Audit Final

Both a test of control and a substantive test

What type of test is an inventory observation?

Because control risk increases, we need to lower detection risk by performing substantive testing and changing the nature, extent, and timing

• Ex: more test counts

What should we do if client’s inventory count and auditor’s test count don’t match?

Talk to warehouse personnel

How do you find out about obsolete or damaged inventory?

Ask the client to segregate received goods and goods to be shipped during the day from the inventory in the warehouse, ask the client abou tthe possibility of shutting down production

How should the client differentiate between the incoming/outgoing inventory during counts?

Take test counts at a time after year end to examine transactions between year-end and count date to determine the year end

When should inventory counts take place?

Consider use of a specialist. Evaluate the specialist based on:

Competency

Understand methods or assumptions used

What should we do if inventory is difficult to value or count?

1. Method of pricing (FIFO, LIFO, etc)

2. Consistency

3. Purchase Invoices

4. Work-in-process

5. Lower of cost or market

Cost Tests:

Inquire

Method of pricing (cost test)

Find out if there were changes in method, requires disclosure

Consistency (cost test) - compare method to prior year

Watch for dates. Find more recent purchase invoices for FIFO, and older purchase invoices/inventory records for LIFO

Purchase invoices (cost test)

Ask the client how they value WIP and determine reasonableness

WIP Cost test

1. Catalog price or website

2. Recent sale near year end

Lower of cost or market (cost test)

1. Beginning of year

2. End of Year

3. Audit Completion Date

4. Audit report release date

Major Activities in Audit:

Beginning of Year

Interim testing, test of controls and substantive procedures

End of year

“Roll forward” work. Substantive procedures, attorney letters, management representations, going-concern assessment, adjusting entries, audit documentation review, analytical procedures

Audit Completion Date

Subsequent events (dual-dating)

Audit report release date

Subsequent discovery of facts

Omitted audit procedures

Management letter

Communication with those charged with governance

1. Inquiry of clients integral legal counsel

2. Review minutes of meetings of stockholders, directors, and committees

3. Review contracts, loan agreements, and correspondence from taxing and governmental agencies

4. Review documentation related to legal services

Procedures for Litigation, claims, and assessment

Attorney Letters: Responsibilities

Auditors initiate request for attorney’s letters and send them. Clients prepare listing, description, and evaluation of litigation, claims, and assessments for letter. Attorney responds to auditors regarding the client’s description of litigation contained in the letter. Attorneys can inform auditors of omissions of asserted claims, attorneys cannot inform auditors of omissions of unasserted claims.

Attorney Letters: Contents

• Listing of pending or threatened litigation, claims, and assessments

• Listing of unasserted LCA

• Progress of each case and intended action

• Likelihood of an unfavorable outcome

• Estimate of the range of potential loss

• Completeness of the listings provided (asserted) and/or limitation son the response (for unasserted claims)

Management Representations

Required without regard to materiality.

• Management’s responsibility for design and implementation of programs and controls related to fraud

• Disclosure of deficiencies in internal control

• Information concerning fraud, non-compliance with laws, related parties, and undisclosed litigation

• Minutes of BoD

• Provided by management to auditors

• Dated using same date as the auditor’s report

Procedures to identify subsequent events

1. Understand how management identifies subsequent events

2. Review latest interim financial statements

3. Inquire of management and other executives

4. Read board minutes and inquire about meetings without minutes

5. Obtain responses to attorney letters

6. Obtain management representations

Subsequent events requiring adjustments

Provides new information about circumstances that existed as of the balance sheet date

Subsequent events requiring disclosure only

Provides information that should be disclosed to users, but does not require an adjustment to financial statements

• Ex: sale of a bond or capital stock issue, purchase of a business, settlement of litigation, loss of plant or inventories, losses on receivables

Subsequent discovery of facts

Following audit report release date. Requires disclosure of events if facts are reliable and existed at reports date, facts affect financial statements and auditors’ reports, persons are relying on financial statements and audit

Auditors should inform board that he or she will notify regulatory agencies and others relying on the reports

What should auditors do if the client refuses disclosure of subsequent discovery of facts?

• Accumulate proposed entries on “score sheet”

• Consider pre tax and after tax effects

• Require adjustment for all material entries or proposed entries totaling a material amount

• Require adjustment for “qualitatively material” entries

• Recommend adjustment for all others (immaterial)

Weigh against materiality for the financial statements as a whole

Adjusting journal entries:

• Auditor’s responsibility (GAAS)

• Disagreements with management

• Critical accounting estimates

• Significant unusual transactions

• Significant difficulties during audit

Communications with individuals charged with governance (audit committee):

A qualified opinion is one where the issue is material but not pervasive. This could be due to:

• Material misstatement

• Scope limitation

What are the two different reasons an audit opinion could be qualified?

Scope limitation

Inability to obtain sufficient, appropriate audit evidence

Adverse

Audit opinion issued if the financial statements are materially misstated and it is pervasive

• Ex: valuing PPE higher

Disclaimer

Audit opinion issued if there was an inability to obtain sufficient, appropriate evidence and it was both material and pervasive.

• Ex: A fire burnt all evidence of AFDA

Component Auditor

A company who audits a subsidiary of a parent company, can be the group auditor or a separate entity

1. Independence of component auditor

2. Competence of component auditor

3. Ability to obtain info affecting consolidation

The Group auditor must determine:

The component would need to be reaudited

What would happen if the group auditor were not satisfied with the component auditor’s competence?

Going Concern

The auditor should evaluate whether substantial doubt exists about an entity’s ability to continue as a going concern for a reasonable period (1 year)

The auditor would ask management about their plans and consider the likelihood of those plans. If those plans involve financing from third parties, the auditor should obtain in writing the intent and ability of the third party

The AICPA requires an additional section titled “Substantial Doubt about the Entity’s ability to continue as a going concern” if there is substantial doubt

The PCAOB requires explanatory language or a paragraph highlighting these issues

What should the auditor do if there is doubt about the going concern of an entity?

1. Additional paragraph that can be placed anywhere after the opinion or basis of opinion paragraphs

2. “If the auditor considers it necessary to draw users’ attention to a matter appropriately presented or disclosed in the financial statements that, in the auditor’s judgement, is of such importance that it is fundamental to users’ understanding…”

3. Ex: significant related party transactions, uncertainty relating to future outcomes, usually important subsequent events

4. Must include heading “Emphasis of Matter” and indicate that the “Auditor’s Opinion is not modified with respect to the matter emphasized”

Emphasis of a matter: (AICPA/PCAOB)

1. If the auditor, in their professional judgement, refers to a matter other than those presented or disclosed in the financial statements because it is relevant to the users’ understanding, auditor’s responsibilities, or the auditor’s report

Ex: Unable to withdraw from an engagement that would result in a disclaimer, law or regulation, or financial statements were prepared with two different general-purpose frameworks (GAAP and IFRS)

Other-matter paragraph (AICPA/PCAOB)

Complexity, remoteness, consequences

Why do we have auditing?

Purpose of an audit

Opinion by the auditor on whether the financial statements are presented fairly, in all material respects, in accordance with an applicable financial reporting framework (GAAP), which enhances the degree of confidence that intended users can place in the financial statements.

Attestation

Written conclusion on “subject matter or an assertion about the subject matter that is the responsibility of another party”

Assurance

Independent professional services that improve the quality of information, or its context, for decision makers

Unqualified, qualified, adverse, disclaimer

Types of audit opinions:

Sarbanes-Oxley Act Provisions

• Formation of the PCAOB

• Requirement of CEO/CFO to certify financial statements

• Requirement of auditor examination of company internal controls

Prohibited Services to Audit Clients:

• Bookkeeping

• Design/implementation of financial information systems

• Actuarial services

• Internal audit outsourcing

• Appraisal or valuation

Materiality for the financial statements as a whole

Type of materiality used in planning as well as evaluating the results of the audit, used to evaluate errors

Performance Materiality

One or more amounts, set to reduce the probability that the aggregate of uncorrected and undetected misstatements in the financial statements exceed materiality for the financial statements as whole

• used to find errors

Materiality to a particular class of transactions

the significance of misstatements within a specific type of transaction, such as revenue, payroll, purchases, inventory, or cash disbursement

Audit risk

risk that the auditor may fail to modify the opinion on financial statements that are materially misstated

Audit risk model

AR = IR x CR x DR

Inherent risk

The likelihood that, int he absence of internal controls, a material misstatement could occur

• in other words, it is a measure of the susceptibility of an account to misstatement

Control risk

The likelihood that a material misstatement would not be caught by the client’s internal controls

• if there are no controls, there is 100% ________

Detection risk

The risk that a material misstatement would not be caught by audit procedures

• Factors that auditors can use to affect detection risk include: Nature, extent, timing

• What I can control

Auditing

The systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between the assertions and established criteria and communicating the results to interested users

Existence/Occurrence

Assets or liabilities of an entity exist at a given date or the recorded transactions have occurred during a given time

Rights and Obligations

Assets are the rights of the entity and liabilities are the obligations of the entity at a given time

Completeness

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

Valuation and allocation

Transactions are recorded at the right amount

Presentation and disclosure

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

Vouch

From f/s to source documents

• gets at existence and occurrence

Trace

From source documents to f/s

• Gets at completeness

Walkthrough

following a transaction from origination to financial records. Use the same documents and information technology that the company uses

• A combination of inquiry, observation, inspection, and re-performance of controls

Design effectiveness

Determines whether the controls over financial reporting, if operating effectively, would be expected to prevent or detect errors or fraud that could result in a material misstatement

Operating Effectiveness

Is whether the control is operating as designed and whether the person performing the control possesses the necessary authority and qualifications to perform the control effectively

Internal control deficiency

Exists when the design or operation of a control does not allow the entity’s management or employees to detect or prevent misstatements in a timely fashion

Significant Deficiencies

Defined as conditions, or combinations of conditions, that could adversely affect the organization

Material weakness

a deficiency, or combination of deficiencies, that results in a reasonable possibility that a material misstatement would not be prevented or detected on a timely basis

1. Control environment

2. Risk Assessment

3. Information and communication

4. Monitoring

5. Control Activities

COSO Components:

Existence and occurrence, Valuation or allocation

Completeness, Presentation and disclosure

Which assertions are relevant for revenue?

1. Test the mathematical accuracy of the sales journal and agree to f/s

2. Vouch selected entries from sales journal to source doc (3 way match)

3. Trace from source documents

4. perform sales cutoff tests

5. Scan for large/unusual entries

6. Recompute quantity x price and tax calculation on invoices

7. Analytical procedures

Common Substantive Tests for Sales:

1. Purchase/sales invoice

2. Bill of lading

3. Sales/purchase order

Three way match:

1. Obtain an aged listing of A/r from client. foot and agree totals to the f/s

2. Vouch a sample in aged listing to documentation (3way match)

3. Confirm a sample of a/r from aged listing with customers (confirmations)

4. Evaluate the client’s provision for uncollectible accounts receivable

5. Perform analytical procedures

6. Evaluate the overall presentation of a/r in the financial statements (Ex is there factoring)

7. Review subsequent receipts

Common Substantive tests: A/r

Lapping

Concealment of a cash shortage by delaying the recording of cash receipts

• Most easily carried out when an employee who receives collections from customers is responsible for the posting of accounts (no separation of custody and recording)

Major vendors, small or zero balances, major vendors used in prior periods

Who do we send a/p confirmations to?

1. Analytical procedures

2. The search for unrecorded liabilities (subsequent disbursements, unpaid invoice file)

How do we find unrecorded liabilities?

1. Obtain a lead schedule of cash balances. Foot to f/s

2. Obtain a year end Bank Reconciliation for each bank account held by client (confirm balance per bank, trace, vouch, agree) and verify mathematical accuracy

3. Prepare a schedule of interbank transfers (to catch kiting)

4. Perform analytical procedures

5. Prepare a proof of cash

6. Count cash on hand

7. Evaluate presentation

Substantive Tests: Cash

Receipt clears books and bank before year end on receiving side, but after year end on disbursement side.

Sign of kiting: