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AUDITING CHAPTER 2. Standards, Materiality, & Risk By David N. Ricchiute. TOPICS. Audit & Attestation standards Auditing concepts Audit risk Materiality in financial statement audit. EARLY DEVELOPMENT OF STANDARDS. 1941 Accounting Series Release (ASR)#21 SEC requires audit report

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auditing chapter 2

AUDITINGCHAPTER 2

Standards, Materiality, & Risk

By

David N. Ricchiute

topics
TOPICS
  • Audit & Attestation standards
  • Auditing concepts
  • Audit risk
  • Materiality in financial statement audit

GBW Ch. 2 8th ed

early development of standards
EARLY DEVELOPMENT OF STANDARDS
  • 1941 Accounting Series Release (ASR)#21
    • SEC requires audit report
    • Audit conducted in accordance with generally accepted standards
  • 1948 AICPA approves generally accepted auditing standards (GAAS)

GBW Ch. 2 8th ed

recent development of standards
RECENT DEVELOPMENT OF STANDARDS
  • 1970s practitioners criticized GAAS as not sufficiently specific
  • 1986 Attestation standards developed
    • Umbrella for engagement standards
    • GAAS applies exclusively to financial statement audits

GBW Ch. 2 8th ed

comparing gaas attestation
COMPARING GAAS & ATTESTATION

AttestationGAAS

GBW Ch. 2 8th ed

general standards
GENERAL STANDARDS

AttestationGAAS

GBW Ch. 2 8th ed

fieldwork standards
FIELDWORK STANDARDS

AttestationGAAS

GBW Ch. 2 8th ed

reporting standards
REPORTING STANDARDS

AttestationGAAS

GBW Ch. 2 8th ed

standards for public company engagements
STANDARDS FOR PUBLIC COMPANY ENGAGEMENTS
  • Sarbanes-Oxley Act of 2002
    • Creates Public Company Accounting Oversight Board (PCAOB)
    • Delegates authority to PCAOB to
      • Oversee, regulate accounting and auditing professions
      • Develop accounting, auditing standards or
      • Accept accounting standards from FASB
      • Accept auditing standards from AICPA

GBW Ch. 2 8th ed

auditing concepts
AUDITING CONCEPTS
  • Independence
  • Due care
  • Evidence
  • Reporting

GBW Ch. 2 8th ed

independence explained
INDEPENDENCE EXPLAINED
  • In fact
    • State of mind
    • Attitude of impartiality
  • In appearance
    • Free of overt interest in client

GBW Ch. 2 8th ed

consulting public company engagements 2000
CONSULTING & PUBLIC COMPANY ENGAGEMENTS 2000

… consulting & other services may shorten the distance between the auditor & management. Independence—if not in fact, then certainly in appearance—becomes a more elusive proposition. … In this dual role, the auditor, who guards the integrity of the numbers, now both oversees & answers to management.

Arthur Levitt, Jr., “Renewing the Covenant with Investors” Speech at NYU Center for Law & Business, 5/10/00.

GBW Ch. 2 8th ed

sec public companies independence reforms 2000
SEC PUBLIC COMPANIES INDEPENDENCE REFORMS 2000
  • Engagement team model of independence
    • Team & immediate family prohibited from investments in clients
  • Increased restrictions for IT and internal audit consulting
  • Required disclosure audit/nonaudit fees in proxy statement

GBW Ch. 2 8th ed

sarbanes oxley independence 2002
SARBANES-OXLEY, & INDEPENDENCE 2002
  • Establishes PCAOB
  • Addresses accountability for corporate & criminal fraud
  • Limits audit firm’s consulting services to public company clients
  • Client board of directors to approve consulting services provided by auditor

GBW Ch. 2 8th ed

services prohibited by sarbanes oxley
SERVICES PROHIBITED BY SARBANES-OXLEY

For public companies:

  • Bookkeeping, other accounting services
  • Information systems design, implementation
  • Valuation or appraisal services
  • Actuarial services
  • Internal audit outsourcing services
  • Management functions, human resources
  • Broker, dealer, investment advisor
  • Legal, expert services
  • Other services to be determined

GBW Ch. 2 8th ed

sec independence public companies 2003
SEC, INDEPENDENCE, & PUBLIC COMPANIES 2003
  • Further independence regulations
    • Rotate engagement partner 5-7 years
    • Restrict firm’s independence for 1 year when client hires member of audit team
    • Violates independence if auditor’s compensation based on selling service other than attest
    • Require auditor report certain matters to client’s audit committee
      • Critical accounting policies

GBW Ch. 2 8th ed

due care explained
DUE CARE EXPLAINED
  • Care when providing professional services
  • Adequate training for professional services

GBW Ch. 2 8th ed

due care in law
DUE CARE IN LAW

Every man who offers his service to another & is employed assumes the duty to exercise such skill as he possesses with reasonable care & diligence. …if one offers his service, he is understood as holding himself out to the public as possessing the degree of skill commonly possessed by others in the same employment & if his pretensions are unfounded, he commits a species of fraud upon every man who employs him . . .

Cooley on Torts

GBW Ch. 2 8th ed

due care worldcom 2002
DUE CARE & WORLDCOM 2002
  • 2nd largest long-distance carrier restated financial statements for 5 quarters
    • Network access fees capitalized instead of expensed
    • Overstated net income by $11 billion
    • Overstated balance sheet by $75 billion
    • Not GAAP
  • Auditor knew but did not challenge

GBW Ch. 2 8th ed

due care prudent practitioner
DUE CARE &PRUDENT PRACTITIONER
  • Foresee unreasonable risk to others
  • Attend to extra risks
  • Consider unusual circumstances or relationships
  • Identify unfamiliar situation & take precautions
  • Resolve doubt
  • Keep current
  • Review work of assistants

GBW Ch. 2 8th ed

due care operationalized
DUE CARE OPERATIONALIZED
  • Auditor obtains knowledge of business to understand events, transactions, practices with significant effect on financial statements
  • Plan audit to limit audit risk to low level
  • Assess possible errors on balance sheet

GBW Ch. 2 8th ed

evidence explained
EVIDENCE EXPLAINED
  • Underlying accounting data
    • Journals, ledgers, reconciliations, accounting manuals
  • Corroborating information
    • Receiving reports, invoices, contracts, representations from 3rd parties

GBW Ch. 2 8th ed

evidence
EVIDENCE
  • Basis for all decisions
    • Evidential matter
    • Planning & supervision
    • Internal control

GBW Ch. 2 8th ed

evidence sufficiency competence
EVIDENCE: SUFFICIENCY & COMPETENCE
  • Sufficiency
    • Quantity useful evidence collected at reasonable cost
  • Competence
    • Validity: varies with source
    • Relevance: related to assertion

GBW Ch. 2 8th ed

evidence hierarchy
EVIDENCE HIERARCHY
  • Independent sources more reliable than management
    • Banks, debtors
  • Evidence obtained directly more persuasive than indirect evidence from management
    • Physical examination, observation, computation, inspection
  • Effective internal control systems produce more reliable evidence

GBW Ch. 2 8th ed

planning supervision explained
PLANNING & SUPERVISION EXPLAINED
  • Planning
    • Developing objectives & strategy
  • Supervision
    • Directing assistants toward

objectives

    • Determining when objectives

are met

GBW Ch. 2 8th ed

internal control
INTERNAL CONTROL
  • Policies & procedures of management & board of directors
  • Provides reasonable assurance their objectives will be achieved
  • Auditor must understand client’s internal controls
    • To plan audit
    • To design audit tests

GBW Ch. 2 8th ed

reporting explained
REPORTING EXPLAINED
  • Report states conclusion
    • Attestation report
      • Whether management’s assertion conforms with stated criteria
    • Audit report
      • Whether financial statements conform to GAAP

GBW Ch. 2 8th ed

audit report conclusion
AUDIT REPORT CONCLUSION

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the company . . ., & the results of its operations and its cash flows . . ., in conformity with generally accepted accounting principles.

GBW Ch. 2 8th ed

strategy for risk
STRATEGY FOR RISK
  • Risk of omissions or misstatements
  • Design engagement to control material omissions or misstatements
  • Provide reasonable not absolute assurance of detecting omissions or misstatements

GBW Ch. 2 8th ed

attestation risk
ATTESTATION RISK

Probability that attester may unknowingly fail to modify a written conclusion about an assertion that is materially misstated

D. N. Ricchiute, Auditing, 8th ed.

GBW Ch. 2 8th ed

audit risk
AUDIT RISK

Probability that auditor may unknowingly fail to modify opinion on financial statements that are materially misstated

D. N. Ricchiute, Auditing, 8th ed.

GBW Ch. 2 8th ed

components of audit risk
COMPONENTS OF AUDIT RISK
  • Client sources of risk
    • Inherent risk
    • Control risk
  • Auditor source of risk
    • Detection risk

GBW Ch. 2 8th ed

components of audit risk defined
COMPONENTS OF AUDIT RISK DEFINED
  • Inherent risk
    • Risk that errors will occur
  • Control risk
    • Risk that internal controls won’t prevent, detect, correct errors
  • Detection risk
    • Risk that audit procedures won’t find errors

GBW Ch. 2 8th ed

inherent risk sources
INHERENT RISK SOURCES

Risk that errors will occur

  • Business
  • Industry
  • Management’s predisposition to manage earnings
  • Aggressive use of GAAP
  • Specific accounts
    • Liquid assets vs. nonliquid assets

GBW Ch. 2 8th ed

control risk sources
CONTROL RISK SOURCES

Risk that internal controls won’t prevent, detect, correct errors

  • Outdated technology
  • Outdated software
  • Lack of respect for controls by top management

GBW Ch. 2 8th ed

detection risk sources
DETECTION RISK SOURCES

Likelihood that errors could occur and not be detected by audit procedures

  • Nature of audit procedures
  • Extent of audit procedures
  • Timing of audit procedures
  • Auditor’s judgment

GBW Ch. 2 8th ed

audit risk model sas no 47
AUDIT RISK MODEL:SAS No. 47

AR = IR x CR x DR

DR = AR

IR x CR

GBW Ch. 2 8th ed

auditor s business risk
AUDITOR’S BUSINESS RISK

The probability that a practitioner might incur damages despite issuing an appropriate report

    • Ex.: litigation
  • Factors affecting auditor’s business risk
    • Aggressive financial reporting
    • Management integrity or reputation
    • Conflicts of interest & regulatory problems
    • Industry characteristics

GBW Ch. 2 8th ed

auditor s response to business risk
AUDITOR’S RESPONSE TO BUSINESS RISK
  • If business risk is higher, adjust audit risk assessment
    • Set audit risk lower
    • Decrease acceptable level of detection risk
    • Increase evidence
    • Drop client
  • If assurance levels all same, do not adjust audit risk

GBW Ch. 2 8th ed

audit failure defined
AUDIT FAILURE DEFINED
  • Failing to perform procedures that would reduce audit risk to a relatively low level
    • Ex.: Sunbeam

Sunbeam’s auditor a) identified reserves not in compliance with GAAP; b) proposed adjustments which management rejected; c) accepted reserves as stated after incorrectly applying materiality analysis

GBW Ch. 2 8th ed

materiality
MATERIALITY

The magnitude or an omission or misstatement of accounting information that, in the judgment of a reasonable person relying on the information, would have been changed or influenced by the omission or misstatement.1

Statement of Financial Accounting Standards No. 2, “Qualitative Characteristics of Accounting Information,” Stamford: FASB, 1980, par 132.

GBW Ch. 2 8th ed

materiality in practice
MATERIALITY IN PRACTICE
  • Preliminary estimate of materiality for planning guides audit effort, evidence collection
    • SAS No. 22, “Planning & Supervision”

GBW Ch. 2 8th ed

audit risk materiality audit effort
AUDIT RISK, MATERIALITY, AUDIT EFFORT
  • Inverse relationship between audit risk and materiality
    • Low audit risk suggests it would take larger amounts to be material
  • Inverse relationship between materiality and audit effort (hours worked)
    • Higher materiality threshold suggests less audit effort

GBW Ch. 2 8th ed

quantitative materiality criteria
QUANTITATIVE MATERIALITY CRITERIA
  • Effect on
    • Net income
    • Total assets
    • Total revenue

GBW Ch. 2 8th ed

sas 99 on materiality
SAS 99 ON MATERIALITY
  • Auditors should
    • Not rely solely on quantitative materiality criteria
    • Judge materiality of misstatements both individually & in aggregate
    • Recognize that intentional but immaterial misstatements are inappropriate & may be unlawful

GBW Ch. 2 8th ed

qualitative materiality considerations
QUALITATIVE MATERIALITY CONSIDERATIONS
  • Misstatement may not be immaterial if:
    • Affects debt compliance requirements
    • Masks change in earnings
    • Conceals unlawful transaction
    • Prompts undue expectations
    • Hides failure to meet analysts’ expectations
    • Associated with an estimate
    • Affects management’s compensation

GBW Ch. 2 8th ed

allocating preliminary materiality estimates
ALLOCATING PRELIMINARY MATERIALITY ESTIMATES
  • On the basis of
    • Relative magnitude of financial statement accounts
    • Relative variability of financial statement accounts
    • Professional judgment

GBW Ch. 2 8th ed