Midterm 2 Ch 6 Audit

Overall Phases of the Audit

1. Plan and Design the Audit

2. Perform tests of internal control effectiveness (determine whether reducing the planned control risk over a particular account can be justified)

3. Perform tests of year end balances (analytical procedures and test of details of balances)

4. Complete the Audit and issue the audit report (Draw conclusions on whether FS are fairly presented then issue)

Steps of Plan and Design Phase of Audit

1. Auditor must balance collecting enough evidence with cost of collecting evidence

2. Obtain a through understanding of the client’s business and industry

3. Obtain an understanding of the client’s I/C (required by auditing standards) and assess control risk

4. Assess the risk of material misstatement in the financial statements (use to decide whether to focus on particular accounts & cycles)

Control risk

The risk that errors/irregularities will occur and not be detected on a timely basis

• High CR means bad I/C, low CR means good I/C

• If CR is low, then auditor further tests I/Cs to hopefully reduce YE testing

Steps of perform tests of internal control effectiveness

1. Test of internal controls: if auditor can rely on the I/C for certain accounts/cycles, then the auditor can reduce the amount of Y/E account balance testing

2. Substantive test of transactions: verify the dollar amounts of transactions (ex. tests whether 2 month's ending balances in cash receipts are posted to the general ledger)

Steps to perform tests of year end balance (field work)

1. Analytical procedures: Use comparisons and relationships with prior years and similar companies in the industry to see if balances appear reasonable (ex. compare inv turnover to see whether inv appears to be building)

2. Tests of account balances: Typically focus on trial balances (ex. confirm cash balances with bank)

Overview of financial statement/audit process

1. FS: Ultimately this is what the audit report covers. F/S created from trial balance

2. Trial Balances/FS cycles: Auditor selects accounts and cycles to audit, using prior experience, materiality, fluctuations, etc. as a guide to selection

3. Management Assertions: Implied criteria used to record/disclose information

4. Specific Audit Procedures: Designed to ensure the auditor has considered all management assertions. Different types of procedures are used depending on type of account involved

Management Assertions

• Implied criteria that management uses to record and disclose information in the F/S.

• Auditors use these assertions to design audit procedures.

• Management assertions are classified into two categories: Classes of transactions (I/S) and Year end balances (B/S)

6 Classes of Transactions (Management Assertions)

1. Occurrence: Whether recorded transactions included in the F/S actually occurred during the accounting period (Concerned with account overstatement)

2. Completeness: All transactions/accounts that should be included in the F/S are included (Concerned with understatement)

3. Accuracy: Address whether transactions have been recorded at the correct amounts

4. Classification: Address whether transactions have been recorded in the appropriate accounts

5. Cutoff: Address whether transactions are recorded in the right accounting period

6. Presentation/Disclosure: Whether amounts are appropriately aggregated/disaggregated, described, relevant, and understandable

6 Year end account balances (Management Assertions)

1. Existence: Whether recorded amounts included in FS actually existed during the accounting period (concern with items that shouldn’t be in FS; account overstatement)

2. Completeness: All accounts that should be in FS are included (concern with leaving something out of FS; account understatement)

3. Valuation/allocation/accuracy: Whether accounts are included in FS at appropriate amounts

4. Classification: Address whether transactions are recorded in the appropriate accounts

5. Rights and obligations: Whether assets are actually the rights of the entity and liabilities are truly obligations of the entity

6. Presentation/disclosure: Whether amounts are appropriately aggregated/disaggregated, described, relevant, and understandable

The auditor’s responsibilities over material errors and fraud (SAS 99)

• Reasonable assurance that material misstatements have not occurred (Misstatements are considered material if the combined statements likely have changed the decision of reasonable F/S user)

• An error is an unintentional misstatement of the financial statements, while fraud is intentional misstatement. No distinction between the two

• More common with non profit

2 differences between fraudulent financial reporting and misappropriation of assets

• Misappropriation of assets (Asset theft): Internal controls can stop some of this, usually committed by employees & benefits one person. Creditors/shareholders are harmed because assets are no longer available

• Fraudulent financial reporting (FS Fraud): ICs are often irrelevant because of the collusion with multiple people. Usually committed by management.

• FS users are harmed because info in decision making is wrong

• More common with for profit

Noncompliance with laws and regulations (Illegal acts)

• Auditor’s responsibilities depend on whether the laws or regulations are expected to have a direct effect on the FS and disclosures

• Direct effects: auditors should obtain sufficient appropriate evidence regarding amounts and disclosures that are directly affected

• Indirect effects: Auditor is responsible for 1. Inquiry of management about whether they are in compliance 2. Inspect correspondence with relevant regulatory authorities

The two most common techniques used by management to misstate financial statement information

1. Improper revenue recognition

2. Overstatement of assets

Earnings Management

The deliberate manipulation of accounts/transactions with the goal of changing net income