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ch 1 audit

Chapter 1: An Introduction to Assurance and Financial Statement Auditing

The Study of Auditing

  • Nature of Auditing:

    • Auditing differs from other accounting courses due to requirements for:

    • Analytical and logical skills.

    • More conceptual focus.

    • Rules and computations to prepare and analyze financial information.

    • Key Point: Auditors need to understand more than just accounting concepts and techniques.

Demand for Auditing and Assurance

  • Analogy: Auditors compared to homeowners:

    • Must be objective, trustworthy, and maintain a good reputation.

    • There is a demand for timely information available for a reasonable price.

Principals and Agents

  • Key Definitions:

    • Principal: Stockholders who have valid interest in the company.

    • Agent: Managers who are hired by principals to manage resources effectively.

  • Public Company Definition:

    • A public company sells stocks or bonds to the public, thus giving them an interest in the stewardship of the company’s resources.

The Role of Auditing

  • Roles and Relationships:

    • Principal (Absentee Owner):

    • Provides capital and hires an agent to manage resources.

    • Faces information asymmetry and conflicts of interest leading to information risk.

    • Agent (Manager):

    • Provides financial reports to the principal and is accountable for them.

    • Auditor:

    • Gathers evidence to evaluate fairness of the agent's financial reports.

    • Issues an audit opinion to accompany the agent's reports, which adds credibility and reduces information risk for the principal.

    • The agent pays the auditor to mitigate this risk.

Definition of Auditing

  • Auditing Defined:

    • A systematic process of:

    • Objectively obtaining and evaluating evidence regarding assertions (claims made by management on financial statements) about economic actions and events.

    • Establishing the degree of correspondence between those assertions and established criteria (e.g., US GAAP).

    • Communicating results to interested users.

Materiality (According to FASB)

  • Definition of Materiality:

    • Information is considered material if omitting or misstating it could influence decisions made by users.

Audit Risk

  • Definition of Audit Risk:

    • The risk that an auditor may inadvertently fail to appropriately modify their opinion on financial statements that are materially misstated.

  • Auditor's Standard Report:

    • States the audit provides reasonable assurance that financial statements do not contain material misstatements.

    • Reasonable Assurance: Indicates some level of risk that a material misstatement is present and undetected by the auditor.

Audit Evidence Regarding Management Assertions

  • Key Elements of Audit Evidence:

    • Evidence assists in evaluating management’s financial statement assertions.

    • Audit evidence must be both sufficient and appropriate:

    • Sufficient: Adequate quantity of evidence.

    • Appropriate: Quality of evidence which includes:

      • Relevance: Is the information related to the specific assertion being tested?

      • Reliability: Can the information indicate the true state of the specific assertion being tested?

Sampling: Inferences Based on Limited Observations

  • Use of Sampling by Auditors:

    • Auditors use knowledge about transactions along with a sampling approach to examine transactions.

    • Three stages of examining transactions:

    1. Internal Controls: Ensure proper handling of transactions.

    2. Transactions (Revenue): Affect account balance.

    3. Ending Account Balances: Example include testing ending cash, accounts receivable (A/R), and debt balances at specific dates (e.g., 12/31/XX).

Auditing Process

  • Management Responsibilities:

    • Implements internal controls.

    • Conducts transactions.

    • Accumulates transactions into account balances.

    • Prepares and issues financial statements to users.

  • Auditor Responsibilities:

    • Obtains evidence and tests management assertions against appropriate criteria.

    • Determines the overall fairness of financial statements.

    • Issues an audit report accompanying the financial statements.

Major Phases of the Audit

  1. Client acceptance/continuance.

  2. Preliminary engagement activities.

  3. Plan the audit.

  4. Consider and audit internal control.

  5. Audit business processes and related accounts.

  6. Complete the audit.

  7. Evaluate results and issue the audit report.

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

  • Key Elements of the Audit Report:

    • Title must include "Independent" (of client) and acknowledged as registered with PCAOB.

    • Main deliverable to the public is the auditor’s report with an audit opinion.

    • Note: The audit report opinions can be categorized as follows:

    • Unqualified Opinion: Most common, indicates that financial statements are free of material misstatements.

    • Qualified Opinion: Issued when financial statements contain a material misstatement and are not corrected.

    • Adverse Opinion: Issued when misstatements are so material that the financial statements cannot be relied upon.

Changes to the Auditor's Report - PCAOB

  • Critical Audit Matters (CAMs):

    • Introduced within the last five years, CAMs must be communicated to the audit committee if they:

    1. Relate to accounts or disclosures material to the financial statements (e.g., estimates, goodwill).

    2. Involve especially challenging, subjective, or complex auditor judgment.

    • Auditors must disclose tenure - year when they began serving as the company's auditor.

Opinion on Financial Statements (Example)

  • Target Corporation Audit:

    • Audited the consolidated financial statements for specific years, presenting fairly in all material respects.

    • Reports must conform to US GAAP and maintain effective internal control.

  • Basis for Opinion:

    • Financial statements are management's responsibility; the auditor's role is to express an opinion based on audits performed in compliance with PCAOB standards.

  • The auditor must assess risks of misstatement due to error or fraud and perform necessary procedures.

Critical Audit Matter

  • Valuation of Vendor Income Receivable:

    • At February 1, 2025, vendor income receivable totaled $543 million.

    • The receivable involves programs affecting cost of sales and requires extensive audit procedures due to the complexity surrounding inputs involved.

  • Audit Procedures:

    • Understanding and evaluating controls over vendor income receivable process, testing completeness and accuracy of inputs, recalculating amounts, and performing sensitivity analyses of inputs.

Report of Independent Registered Public Accounting Firm

  • Opinion on Internal Control Over Financial Reporting:

    • Audited Target Corporation’s internal control relying on COSO criteria, maintaining effectiveness as of February 1, 2025.

  • Definition of Internal Control:

    • Designed for reasonable assurance on reliability of financial reporting;

    • Involves:

    1. Maintenance of accurate transaction records.

    2. Recording transactions for financial statement preparation per GAAP.

    3. Timely detection of unauthorized asset acquisitions.

  • Limitations:

    • Internal controls may not detect or prevent all misstatements due to inherent limitations.

Additional Notes on Audit Reports

  • Qualified Opinion:

    • Issued if a material misstatement exists and the client refuses correction.

  • Adverse Opinion:

    • Issued if misstatements pervasively affect financial statements and renders them unreliable.