Auditing, Chapters 6-9 + 11 Definitions and Groupings

1. Understand objectives and responsibilities for the audit, 2. Divide financial statements into cycles, 3. Know management assertions about financial statements, 4. Know general audit objectives for classes of transactions, accounts, and disclosures. 5. Know specific audit objectives for classes of transactions, accounts, and disclosures.

The five steps to develop audit objectives.

Purpose of an audit, per the AICPA.

These standards indicate that the purpose of an audit is to provide financial statement users with an opinion by the auditor on whether the financial statements are presented fairly, in all material respects, in accordance with an applicable financial accounting framework, which enhances the degree of confidence that intended users can place in the financial statements.

Adopting sound accounting policies, maintaining adequate internal control, and making fair representations in the financial statements.

Management responsibilities for financial statement audits.

Obtain reasonable assurance about whether the financial statements are as a whole 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, to report on the financial statements, and communicate as required by auditing standards, in accordance with the auditor’s findings.

Auditor responsibilities for financial statement audits.

Error

An unintentional misstatement of the financial statements.

Fraud

An intentional misstatement of the financial statements.

Misappropriation of Assets

A fraud involving the theft of an entity’s assets.

Fraudulent Financial Reporting

Intentional misstatements or omissions of amounts or disclosures in financial statements to deceive users.

Professional Skepticism

An attitude of the auditor that includes a questioning mind that is alert to conditions that may indicate possible misstatement due to fraud or error and a critical assessment of audit evidence.

A questioning mind and a critical assessment of the audit evidence.

The two primary components of professional skepticism.

A questioning mindset, suspension of judgment, search for knowledge, interpersonal understanding, autonomy, and self-esteem.

The six characteristics of professional skepticism.

Questioning Mindset

A disposition to inquiry with some sense of doubt.

Suspension of Judgment

Withholding judgment until appropriate evidence is obtained.

Search for Knowledge

A desire to investigate beyond the obvious, along with the desire to corroborate.

Interpersonal Understanding

Recognition that people’s motivations and perceptions can lead them to provide biased or misleading information.

Autonomy

The self-direction, moral independence, and conviction to decide for oneself, rather than accepting the claims of others.

Self-Esteem

The self-confidence to resist persuasion and challenge assumptions or conclusions.

1. Identify and define the issue, 2. Gather the facts and information and identify the relevant literature, 3. Perform the analysis and identify potential alternatives, 4. Make the decision, 5. Review and complete the documentation and rationale for the conclusion.

The five key elements of a professional judgment process.

Availability, confirmation, overconfidence, anchoring, and automation.

The five professional judgment “traps.”

Availability

The tendency to place more weight on events or experiences that immediately come to mind or are readily available than those that are not.

Confirmation

The tendency to put more weight on information that corroborates an existing belief than information that contradicts or puts doubt on that belief.

Overconfidence

The tendency to overestimate one’s own ability to make accurate assessments of risks or other judgments or decisions.

Anchoring

The tendency to use an initial piece of information as an anchor against which subsequent information is inadequately assessed.

Automation

The tendency to favor output generated from automated systems, even when human reasoning or contradictory information raises questions about whether such output is reliable or fit for purpose.

Cycle Approach

A common way to divide an audit, where closely-related types of transactions and account balances are within the same statement.

Sales and collection cycle, acquisition and payment cycle, payroll and personnel cycle, inventory and warehousing cycle, and capital acquisition and repayment cycle.

The five most noteworthy cycles in an audit.

Seven audit objectives that must be met before the auditor can conclude that the total for any given class of transactions is fairly stated. These are occurrence, completeness, accuracy, classification, timing, posting and summarization, and presentation.

Transaction-Related Audit Objectives

Nine audit objectives that must be met before the auditor can conclude that any given account balance is fairly stated and the related disclosures are relevant and understandable. These are existence, completeness, accuracy, cutoff, detail tie-in, realizable value, classification, rights and obligations, and presentation.

Balance-Related Audit Objectives

Management Assertions

Implied or expressed representations by management about classes of transactions and the related accounts and disclosures in the financial statements.

Existence or occurrence, completeness, valuation or allocation, rights and obligations, and presentation and disclosure.

Five categories of PCAOB Management Assertions

Existence or Occurrence

Assets or liabilities of the public company exist at a given date, and recorded transactions have occurred during the period.

Completeness

All transactions and accounts that should be presented in the financial statements are so included.

Valuation or Allocation

Assets, liability, equity, revenue, and expense components have been included in the financial statements at appropriate amounts.

Rights and Obligations

The public company holds or controls rights to the assets, and liabilities are obligations of the company at a given date.

Presentation and Disclosure

The components of the financial statements are properly classified, described, and disclosed.

Assertions about classes of transactions and events and related disclosures for the period under audit, and assertions about account balances and related disclosures at period end.

Two Categories of AICPA Management Assertions

Relevant Assertions

Assertions that have a meaningful bearing on whether an account is fairly stated and used to assess the risk of material misstatement and the design and performance of audit procedures.

Plan and design an audit approach based on risk assessment procedures, perform tests of controls and substantiative tests of transactions, perform substantiative analytical procedures and tests of details of balances, and complete the audit and issue a report.

Four phases of a financial statement audit.

Audit Evidence

Information used by the auditor in arriving at the conclusions on which the auditor’s opinion is based. This is information where audit procedures have been applied and consists of information that corroborates or contradicts assertions in the financial statements.

The nature, timing, and extent of audit procedures.

The three decisions on what audit evidence to gather and how much of it to accumulate.

Audit Procedure

The act the auditor performs during the course of an audit to comply with auditing standards.

Audit Program

The list of audit procedures for an audit area or an entire audit.

Appropriateness and Sufficiency.

The two determinants of the persuasiveness of evidence.

Appropriateness of Evidence

A measure of the quality of evidence, meaning its relevance and reliability in meeting audit objectives for classes of transactions, account balances, and related disclosures.

Reliability of Evidence

The degree to which evidence can be believable or worthy of trust.

Independence of provider, auditor’s direct knowledge, qualifications of individuals providing the information, effectiveness of client’s internal controls, degree of objectivity, and timeliness.

Six characteristics of reliable evidence.

Sufficiency of Evidence

The quantity, or sample size, of the audit evidence.

Physical examination, confirmation, inspection, analytical procedures, inquiry, recalculation, reperformance, and observation.

The eight types of audit evidence.

Physical Examination

The inspection or count by the auditor of a tangible asset.

Confirmation

The receipt of a direct written response from a third party verifying the accuracy of information that was requested by the auditor.

Inspection

The auditor’s examination of documents and records, whether internal or external to the client, to substantiate the information that is, or should be, included in the financial statements.

Vouching

The process of auditors using documentation to support recorded transactions or amounts.

Tracing

The process of auditors tracing from receiving reports to the acquisitions journal to satisfy the completeness objective.

Analytical Procedures

Evaluations of financial information through analysis of plausible relationships among both financial and nonfinancial data.

Inquiry

The obtaining of written or oral information from the client in response to questions from the auditor.

Recalculation

Rechecking a sample of calculations made by the client.

Reperformance

The auditor’s independent tests of client accounting procedures or controls that were originally done as part of the entity’s accounting and internal control system.

Observation

Looking at a process or procedure being performed by others.

Audit Documentation

The record of the audit procedures performed, relevant audit evidence obtained, and conclusions the auditor reached.

To enable the auditor to obtain sufficient appropriate evidence for the circumstances, to help keep audit costs reasonable, and to avoid misunderstandings with the client.

Three primary reasons why the auditor should properly plan engagements.

Accept client and perform initial audit planning, understand the client’s business and industry, perform preliminary analytical procedures, set preliminary judgment about materiality and performance materiality, identify significant risks due to fraud or error, assess inherent risk, understand system of internal control and assess control risk, and finalize overall audit strategy and audit plan.

Eight steps in planning an audit and designing an audit approach.

Acceptable Audit Risk

A measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unmodified opinion has been issued.

Client Business Risk

The risk that the entity fails to achieve its objectives or execute its strategies.

Risk of Material Misstatement

The risk that the financial statements contain a material misstatement due to fraud or error prior to the audit.

The auditor decides whether to accept a new client or continue serving an existing one, the auditor identifies why the client wants or needs an audit, the auditor obtains an understanding with the client about the terms of the engagement, and the auditor develops the overall strategy for the audit.

Four aspects of initial audit planning.

The likely statement users and their intended uses of them.

Two major factors impacting acceptable audit risk.

Engagement Letter

An agreement between the CPA firm and the client as to the terms of the engagement for the conduct of the audit and related services.

Audit Strategy

The overall approach to the audit that considers the nature of the client, risk of significant misstatements, and other factors such as the number of client locations and past effectiveness of internal controls.

Risk Assessment Procedures

The process of obtaining audit evidence that provides an appropriate basis for identifying and assessing risks of material misstatement, whether due to fraud or error, and for designing further audit procedures.

Materiality

The magnitude of misstatements, including omissions, that individually, or when aggregated with other misstatements, are substantially likely to influence the judgment made by a reasonable user of the financial statements.

Performance Materiality

Materiality for all segments of the audit.

Preliminary Judgment about Materiality

The maximum amount by which the auditor believes that the statements could be misstated and still not affect the decisions of reasonable users.

Tolerable Misstatement

The application of performance materiality to a sampling procedure (AICPA standards) or the materiality allocated to any given account balance (PCAOB standards).

Auditors expect certain accounts to have more misstatements than others, both understatements and overstatements must be considered, and relative costs affect the allocation.

Three major difficulties in allocating materiality to balance sheet accounts.

Known Misstatements

Misstatements where the auditor can determine the amount in the account.

Likely Misstatements

Misstatements that arise either from differences between management’s and the auditor’s judgment about estimates of account balances or from projections of misstatements based on an auditor’s test of a sample from a population.

Inherent risk and control risk.

Two components of the risk of material misstatements.

Inquiries of management and others within the entity, analytical procedures, observation and inspection, discussion among engagement team members, and other risk assessment procedures.

Five risk assessment procedures.

Significant Risk

An identified and assessed risk of material misstatement that, in an auditor’s professional judgment, requires special audit consideration due to the combination of the likelihood of the misstatement occurring and the potential magnitude should a misstatement occur.

Nonroutine Transactions

A transaction this is unusual, due to either size or nature, and that is infrequent in occurrence.

Planned Detection Risk

The risk that audit evidence for an audit objective will fail to detect misstatements exceeding performance materiality.

Inherent Risk

The measurement of the auditor’s assessment of the susceptibility of an assertion about a class of transactions, account balances, or disclosure to material misstatement, before considering the effectiveness of related internal controls.

Control Risk

The measurement of the auditor’s assessment of the risk that a material misstatement could occur in an assertion and not be prevented or detected and corrected on a timely basis by the client’s internal controls.

Engagement Risk

The risk that the auditor or audit firm will suffer harm after the audit is finished, even though the audit report was correct.

System of Internal Control

The system designed, implemented, and maintained by those charged with governance, management, and other personnel to provide reasonable assurance about the achievement of an entity’s objectives with regard to the reliability of financial reporting, effectiveness and efficiency of operations, and compliance with applicable laws and regulations.