AUD CH 6
Typical cycles
(1) the revenue(sales and collections) cycles (2) the acquisition(purchases and disbursements) cycle (3) the conversion (production) cycle (4) the payroll cycle (5) the investing cycle (6) the financing cycle
The auditors' consideration of control risk involves
analyzing the design and implementation of internal control to decide whether the internal control system appears adequate to prevent or detect and correct material misstatements.
Systems portion of the audit plan primarily addresses tests of internal control and
assessing control risk.
Management may use a variety of techniques to measure and review performance such as
budgets, key performance indicators, variance analysis, and sement performance reports.
The impact of cutoff errors upon the financial statements varies with the nature of the
error.
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.
Many firms have developed a balance scorecard
that uses a combination of financial and nonfinancial performance measures to assess the financial, customer, internal business process, and learning and growth perspectives of the organization.
The client's staff may prepare many audit working paper for the auditors,
thus reducing the cost of the audit.
Materiality judgements depend both
upon the financial reporting framework being used and on the auditors' professional judgement.
A number of assets are valued at cost. therefore , a common audit procedure is to
vouch the acquisition cost of assets to paid checks and other documentary evidence.
A time budget for an audit is
constructed by estimating the time required for each step in the audit plan for each of the various levels of auditors and totaling those estimated amounts.
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.
Test of controls are performed to
determine whether key controls are properly designed and operating effectively.
The required understanding of the client is used by the auditors to help plan the audit and to assess the risks of material misstatement at the financial statement and
relevant assertion levels.
How do the auditors respond to fraud risks>
(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., (3) performance of procedures to further address the risk of management override of internal control.
The auditors' consideration of risks of material misstatement from fraud recognizes that there are two distinct types
(1) misstatements arising from fraudulent financial reporting(management fraud) and (2) misstatements arising from misappropriation of assets(defalcations)
ACIPA AU-C 240 and PCAOB AS 2401 provide lists of such factors organized around the three fundamental conditions outlined by the fraud risk triangle for the commission of fraud:
(1) some type of incentive or pressure, (2) an opportunity to commit fraud, (3) an attitude that allows the individual to rationalize the act.
For the risk assessment, the auditors should document
(1) the discussion of the audit team concerning the risk of material misstatements due to error or fraud. (2) the key elements of the understanding of the entity and its environment (3) the assessment of the risk of material misstatement of both the financial statement level and the relevant assertion level (4) the risks identified.
In determining whether a risk is a significant risk, the auditors ignore the effects of the client's controls and consider
(1) the nature of the risk (2) the likely magnitude of the potential misstatements that may occur (3) the likelihood of the misstatement occurring.
The auditors should establish an understanding with the client regarding the terms of the audit engagement. This understanding should include:
(1) the objective and scope of the audit (2)auditor and management responsibilities. (3) inherent limitations of an audit (4) the applicable financial reporting framework, (5)the expected form and content of reports to be issued by the auditors.
PCAOB defines a significant account or disclosure as one that has a reasonable possibility of containing a material misstatement. Recall that we have summarized these assertions as:
1. Existence and occurrence. 2. Rights and obligations 3. Completeness 4. Cutoff 5. Valuation, allocation, and accuracy. 6. Presentation and disclosure.
Stages involved with every engagement:
1. Plan the audit 2. Obtain an understanding of the client and its environment, including internal control 3. Assess the risks of misstatement and design further audit procedures. 4. Perform further audit procedures. 5. Complete the audit. 6. Form an opinion and issue the audit report.
When the overall audit strategy has been established, the auditors are able to start developing the audit plan. Although audit plans differ in form and content among public accounting firms, a plan should include a high-level description of the nature, timing, and extent of
1. Planned risk assessment procedures sufficient to asses the risks of material misstatement. 2. Planned further audit procedures for each material class of transactions, account balance, and disclosure. This includes tests of controls and substantive procedures. 3. Other audit procedures in order to comply with generally accepted audit standards.
Concerning the overall attractiveness of the industry, auditors considers such factors as
Barriers to entry. Strength of competitors. Bargain power of suppliers of raw materials and labor, Bargain power of customers.
The general approach followed during risk assessment is to use all the evidence obtained about the client and its environment to
Identify risks. Relate the identify risks to what can go wrong at the relevant assertion level. Consider whether the risks are of a magnitude that could result in a material misstatement. Consider the likelihood that the risk could result in a material misstatement.
To obtain the understanding of the entity and its environment, auditors perform risk assessment procedures, which include
Inquiries of management and others within the entity. Analytical procedures. Observation and inspection relating to client activities, operations, documents, reports, and premises. Other procedures such as inquiries of others outside the company and reviewing information from external resources.
(6) form an opinion and issue the audit report
Public company reporting on large public companies require reporting on internal control and on the financial statements. Nonpublic company reporting ordinarily involves only reporting on the financial statements.
Predictability of auditing procedures..
The auditors may incorporate an added element of unpredictability in the selection of auditing procedures. As examples, they may use differing sampling techniques, adjusting the timing of testing from what otherwise would be expected, or perform procedures at locations on an unannounced basis.
assigning personnel and supervision
The auditors may respond by assigning additional staff with specialized skill and knowledge or by assigning more experienced staff to the engagement.
professional skepticism and audit evidence=>
The auditors may respond by designing procedures to obtain more reliable evidence in support of specific financial statement items or by obtaining additional corroboration of management's explanations or representations concerning material matters, such as third party confirmation, the use of a specialist, or examination of documentation from independent sources.
The direct rate is then increased for overhead costs and
a profit element. In additional to standard per diem or per hour fees, clients are charged for direct costs incurred by the public accounting firm.
Determining the proper valuation of assets requires
a thorough knowledge of generally accepted accounting principles. The auditors should not only establish that the accounting method used to value a particular asset is generally accepted, but also determine that the method valuation is appropriate and properly applied in the circumstances.
The auditors' selection of further audit procedures is based on the materiality of the
account balances, transactions, and disclosures being audited and the assessed risks of material misstatements.
The Sarbanes-Oxley act of 2002 provides that audit committee members should not receive any consulting,
advisory, or other compensatory fee from the company, or be affiliated with the company. At Least one must be financial expert.
Obtaining an understanding of the nature of internal control is
an essential part of this process because it allows auditors identify accounts and classes of transactions that may be misstated and to tailor audit procedures to the existing internal control system.
The predecessor auditors are
an excellent source of information about the prospective client, in many circumstances this communication will occur before a formal proposal is presented to a prospective client.
Risk assessment procedures
are used to gather information and include researching the characteristics of the client's industry, inquiries of management, analytical procedures, observation and inspection, and other procedures.
(3) inherent risk is the risk of misstatement of an
assertion without considering internal control.
When the auditors are testing the completeness of assets, they are looking for
assets that have been acquired but not recorded in the accounting records.
An audit committee must be composed of
at least three independent directors- that is, outside directors(niethier officers nor employees) who have no other relationship that might impair their independence.
Auditors consider materiality both in planning the audit and in evaluating audit findings. In planning the audit,
auditors use materiality as an input into determining the proper scope of audit procedures to obtain reasonable assurance of detecting material misstatements in the financial statements.
For public companies, there is another source of information available for investigating a change in
auditors. Regulations of the SEC require companies subject to its jurisdiction to file a Form 8-K reporting changes in independent auditors and the reasons therefore.
Materiality is
basic to financial statement auditing because an audit is performed to obtain reasonable assurance about whether the financial statements are free of material misstatement.
Some test of controls provide substantive evidence about an account ot class of transactions. These procedures are referred to as dual-purpose procedures(tests)
because they serve as both a test of controls and a substantive test of the details of the transactions that occurred during the year.
Potential successor auditors should attempt to communicate with the predecessor auditors
before accepting the engagement.
Many inherent risk arise because of
business risks faced by management, including the possibility of material misstatement due to fraud.
Arrangements for the audit should be made through
contact with the company's audit committee.
Audit planning, auditors use a risk-based approach in which they are
continually considering the possibility of material financial statement misstatements.
When assets are in the custody of others, such as cash in banks and inventory on consignment, the appropriate audit procedure may br
direct confirmation with the outside party. The existence of accounts receivable normally is verified by confirming with customers the amount receivable.
Each public accounting firm develops a per hour or per diem fee schedule for
each category of audit staff, based on direct salaries and such related costs as payroll taxes and benefits.
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. This overall risk is often referred to as
engagement risk.
The systems portion of the audit plan includes tests of controls over transactions. The evidence obtained from these tests may be of two types: evidence about the effectiveness of controls and
evidence that substantiates the recorded amount of the transactions
The other characteristics of the client's industry that auditors consider include
factors such as economic conditions and financial trends, governmental regulations, changes in technology, and widely used accounting methods.
Ability to do satisfactory work when given abundant time is not a sufficient qualification,
for time is never abundant in public accounting.
Relevant assertion is one that
has a reasonable possibility of containing a material misstatement(without regard to controls over it).
The CPAs should investigate the history of the prospective client,
including such matters as the identities and reputations of the directors, officers, and major stockholders.
To obtain the audit, the auditors may be asked to submit a competitive proposal that will include
information on the nature of services that the firm offers, the qualifications of the firm's personnel, anticipated fees, and other information to convince the prospective client to select the firm.
The first step in substantiating an asset is to verify the existence of the asset. For assets such as cash on hand, marketable securities, and inventories, existence of the asset usually may be verified by physical observation or
inspection, and by vouching from the recorded entry to the source documents created when the assets were required.
The period before the balance sheet date is termed the
interim period.
Performance Materiality
introduced to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected immaterial misstatements in the financial statements would exceed overall financial statement materiality.
Analytical procedures
involve comparisons of financial statement balances and ratios for the period under the audit with auditor expectations developed from sources such as the client's prior years' financial statements, published industry statistics, and budgets.
A transaction cycle or class of transactions,
is the sequence of procedures applied by the client in processing a particular type of recurring transaction.
WHen the engagement letter is accepted by the authorized client official,
it presents an executory contract between the auditor and the client.
In a manual accounting system, this audit trail consists of source documents,
journal entries and ledger entries.
Designing further audit procedures is a critical process that involves complex judgement to
link specific audit procedures with the assessed risks at the relevant assertion level. When designing further audit procedures, auditors consider the nature, timing, and extent of appropriate procedures.
2. Auditors should gather sufficient background information to assess the risks of
material misstatement of the financial statements and to design the nature, timing, and extent of further audit procedures.
Staff time is the basic unit of
measurement for audit fees.
(5)The auditors perform a number of procedures
near the time of completion of the audit. Include completing the search for unrecorded libabilities, completing the review of minutes of meetings, performing final analytical procedures, completing the search to identify loss contingencies and subsequent events, and obtaining a representation letter from management.
Significant risks often relate to
nonroutine transactions and estimation transactions. A significant risk for a particular audit may arise from a fraud risk.
The auditors may use the statement of cash flows while
obtaining an understanding of the client, particularly as a part of risk assessment analytical procedures.
Audit procedures in the systems portion of the plan 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.
Because auditors are ethically prohibited from disclosing confidential client information without the client's consent, the successor auditors must ask management
of the prospective client to authorize the predecessor auditors to respond fully to the successor's inquiries.
The auditors' understanding of the nature of the client will include the client's competitive position,
organizational structure, governance process, accounting policies and procedures, ownership, capital structure, and product lines.
Plant and equipment, physical examination establishes existence but not
ownership. Plant and equipment may be rented or leased rather than owned. To verify the client's rights to plant assets, the auditors should inspect documentary evidence such as property tax bills, purchase documents, and deeds.
Test of a control measures the effectiveness of a
particular control in preventing or detecting a misstatement; it does not substantiate the dollar amount of an account balance.
the audit plan includes the audit risk assessment procedures and
planned further audit procedures.
Two major portions of these procedures are procedures to obtain an understanding and assess the effectiveness of the client's internal control(the "systems portion") and
procedures aimed directly at financial statement account balances (the "substantive portion")
The term cutoff refers to the
process of determining that transactions occurring near the balance sheet date are assigned to the proper accounting period.
In response to fraud risks, the auditors may modify their overall approach to the audit in one or more of the following ways:
professional skepticism and audit evidence assigning personnel and supervision accounting principles predictability of auditing procedures
Effective internal control provides assurance that acquisitions are
recorded and helps the auditors to establish the completeness of recorded assets. When such controls are found to be ineffective, the scope of substantive procedures should be increased, but this is often a difficult task,
Most risks of misstatement relate to one or a few relevant assertions that
relate to one or more significant accounts or disclosures
Planning includes the analytical and other procedures to be applied as
risk assessment procedures, the level of materiality, and the likely need for specialists.
While assessing risks, the auditors should determine which of the identified risks require special audit consideration. Such risks are referred to as
significant risks.
The concept of an audit committee does not apply to businesses organized as
sole proprietorships; partnerships; and small, closely held corporations.
The concept of materiality recognizes that
some matters are important to the fair representation of financial statements, while others are not.
These further audit procedures include substantive procedures for all relevant assertions and, if, needed
test controls.
(4) Further audit procedures include a combination of additional
test of controls and substantive procedures relating to account balances, transactions, and disclosures.
Estimating a fee for an audit involves
the application of the CPA firm's daily or hourly rates to the estimated time required.
Accounting principles
the auditors may decide to further consider management's selection and application of significant accounting principles, particularly those related to subject measurements and complex transactions.
To verify the client's cutoff of transactions,
the auditors should review transactions recorded shortly before and after the balance sheet date to ascertain that these transactions are assigned to the proper period.
In evaluating audit findings,
the auditors use materiality to evaluate whether identified uncorrected misstatement(plus an allowance for undetected misstatements) are material to the financial statements.
Most audit firms organize much of the substantive portion of their audit plans around
the balance sheet accounts.
As a party of the auditors' procedures for establishing completeness as well as existence of recorded assets, the auditors will verify
the client's cutoff of transactions included in the period.
1. Planning the audit. Audit planning begins with determining the requirements for the engagement, including
the financial statements to be audited, any other requirements, and the timing of the engagement
An understanding of the client and its environment encompasses
the nature of the client, including the client's application of accounting policies. The industry, regulatory, and other external factors affecting the client. The client's objectives and strategies and related business risk. Methods used by the client to measure and review performance. The client's internal control.
Vouching
the process of working backward from the financial statement figures the details to the detailed documents, provides evidence that financial statement figures are based upon valid transactions; it tests the existence or occurrence assertion.
In the first audit of the client, the auditors should obtain sufficient appropriate evidence about whether the opening balances for
the various accounts contain misstatements that materially affect the current period's financial statement.
when the auditors have obtained a sufficient understanding of the client,
they establish an overall audit strategy that considers those characteristics of the audit that determine its scope, such as industry reporting requirements, client locations, and the basis of reporting followed by the client.
Test controls are needed
when the auditors' risk assessment includes an expectation that controls are operating effectively, or when substantive procedures alone do not provide sufficient appropriate audit evidence.
Audits are designed to identify materially misstated financial statement,
whether caused by one or more individual material misstatements, or by a combination of individually immaterial misstatement.
tolerable misstatement
which may be viewed as the application of performance materiality to a particular audit procedure. May be the same amount or lower than performance materiality depending upon the audit sampling technique being used and the number of audit procedures affecting the relevant assertions.