Audit CH 5
Detection risk is 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.
Right and obligations
the company holds rights to the assets, liabilities are the obligations of the company.
Substantive procedures include
Analytical procedures and tests of details.
Risk Assessment Procedures
Are designed to obtain an understanding of the client and its environment, including its internal control, to assess the risks of material misstatement
Every audit client generates internal financial information that may be used in
performing analytical procedures.
Audit risk
refers to the possibility that the auditors may unknowingly fail to appropriately their opinion on financial statements that are materially misstated.
A sophisticated expectation development technique using statistical models to quantify auditor expectation is
regression analysis.
Relevance
relates to the assertion being addressed.
Scanning is a type of
analytical procedure in which auditors use professional judgement to review accounting data to identify significant or unusual items for testing.
substantive procedures
are designed to detect material misstatements of relevant assertions. Include (a) analytical procedures, (b) test of details of account balances, transactions, and disclosures.
Inherent risk x control risk x detection risk =
audit risk
In assessing inherent risk, it is often useful to segregate transactions into three types:
routine, nonroutine, and estimation.
Examples of routine transactions
sales, purchases, cash disbursements, cash receipts, and payroll transactions. These restrict inherent risk, although controls certainly must be implemented to assure proper recording.
Audit procedures may be performed before the client's year-end or
subsequent to year-end. Performing procedures from an interim date increases audit risk because material misstatements may arise in the remaining period between the date of the test and year-end.
Both the AICPA and the PCAOB require auditors to obtain a representation letter on every engagement and provide
suggestions as to its form and content. These letters are dated as of the date of the auditors' report and usually are signed by both the client's chief executive officer and chief financial officer.
At the conclusion of the audit, the CPAs obtain from client officers a written representation letter
summarizing the most important oral representations made by management during the engagement.
Most documents created with the client organization represent a lower quality evidence
than a processed check because they circulate only within the company and do not receive the critical review of an outsider.
cutoff
the process of determining that transactions occurring near the balance sheet date are assigned to the proper accounting period.
It is important to realize that while auditors gather evidence to assess inherent risk and control risk,
they gather evidence to restrict detection risk to appropriate level.
When confirmations are mailed,
to obtain assurance that the confirmation reply comes directly to the auditors and not to the client, the auditors will enclose with the confirmation request a return envelope addressed to the auditors' office.
It is the risk that he auditors will issue an
unmodified(unqualified opinion on financial statements that contain a material departure from generally accepted accounting principles.
A common-size balance sheet presents all assets, liabilities, and owner's equity amounts as a percentage of total assets. The development of common-size financial statements is also known as
vertical analysis.
Observations involves
watching a process or procedure being performed by others.
Audit documentation, also knows as
working papers or workpapers, is the record of the audit procedures performed, relevant audit evidence obtained, and the conclusions the auditors reach. May be recorded on paper or on electronic or other media.
A client representation letter should never
be used as a substitute for performing other audit procedures.
Ratio analysis involves comparisons of relationships between two or more
financial statement accounts, or comparisons of account balances to nonfinancial data(e.g revenue per sales order)
The proffessional standards require a period of not less than
five years, while the Sarbanes-Oxley act of 2002 requires that auditors maintain documentation for seven years. Public=7, nonpublic=5
There are two basic approaches to ratio analysis:
horizontal analysis and cross section analysis.
The audit file
includes the working papers for a particular engagement and is the principal record of the work performed during the audit.
Both inherent risk and control risk exist
independently of the audit of financial statements. That is, the risk of material misstatement exists regardless of whether an audit is performed. The auditor may make separate assessments of the two risks or an overall assessment of the risk of material misstatement for the relevant assertion.
Related parties refers to
individuals or entities who may have dealings with the client in which one party is significantly influenced by the other such that it may not pursue its separate interests.
Audit evidence in paper or electronic form that is obtained through
inspection of records and documents is referred to as documentary evidence and includes examination of a variety of records supporting the company's business and accounting information system such as checks, invoices, contracts, and minutes of meetings.
Appropriateness
is the measure of the quality of that audit evidence. Auditors' consider both its relevance and its reliability in providing support for, or detecting misstatements in, financial statement assertions.
control risk
is 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.
When available, the most reliable single piece of documentary evidence created within the client's organization is a
paid check.
Helping the auditors identify items that indicate a heightened risk of material misstatement of the financial statements is the objective of analytical procedures ___.
performed at the risk assessment stage.
AICPA AU-C 230 requires that audit documentation provide
(1) evidence of the auditors' basis for concluding on the achievement of the audit's overall objectives (2) evidence that the audit was planned and performed in accordance with GAAS.
Test of details may be divided into three types:
(1) test of account balances, =>address whether there are misstatements in the ending balance of an account. (2) test of classes of transactions => address whether particular types of transactions are valid and have been properly accounted for during the period. (3) test of disclosures =>whether financial statement disclosures are properly presented.
Substantive procedures of two general types are preformed:
(1) tests of details of balances, transactions, and disclosures and (2) substantive analytical procedures.
The quantity needed is affected by the risk of misstatements
(the greater the risk the more audit evidence required) and also the reliability of the evidence.
Inspection of tangible assets by the auditors ordinarily provides the
best evidence of the existence of the assets.
Completeness
All assets, liabilities, equity interests, and transactions that should have been recorded have been recorded.
Audit working papers are the property of the
auditors, not of the client. At no time does the client have the right to demand access to the auditors' working papers. After the audit, the working papers are retained by the auditors.
Detection risk
is the risk that the auditors' procedures will not detect a material misstatement that exists in a relevant assertion. Is a function of the effectiveness if the audit procedures and their application by the auditors.
Audit working papers take the form of bank reconciliations or analyses of ledger accounts;
others may consist of copies of minutes of directors' meetings; still others might be organization charts or flowcharts of the client's internal control.
For each of the major financial statement componenets
(1) account balances (2) classes of transactions and events occuring during the period under the audit(transactions) (3) presentations and disclosures (disclosures)-management may be viewed as implicitly or explicitly making assertions regarding the propriety of the information.
The auditors usually maintain two files of working papers for each client:
(1) current files for every completed audit (2) a permanent file of relatively unchanging data.
Representations fall under :
1. All accounting records, financial data, and minutes of directors' meetings have been made available to the auditors. 2. The financial statements are complete and were prepared in conformity with generally accepted principles. 3. Management believes that the adjusting entries brought to its attention by the auditors and not recorded are not material 4. Management acknowledges its responsibility to design and implement programs and controls to prevent and detect fraud and to disclose information to the auditors on alleged or suspect fraud. 5. All items requiring disclosure(such as loss contingencies, noncompliance with laws and regulations and related party transactions) have been properly disclosed.
Business characteristics such as the following are indicative of high inherent risk:
Consistent profitability of the client relative to other firm in the industry, Operating results that are highly sensitive to economic factors, Going concern problems, Large known and likely misstatements detected in prior audits, Substantial turnover, questionable reputation, or inadequate accounting skills of management.
How detailed should documentation be?
This depends on several factors, such as the nature of the auditing procedure being performed, the risk of misstatement involved in the area being tested, the significance of the evidence to the overall audit, the extent of judgment involved while performing the work, and the nature of the findings or results.
Cutoff
Transactions and events have been recorded in the correct accounting period.
Inherent risk also varies by the nature of the
account.
Even if the transactions are recorded appropriately, the auditors also must be concerned that material related party transactions are
adequately disclosed in the client's financial statements or the related notes.
NO information may be discarded from the working papers after the
documentation completion date.
The degree of reliance to be placed on
documents created and used only within the organization depends on the effectiveness of the internal control.
Factors that affect inherent risk relate to :
either the nature of the client and its environment or the nature of the particular financial statement element.
During an audit, client oral inquiries ___.
may be made of both officers and employees.
When obtaining audit evidence, inquires of knowledgeable persons ___.
may be oral or written and may result in oral or written replies.
The paid check (or its electronically processed copy)
may be viewed as evidence that an asset was acquired at a given cost, or as proof that a liability was paid or an expense incurred.
After the close of this 60 day period, referred to as document completion date,
no information may be discarded from the audit working papers.
In evaluating the appropriateness of audit evidence,
auditors consider both its relevance and its reliability.
Existence and occurance
Assets, liabilities, and equity interest exist and recorded transactions and events occured,
Traditional financial ratios typically are classified into 4 categories:
1. Liquidity ratios, such as the current ratio and the quick ratio. 2. Leverage ratios, such as debt to equity ratio and the long-term debt to equity ratio, 3. Profitability ratios, such as gross profit percentage and return on total assets. 4. Activity ratios, such as inventory turnover and accounts receivable turnover.
Types of procedures
1. Risk assessment procedures 2. Test of controls 3. Substantive procedures
the permanent file serves three 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 3. to preserve working papers on items that show relatively few or no changes, thus eliminating the necessity for their preparation year after year.
Test of Controls
are designed to test the operating effectiveness of controls in preventing or detecting material misstatements.
Throughout the audit, the auditors accumulate the misstatements identified(other than those regarded as clearly trivial) and propose appropriate
adjusting journal entries(AJE)
memoranda of the planning process and significant discussions with the client management are also considered
administrative working papers.
To conduct a satisfactory audit, the auditors must be given unrestricted access to
all information about the client's business.
In addition, the auditors develop reclassification journal entries(RJEs) for items that,
although correctly recorded in the accounting records, must be reclassified for fair presentation in the client's financial statements.
Calculating days sales in ending accounts receivable and comparing it to the prior year would be an example of
analytical procedure.
Financial reports of prior years, forecasts, production reports and monthly performance reports are
but a few data sources that may be expected to bear predictable relationships to financial statement amounts.
Examples of internally created documents that do not leave the client's possession are
client copies of sales invoices, shipping notices, purchase orders, receiving reports, and credit memoranda.
Auditors are given 60 days after the audit report release date (the date the client is granted permission to use the report) to
complete the audit file by assembling a complete and final set of audit documentation.
Analytical procedures involve
evaluations of financial statement information by a study of relationships among financial and nonfinancial data.
Confirmations generally are effective at providing evidence about the assertion of
existence of accounts, but they are less effective at addressing completeness and appropriate valuation.
Inspection provides high-quality evidence as to the
existence of certain assets, but generally it needs to be supplemented by other types of evidence to determine the ownership, proper valuation, and condition of those assets.
Audit documentation should be sufficient to allow an
experienced auditor to understand the audit work performed, the evidence obtained, and the significant conclusions reached.
nonroutine transactions
involve activities that occur periodically, such as the taking of physical inventory, calculating depreciation expense and adjusting financial statements for foreign currency gains and losses. Inherent risk may be HIGH.
Routine transactions
involve recurring financial statement activities recorded in the accounting records in the normal course of business
Analytical Procedures
involve the comparisons of relationships among financial and sometimes nonfinancial data.
According to the professional standards, audit documentation should be retained for
not less than five years,
The reliability of evidence is dependent on the circumstances in which it is
obtained.
A basic premise underlying the application of analytical procedures is that
plausible relationships among data may reasonably be expected to exist and continue in the absence of known conditions to the contrary.
The term sufficient relates to the
quantity of evidence that the auditors obtain.
Separate lead schedules(also called grouping sheets or summary schedules) are
set up to combine similar general ledger accounts, the total of which papers on the working trial balance as a single amount..
Detection risk exists because
the auditors' substantive procedures are not 100% effective, due to both sampling and other factors.
estimation transactions
which are the activities that create accounting estimates. Have the highest level of inherent risk. Ex: allowance for doubtful accounts
Audit evidence gathered from oral or written inquiries made by the auditor can include ___.
written representations from outside parties, oral representations from company personnel, written representations from company personnel.
Types of working papers
1. Audit administrative working papers 2. Working trial balance and Lead schedules 4. Adjusting journal entries and reclassification entries 5. Supporting schedules 6. Analysis of a ledger account 7. Reconciliations 8. Computational working papers 9. Corroborating documents
The auditors perform a variety of audit procedures to obtain audit evidence, including
1. Inspection of records and documents. 2. Inquiry of knowledgeable persons within the outside the entity. 3. External confirmation. 4. Inspection of tangible assets. 5. Observation of processes or procedures being performed by others. 6. Recalculation of mathematical accuracy 7. Reperformance of procedures. 8. Analytical procedures.
Valuation, allocation, and accuracy.
All transactions, assets, liabilities, and equity interests are included in the financial statements at proper amounts.
cross-sectional analysis
involves comparisons with similar firms at a point in time, often comparing the client's ratios to industry averages.
Regression analysis
involves the use of statistical models to quantify the auditors' expectation about the financial statement amount or ratio.
Sufficiency
is a measure of the quantity of audit evidence that should be obtained.
When an unresolved difference of opinion arises ___.
the opinion of the partner-in-charge will prevail in the audit report, all members of the audit team have the right to document the disagreement in the working papers.
Reperformance involve the auditors independently performing
procedures or activities that were originally performed by the client, ordinarily as a part of the company's internal control.
Horizontal analysis
involves a review of client financial statement amounts and ratios over time
Audit evidence
is all the information used by the auditors in arriving at the conclusions on which the audit opinion is based. It includes the information contained in the accounting records underlying the financial statements and other information.
Inherent risk
is the possibility of material misstatement of an assertion before considering the client's internal control.
Control risk is a function of the effectiveness of both
the design and operation of internal control in achieving the clients' objectives relevant to the preparation of its financial statements.
Recalculations made independently by
the auditors to prove the arithmetical accuracy of the client's analyses and records. At a high level, this should include making certain that accounting records agree with ot can be reconciled to the financial statement. At a more detailed level, the auditors computations might consist of footing a column of figures in a sales journal or in a ledger account to prove that column total.
Management is responsible for
the fair presentation of financial statements in conformity with generally accepted accounting principles.
Audit evidence is ordinarily more reliable when it is:
1. Obtained from knowledgeable independent sources outside the client company rather than nonindependent sources. 2. Generated internally through a system of effective controls rather than ineffective controls. 3. Obtained directly by the auditors rather than indirectly or by inference 4. Documentary is form (paper or electronic) rather than in the form of an oral representation 5. Provided by original documents rather than photocopies or facsimiles.
The 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 auditor's' proposed adjustments and reclassifications and for the final amounts that will appear in the financial statements.
A working trial balance, ordinarily an electronic spreadsheet, is the backbone of the entire set of audit working papers; it is the key schedule that controls and summarizes all supporting papers.
Presentation and Disclosure
Accounts are described and classified in accordance with generally accounting principles, and financial statement disclosures are complete, appropriate and clearly expressed.
mgmt is responsible for presenting financial statements that have proper
amounts in the various accounts, including properly recorded transactions, and properly presented disclosures
