9.401 Auditing

1. 9.401 Auditing Chapter 5 Audit Responsibilities and Objectives

2. Auditor’s Responsibility….. • To accumulate evidence to determine if the f/s are fairly stated in accordance with GAAP in all material respects, • and to issue an appropriate report

3. Managements’s Responsibility….. • Adopting sound accounting policies • Maintaining adequate internal control • Generating financial statements. Still mgmt responsibility even if: • Auditor provided bookkeeping services • Auditor prepared f/s • Auditor offered suggestions

4. Auditor vs. Management • When auditor and management disagree on a material issue: • If management capitulates, issue clean opinion • Auditor can’t force management to alter financial statements • If management refuses, auditor must qualify opinion

5. Auditors and Errors • Errors =unintentional misstatements of f/s • Mistake in gathering or processing data • Incorrect estimate from oversight or misinterpretation of facts • Mistake in application of GAAP relating to amount, classification, presentation or disclosure • Auditors seek reasonable, not absolute, assurance that f/s contain no material errors….

6. Why not provide absolute assurance? • Can’t because: • Use of sampling • Auditors use judgment, which is fallible • F/S contain estimates • Audit evidence is persuasive, not conclusive • Internal control has limitations • Won’t because prohibitive costs exceed benefits

7. Auditors and Fraud • Employee Fraud =usually theft of assets from company • Management Fraud =intentional misstatement of f/s, usually to deceive stakeholders

8. Auditors and Fraud • Auditors have less responsibility towards fraud because: • Object of concealment • Can be hard to find if: • Employees are colluding • Management is overriding internal controls

9. Auditors and Fraud • Auditors must be alert to factors increasing consider the risk of misstatements: • means and opportunity • (eg. Weak internal controls, areas of judgment or complexity, dominant mgmt, decentralized org) • motive • (eg. High expectations, financial problems, bonuses, IPO’s) • mgmt character and engagement • (eg. Aggressive, dishonest, evasive) • New client, assets subject to misappropriation

10. Auditors and Fraud • If risk of fraud is high: • Be critical of accounting policies • Use more experienced personnel • Close supervision • Do more work, more effective procedures, and closer to year end (=nature, timing and extent) • Consider withdrawing from engagement

11. Throughout Audit • Exercise professional scepticism • Assume good faith of management • Be aware that management could be dishonest • Be alert to red flags which call management good faith into question

12. Red Flag Examples: • Handwritten records usually computerized • Evasive, uncooperative management • Unrealistic time deadlines set by mgmt • Limitation in scope imposed by mgmt • Conflicting or unsatisfactory evidence • Unsupported or unusual transactions, particularly close to year end • Fewer confirmation responses than expected or significant differences found

13. What to do when red flags appear: • Perform additional work to confirm or dispel suspicions. • If suspicions are confirmed: • Talk to appropriate level of mgmt • Talk to audit committee • Consider effect on rest of audit • Consider effect on evidence already gathered • Consider if you should resign from audit-consult a lawyer

14. Auditors and Illegal Acts • Auditors are less likely to find illegal acts than errors: • May not be directly related to audit • Auditor may be unaware of laws • Detecting violations may be outside of auditor’s expertise, question of law • May be concealed • The more the illegal act has a “direct effect” on f/s, the greater the auditor’s responsibility

15. Auditors and Illegal Acts • Auditors should at minimum: • Identify laws whose violation affects f/s • Ask management about policies designed to prevent illegal acts • Obtain written representation from mgmt • If auditor DOES discover an illegal act: • Inform mgmt and audit committee • Consider effect on f/s and audit report • Consider effect on audit evidence, mgmt good faith

16. How to perform an audit • Financial statements are made up of Account Balances, which are made up of Transactions • The financial statements contain implied management assertions. Auditing these assertions leads to objectives which can be balance related (when auditing account balances) or transaction related (when auditing transactions)

17. Management Assertions Existence • Existence or Occurrence • Assets, liabilities and equities exist and that a transaction occurred that pertains to the entity • Completeness • There are no unrecorded assets, liabilities or transactions • Ownership or Rights and Obligations • Assets of the company is owned by entity at given date, liabilities represent obligations Completeness Ownership

18. Management Assertions Valuation • Valuation or Measurement • Assets or liabilities recorded at appropriate carrying value; transactions recorded in proper amount and allocated to proper period • Presentation and Disclosure • An item is disclosed in accordance with GAAP Presentation

19. Assertions and Objectives

20. Which assertions are violated? • According to the company books, there are 25 delivery vans but your physical count reveals that they only have 20. • The company forgot to record on their financial statements that they will likely have to pay a settlement of two million dollars in connection with a civil lawsuit. • The company has several accounts receivable from customers who have declared bankruptcy. • The company does not show the breakdown between current and non-current assets and liabilities on the financial statements.

21. Which assertions are violated? • A non-profit organization often receives sizable cash donations but only issues receipts if the donor requests them. It is possible that some cash is pocketed by the employees. • The company calculates amortization on their machinery using an estimated useful life of 60 years, which seems unreasonably long given the probability of technological obsolescence. • The company failed to include in their financial statements an inventory shipment received immediately before year end. • The inventory of a second hand clothing store is recorded on their financial statements, when it is actually inventory on consignment.

22. Which assertions are addressed by these procedures? • You send out confirmations to accounts receivable customers recorded in the company books. • You check to see that the inventory you counted in the warehouse is recorded in the company books. • You recalculate the amortization of prepaid insurance. • You request that the company’s major suppliers send you a copy of your client’s statement of account that you will check with your company’s records.

23. Which assertions are addressed by these procedures? • You compare the ratio of the allowance for doubtful accounts to accounts receivable with the ratio of prior years. • You check sales invoices after the year end to see if the inventory selling price was higher than its original cost. • For each investment, you check if the amount of dividend revenue earned from portfolio investments corresponds with dividends declared according to the “Dividend Record Guide”. • You check to see if the level of sales returns recorded after the year end seems to be normal.

24. Phases of Audit • Planning • Obtain knowledge of business • Understand internal control and assess risk • Tests of Controls • Analytical procedures and substantive tests of balances • Complete audit and issue report