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Auditing and Assurance - ppt notes ch 1

The Study of Auditing

  • Focuses on analytical and logical skills; more conceptual in nature
  • Emphasizes rules and computations to prepare and analyze financial information
  • Auditing is different from other accounting courses because auditors need to understand more than just accounting concepts and techniques

Demand for Auditing and Assurance

  • Simple analogy: Auditors and homeowners
  • Role of auditors is to reduce information asymmetry and provide assurance to users of financial statements

Principals and Agents

  • Managers are agents of stockholders (principals)
  • Principals = stockholders; Agents = managers
  • A public company sells its stocks or bonds to the public, giving the public a valid interest in the proper use or stewardship over the company’s resources

The Role of Auditing

  • Principal provides capital and hires an agent to manage resources
  • Information asymmetry and conflicts of interest create information risk for the principal
  • Auditor's role: gather evidence to evaluate the fairness of the agent's financial reports
  • Auditor issues an audit opinion to accompany the agent's financial reports, adding credibility and reducing principal's information risk
  • Agent is accountable to the principal; provides financial reports
  • Auditor is hired by the agent to report on the fairness of the agent's financial reports
  • Agent pays the auditor to reduce the principal's information risk

Auditing

  • Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users.
  • Fill-ins (per transcript):
    • Evidence
    • Assertions
    • Criteria

Materiality

  • Information is material if it could influence decisions that users make

Audit Risk

  • Audit risk is the risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated
  • The auditor’s standard report states that the audit provides only reasonable assurance that the financial statements do not contain material misstatements
  • Reasonable assurance implies some likelihood that a material misstatement could be present in the financial statements and the auditor will fail to detect it

Audit Evidence Regarding Management Assertions

  • Evidence assists the auditor in evaluating management’s assertions
  • Audit evidence should be sufficient and appropriate
    • Sufficient – does the auditor have enough evidence?
    • Appropriate – quality of evidence
    • Relevance – Is the information related to the specific assertion being tested?
    • Reliability – Can the information be relied upon to signal the true state of the assertion?

Sampling: Inferences Based on Limited Observations

  • Auditors use their knowledge about the transactions and/or a sampling approach to examine the transactions
  • Evidence can be collected at three stages of the client’s accounting system:
    1. Tests of controls – ensure proper handling of transactions
    2. Tests of details of balances – that affect the account balance
    3. Tests of ending balances / disclosures – example: test ending cash, A/R, debt balances at 12/31/XX

Process

  • Management implements internal controls; conducts transactions; accumulates transactions into account balances; prepares financial statements; issues financial statements to users
  • Auditor obtains evidence; tests management assertions against appropriate criteria; determines overall fairness of financial statements; issues audit report to accompany financial statements

Major Phases of the Audit

  • Client acceptance/continuance
  • Preliminary engagement activities
  • Plan the audit
  • Consider and audit internal control
  • Audit business processes and related accounts
  • Complete the audit
  • Evaluate results and issue audit report

Issue the Audit Report (Public Company Auditor’s report)

  • The title of the audit report includes the words Independent and Auditor's
  • The auditor’s report has an audit opinion
  • Until recently, the audit output was primarily this opinion

Audit Reports

  • The unqualified audit report is the most common type of report issued (informally a clean opinion)
  • An unqualified opinion means the financial statements are free of material misstatements, so the auditor does not find it necessary to qualify the opinion about the fairness of the financial statements

Changes to the Auditors Report - PCAOB (1-15)

  • CAMs – Critical Audit Matters
  • Communicated to the audit committee and that:
    • relate to accounts or disclosures that are material to the financial statements; and
    • involved especially challenging, subjective, or complex auditor judgment
  • Disclose auditor tenure — the year in which the auditor began serving consecutively as the company's auditor

Opinion on the Financial Statements (Target Corporation example)

  • We have audited the accompanying consolidated statements of financial position of Target Corporation as of Feb 1, 2025 and Feb 3, 2024, the related consolidated statements of operations, comprehensive income, shareholders' investment and cash flows for each of the three years in the period ended Feb 1, 2025, and the related notes (the consolidated financial statements)
  • In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Corporation at Feb 1, 2025 and Feb 3, 2024, and the results of its operations and its cash flows for each of the three years in the period ended Feb 1, 2025, in conformity with U.S. generally accepted accounting principles (GAAP)
  • We also audited, in accordance with the standards of the Public Company Accounting Oversight Board (PCAOB), the Corporation's internal control over financial reporting as of Feb 1, 2025, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) 2013 framework, and our report dated Mar 12, 2025 expressed an unqualified opinion thereon
  • Basis for Opinion: The Corporation's management is responsible for the financial statements; our responsibility is to express an opinion based on our audits conducted according to PCAOB standards
  • We are independent with respect to the Corporation under U.S. securities laws and SEC/PCAOB rules
  • Our audits included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements; evaluating accounting principles used and significant estimates made by management; and evaluating the overall presentation
  • We believe our audits provide a reasonable basis for our opinion

Critical Audit Matters (CAM) Cont.

  • Critical Audit Matter described: The valuation of vendor income receivable
  • At Feb 1, 2025, vendor income receivable totaled 543,000,000
  • Vendor-sponsored programs are recorded as a reduction of cost of sales when earned; receivable is recorded for amounts earned but not yet received
  • Auditing the vendor income receivable is challenging due to inputs in the model (forecasted collections, time period over which collections have been earned)
  • High volume of transactions requires extensive audit effort to address completeness and accuracy of inputs
  • How We Addressed the Matter:
    • Obtained understanding, evaluated design and tested operating effectiveness of controls over the vendor income receivable process, including input controls
    • Tested inputs for a sample of vendor-sponsored programs; verified nature and source of inputs and terms of contractual agreements
    • Recalculated the amount of vendor income earned based on inputs and contracts; reassessed the time period over which collections were earned
    • Performed sensitivity analyses of inputs to evaluate changes in the receivable
    • Performed audit procedures over vendor income collections after the balance sheet date to support year-end receivable

Signature and Date

  • /s/ Ernst & Young LLP
  • Minneapolis, Minnesota
  • March 12, 2025
  • We have served as the Corporation's auditor since 1931

Report of Independent Registered Public Accounting Firm (Internal Control over Financial Reporting)

  • Opinion on Internal Control Over Financial Reporting as of Feb 1, 2025, based on COSO criteria (2013 framework)
  • We also audited the consolidated financial statements in accordance with PCAOB standards
  • Basis for Opinion: Management is responsible for maintaining effective internal control; our responsibility is to express an opinion based on our audit
  • We conducted our audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects
  • The internal control framework includes policies and procedures to (1) maintain detailed records of transactions and dispositions of assets; (2) provide reasonable assurance that transactions are recorded properly; (3) prevent or timely detect unauthorized acquisition, use, or disposition of assets
  • Inherent limitations of internal control over financial reporting may prevent detection of misstatements; future-period effectiveness may change

Internal Control Definition and Limitations

  • A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and preparation of financial statements in accordance with GAAP
  • It includes policies and procedures that pertain to maintaining detailed records; ensure transactions are recorded as necessary; ensure receipts and expenditures are authorized
  • It provides reasonable assurance regarding prevention or timely detection of unauthorized activities

Audit Reports – Contd. (Qualified and Adverse Opinions)

  • The auditor may issue a qualified opinion
  • If a client’s financial statements contain a misstatement that the auditor considers material and the client refuses to correct it, the auditor will likely qualify the report, stating that the financial statements are not fairly stated with respect to the misstatement identified
  • The auditor may issue an adverse opinion if the misstatement is so material that it pervasive affects the interpretation of the financial statements
  • In an adverse opinion, the financial statements are not fairly stated and should not be relied upon