Audit: Topic 4
reasonable assurance
- A measure of the level of the auditor's certainty - Reasonable assurance is high, but not absolute, assurance - Auditors do not guarantee correctness - Auditing standards indicate reasonable assurance is a high, but not absolute, level of assurance that the financial statements are free of material misstatements. - The concept of reasonable, but not absolute, assurance indicates that the auditor is not an insurer or guarantor of the correctness of the financial statements. > Thus, an audit that is conducted in accordance with auditing standards may fail to detect a material misstatement. - If auditors were responsible for making certain that all the assertions in the statements were correct, the types and amounts of evidence required and the resulting cost of the audit function would increase to such an extent that audits would not be economically practical. > Even then, auditors would be unlikely to uncover all material misstatements in every audit.
Accuracy, valuation, and allocation
- Accuracy > Inventory quantities on the client's perpetual records agree with items physically on hand. > Prices used to value inventories are materially correct. > Extensions of price times quantity are correct and details are correctly added. - Cutoff > Inventory footnote disclosures are appropriately measured and described. > Purchase cutoff at year end is proper. - Detail tie-in > Sales cutoff at year end is proper. - Realizable value > Total of inventory items agrees with general ledger. > Inventories have been written down where net realizable value is impaired.
Completeness
- All transactions and accounts that should be presented in the financial statements are so included. - Ex: there are no unrecorded receivables - Existing sales transactions are recorded. - All sales disclosures required by GAAP are included in the financial statements. - All existing inventory has been counted and included in the inventory summary. - All inventory disclosures required by accounting standards are included in the financial statements.
International auditing standards and AICPA auditing standards further divide management assertions into two categories:
- Assertions about classes of transactions and events and related disclosures for the period under audit - Assertions about account balances and related disclosures at period end
Occurrence or existence
- Assets or liabilities of the public company exist at a given date, and recorded transactions have occurred during the period. - All recorded inventory exists at the balance sheet date. - Recorded sales are for shipments made to nonfictitious customers.
Evaluation and allocation
- Assets, liability, equity, revenue, and expense components have been included in the financial statements at appropriate amounts. - Ex: Uncollectible accounts have been provided for. - Ex: Receivables that have become uncollectible have been written off. - Ex: The total of the amounts on the accounts receivable listing agrees with the general ledger balance for accounts receivable. - Ex: Sales cutoff at year end is proper.
Assertions lead to audit objectives
- Auditor may use different terms to express the management assertion > They should consider the relevance of each assertion for each significant class of transactions and account balance - Relevant assertions have a meaningful bearing on whether the account is fairly stated and are used to assess the risk of material misstatement and the design and performance of audit procedures
Auditor's responsibilities for detecting material errors and fraud:
- Auditors generally focus on planning and performing audits to detect unintentional errors made by management and employees - Auditing standards make no distinction between the auditor's responsibilities for detecting errors vs fraud - Key difference: The standards do recognize that fraud is more difficult to detect because those who are committing the fraud attempt to conceal the fraud
setting audit objectives: Efficient audits require auditors to obtain a combination of assurance related to:
- Classes of transactions - Ending balances in the related accounts > This process requires auditors to develop general audit objectives to meet the above requirements, which are later developed into specific audit objectives and audit procedures. > These audit objectives are aligned with management's assertions about the transactions, accounts, and disclosures
For each management assertion, there are related audit objectives
- General transaction-related - Specific transaction-related
classification
- Inventory items are properly classified as to raw materials, work in process, and finished goods. - Sales transactions are properly classified.
Distinguish between management's and the auditor's responsibility for the financial statements being audited.
- It is management's responsibility to maintain adequate internal control and make fair representations in the financial statements. The auditor's responsibility is to report the findings of the audit in the auditor's report. - It is management's responsibility to adopt sound accounting policies. The auditor's responsibility is to conduct an audit of the financial statements in accordance with accounting standards.
management assertions
- Management assertions are implied or expressed representations by management about classes of transactions and the related accounts and disclosed in the financial statements - Assertions by management are directly related to the financial reporting framework (US GAAP or IFRS) that format the criteria that management used to record and disclose accounting information in the financial statements - Management assertions lead to the audit objectives
how are responsibilities expressed through certifications (for public companies) and audit reports
- Management owns the financial statements > In public companies, the CEO and CFO (management) have to certify financial statements, not in private companies - The auditor owns their audit opinion
What do the standard mean by "free from material misstatement"
- Misstatements are usually considered material if the combined uncorrected errors/fraud in the financial statement would likely have changed or influence the decisions of a reasonable person using the statements - Management doesn't know the materiality number, only the auditor does
Do you believe the CEO and CFO of a public company perceive an even greater responsibility as a result of the Sarbanes-Oxley Act requirement to certify the financial statements submitted to the SEC?
- Requiring the CEO and CFO of a public company to personally certify and provide assurance on the financial statements and internal controls is likely to result in them taking their responsibility more seriously and taking additional precautions to gain comfort with the fairness of the representations. - The Sarbanes-Oxley Act can impose criminal penalties, including significant monetary fines or imprisonment for up to 20 years for anyone who knowingly falsely certifies those statements.
R7: Collingwood
- Talking about quarterly reports - The importance of earnings to investors and why they rely on these earnings to make decisions
Presentation and disclosure
- The components of the financial statements are properly classified, described, and disclosed. - Ex: Accounts receivable are appropriately aggregated and clearly described in the financial statements.
Rights and obligations
- The public company holds or controls rights to the assets, and liabilities are obligations of the company at a given date. - The company has title to all inventory items listed. - Inventories are not pledged as collateral.
Describe why the auditor generally divides the audit into financial statement cycles/segments.
- To make it easier to audit the financial statements; the auditor needs to break the FS down into manageable parts - Ex: Revenue cycle, purchases and payables cycle (DO NOT need to know the different types of cycles though) - Divides classes of transactions and account balances into smaller more manageable pieces - Focused on those that are closely related - Places these related classes/accounts into segments ("cycles")
responsibilities of management
- financial statements and internal controls - SOX increases management's responsibility for the financial statements - CEO and CFO must certify quarterly and annual financial statements submitted to the SEC - Many public companies include a statement regarding management responsibility in relation to the CPA firm. - The responsibility for adopting sound accounting policies, maintaining adequate internal control, and making fair representations in the financial statements rests with management rather than with the auditor.
The responsibilities of the independent auditor in the audit of financial statements include the following:
- have the abilities expected of a qualified person in the auditing profession. - express an opinion on the financial statements - exercise informed judgment during the selection of procedures used in the audit and in arriving at an opinion - conduct an audit that conforms to auditing standards
responsibilities of the auditor
- obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are presented fairly, in all material respects, in accordance with an applicable financial reporting framework; and - report on the financial statements, and communicate as required by auditing standards, in accordance with the auditor's findings. - Auditors spend a great portion of their time planning and performing audits to detect unintentional mistakes made by management and employees.
cutoff
- timing - Sales transactions are recorded on the correct dates.
5 primary PCAOB assertions
1. Occurrence or existence 2. Completeness 3. Rights and obligations 4. Evaluation and allocation 5. Presentation and disclosure
Discuss the concept of "reasonable assurance" and the degree of confidence that financial statement users should have in the financial statements.
Auditing standards indicate that reasonable assurance is a high level of assurance. Accordingly, financial statement users should have a high degree of confidence in the financial statements. However, reasonable assurance is not a/an absolute level of assurance, and there is at least some risk that the audited financial statements may include material misstatements.
Which of the following best describes the reason why an independent auditor reports on financial statements?
Different interests may exist between the company preparing the statements and the persons using the statements.
State the effect on the financial statements (overstatement or understatement) of a violation of each in the audit of accounts receivable.
In the audit of accounts receivable, a nonexistent account receivable will lead to an overstatement of the accounts receivable balance. A violation of completeness occurs when a failure to include a customer's account balance will lead to an understatement of the accounts receivable balance.
presentation
Inventory is properly aggregated and costing method is clearly described in the financial statements.
Discuss the differences between misappropriation of assets and fraudulent financial reporting on the fair presentation of the financial statements.
Misappropriation of assets ordinarily occurs because of inadequate or overridden internal controls. In many cases, the dollar amounts are often small, and thus will have no effect on the fair presentation of financial statements. Fraudulent financial reporting is difficult to uncover because it is possible for management to override internal controls. In many cases, the amounts are extremely large and may affect the fair presentation of financial statements.
material vs immaterial misstatements
Misstatements are usually considered material if the combined uncorrected errors and fraud in the financial statements would likely have changed or influenced the decisions of a reasonable person using the statements
Distinguish between the existence and completeness balance-related audit objectives.
The existence objective deals with whether amounts included in the financial statements should actually be included. The completeness objective deals with whether all amounts that should be included have actually been included.
What is fraudulent financial reporting?
The intentional misstatement of financial information by management or a theft of assets by management, which is covered up by misstating financial statements.
Identify the management assertion and general balance-related audit objective for the specific balance-related audit objective: All recorded fixed assets exist at the balance sheet date.
The management assertion and the general balance-related audit objective are both existence.
Distinguish between fraudulent financial reporting and misappropriation of assets
The theft of assets by employees.
State the objective of the audit of financial statements. In general terms, how do auditors meet that objective?
The auditor's objective of the audit of the financial statements is the expression of an opinion on the fairness of the financial position, results of operations, and cash flows in conformity with applicable accounting standards. The auditor meets that objective by accumulating sufficient appropriate evidence to determine whether management's assertions regarding the financial statements are fairly stated.
An auditor will most likely review an entity's periodic accounting for the numerical sequence of shipping documents to ensure all documents are included to support management's assertion about classes of transactions of
completeness
In the audit of accounts payable, an auditor's procedures will most likely focus primarily on management's assertion about account balances of
completeness.
For the Accounts Receivable account balance, which assertion is likely to be assessed as higher risk?
existence
The major reason an independent auditor gathers audit evidence is to
form an opinion on the financial statements.
Because of the risk of material misstatement, an audit should be planned and performed with an attitude of
professional skepticism.
Identify the two broad categories of management assertions.
(1) Assertions about classes of transactions and events and related disclosures (2) assertions about account balances and related disclosures.
Describe management's responsibility for the financial statements.
Management's responsibility is to adopt sound accounting policies, maintain adequate internal control, and make fair representations in the financial statements.
An auditor reviews aged accounts receivable to assess likelihood of collection to support management's assertion about account balances of
accuracy, valuation, and allocation.
Distinguish between the terms errors and fraud. What is the auditor's responsibility for finding each?
An error is an unintentional misstatement of the financial statements. Fraud represents an intentional misstatement. The auditor is responsible for obtaining reasonable assurance that material misstatements in the financial statements are detected, whether those misstatements are due to errors or fraud.
