAOB 315)

Requires the successor auditors to attempt to communicate with the predecessor BEFORE accepting the engagement.

Inherent Risk

The possibility of material misstatement of an assertion before considering the client's internal control. Routine, Nonroutine, and Estimation.

Documentary Evidence

When available, the most reliable single piece of DE created within the client's organization ordinarily is a paid check.