Summary Auditing & Assurance Services A Systematic Approach

Table of Contents Chapter 1: An Introduction to Assurance and Financial Statement Auditing Chapter 2: The Financial Statement Auditing Environment Chapter 3: Audit Planning, Types of Audit Tests, and Materiality Chapter 4: Risk Assessment Chapter 5: Evidence and Documentation Chapter 6: Internal Control in a Financial Statement Audit Chapter 7: Auditing Internal Control over Financial Reporting Chapter 8: Audit Sampling: An Overview and Application to Tests of Controls Chapter 9: Audit Sampling: An Application to Substantive Tests of Account Balances Chapter 10: Auditing the Revenue Process Chapter 11: Auditing the Purchasing Process Chapter 12: Auditing the Human Resource Management Process Chapter 13: Auditing the Inventory Management Process Chapter 14: Auditing the Financing/Investing Process:Prepaid Expenses, Intangible Assets, and Property, Plant, and Equipment Chapter 15: Auditing the Financing/Investing Process:Long-Term Liabilities, Stockholders’ Equity, and Income Statement Accounts Chapter 16: Auditing the Financing/Investing Process: Cashand Investments Chapter 17: Completing the Audit Engagement Chapter 18: Reports on Audited Financial Statements Chapter 19: Professional Conduct, Independence, and Quality Management Chapter 20: Legal Liability Chapter 21: Assurance, Attestation, and Internal Auditing Services 3 CHAPTER 1 AN INTRODUCTION TO ASSURANCE AND FINANCIAL STATEMENT AUDITING Answers to Review Questions 1-1 The study of auditing is more conceptual in nature compared to other accounting courses. Rather than focusing on learning the rules, techniques, and computations required to prepare financial statements, auditing emphasizes learning a framework of analytical and logical skills to evaluate the relevance and reliability of the systems and processes responsible for financial information, as well as the information itself. To be successful, students must learn the framework and then learn to use logic and common sense in applying auditing concepts to various circumstances and situations. Understanding auditing can improve the decision making ability of consultants, business managers, and accountants by providing a framework for evaluating the usefulness and reliability of information. 1-2 There is a demand for auditing in a free-market economy because the agency relationship between an absentee owner and a manager produces a natural conflict of interest due to the information asymmetry that exists between the owner and manager. As a result, the agent agrees to be monitored as part of his/her employment contract. Auditing appears to be a cost-effective form of monitoring. The empirical evidence suggests auditing was demanded prior to government regulation such as statutory audit requirements. Additionally, many private companies and other entities not subject to government auditing regulations also demand auditing. 1-3 The agency relationship between an owner and manager produces a natural conflict of interest because of differences in the two parties’ goals and because of information asymmetry that exists between them. That is, the manager generally has more information about the ‘true’ financial position and results of operations of the entity than the absentee owner does. If both parties seek to maximize their own self-interest, it is likely that the manager will not act in the best interest of the owner and may manipulate the information provided to the owner accordingly. 1-4 Independence is an important standard for auditors. If an auditor is not independent of the client, users may lose confidence in the auditor’s ability to report truthfully on the financial statements, and the auditor’s work loses its value. From an agency perspective, if the principal (owner) knows that the auditor is not independent, the owner will not trust the auditor’s work. Thus, the agent will not hire the auditor because the auditor’s report will not be effective in reducing information risk from the perspective of the owner. 1-5 Auditing (broadly defined) 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. Assurance is engagement in which a practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation or measurement of a subject matter against criteria. Examples of assurance services are assurance (audit) of financial statements, assurance of prospective financial information, assurance of reporting on internal control, assurance of sustainability reporting, and assurance of electronic commerce. 4 1-6 The phrase systematic process implies that there should be a well-planned, logical approach for conducting an audit that involves objectively obtaining and evaluating evidence. 1-7 Materiality: "Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor." (IASB). Audit risk is defined as the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated (ISA 200). The audit report states that the auditor obtains “reasonable assurance” whether the financial statements are free from “material” misstatement. The term reasonable assurance informs the reader that there is some level of risk that the audit did not detect all material misstatements. In addition, the auditor’s opinion commonly uses the wording that the financial statements present fairly, “in all material respects.” These phrases communicate to third parties that the audit report is limited to material information. 1-8 On most audits, it is not feasible or cost-effective to audit all transactions. For example, in a small business, the auditor might be able to examine all transactions that occurred during the period. However, it is unlikely that the owner of the business could afford to pay for such an extensive audit. For a large organization, the sheer volume of transactions prevents the auditor from examining every transaction. Thus, there is a trade-off between the exactness or precision of the audit and its cost. 1-9 The major phases of the audit are:  Client acceptance/continuance and establishing engagement terms  Preplanning  Assess risks and establish materiality  Plan the audit  Consider internal control  Audit business processes and related accounts  Complete the audit  Evaluate results and issue audit report 1-10 The auditor’s understanding of the entity and its environment includes knowledge about: (1) the nature of the entity, (2) its objectives and strategies, (3) its industry, regulatory, and other external factors, (4) its management, (5) its governance, (6) its measurement and performance process, and (7) its business processes. 1-11 Sometimes auditors will face situations where no standard audit procedure exists, such as the example from the text of verifying the inventory of reindeer. Such circumstances require that the auditor possess creativity and innovation when planning and administering audit procedures where little or no precedent exists. Every client is different, and applying auditing concepts in different situations requires logic and common sense, and frequently creativity and innovation. Solutions to Problems 1-12 The memo should cite the following facts:  There is a historical relationship between accounting and auditing. 5  When parties to the agency relationship (contract) do not possess the same amount of information (information asymmetry) there is a natural conflict of interest between the parties. For example, when an owner and manager are negotiating an employment contract, the owner may assume that the manager likely will use organizational funds for personal uses. Auditing plays an important role in such relationships. The owner and manager will consummate an employment contract only if the manager agrees to be monitored. Auditing can be used to monitor the contract agreed to by the two parties. (P.S. As a lawyer, Lee should be well versed on contract law.)  Auditing is also used to monitor other types of contracts for which no laws or regulations require an audit, for example, contracts between management and debt holders.  There is historical evidence of forms of auditing in the early Greek states and in the United Kingdom during the industrial revolution. Additional evidence for the demand for auditing is also provided by the fact that many private companies and other entities not subject to a statutory audit requirement contract for audits. 1-13 There are two major factors that may make an audit necessary for Greenbloom Garden Centers. First, the company may require long-term financing for its expansion into other cities. Entities such as banks or insurance companies are likely to be the sources of the company’s debt financing. These entities may require audited financial statements before lending significant funds and require audited financial statements during the time period the debt is outstanding. There is information asymmetry between the lender of funds and the owner of the business, and this asymmetry results in information risk to the lender. Even if the business could get funding without an audit, a standard audit report with an unmodified opinion by a reputable auditor might very well reduce the lender’s information risk and make the terms of the loan more favorable to the owner. Second, as the company grows, the family will lose control over the day-to-day operations of the stores. An audit can provide an additional monitoring activity for the family in controlling the expanded operations of the company. 1-14 a. Evidence supporting the financial statements consists of the underlying accounting data and all corroborating information available to the auditor. b. Management makes assertions about components of the financial statements. For example, an entity's financial statements may contain a line item that accounts receivable are €1,750,000. In this instance, management is asserting, among other things, that the entity owns the receivable and that the receivables are properly valued (i.e., net realizable value). Audit evidence helps the auditor determine whether management’s assertions are being met. If the auditor is comfortable that he or she can provide reasonable assurance that all assertions are met for all accounts, he or she can issue an audit report with an unmodified opinion. c. In searching for and evaluating evidence, the auditor should be concerned with the relevance and reliability of evidence. If the auditor relies on evidence that relates to a different assertion from the one being tested, an incorrect conclusion may be reached about the management assertion. Reliability refers to the ability of evidence to signal the true state of the assertion. 1-15 The auditor’s understanding is obtained during the first two boxes shown in Figure 1-3— Client Acceptance/Continuance and Pre-Planning. The intervening steps include: Assess Risks and Establish Materiality In order to properly plan the audit, the audit team must make a preliminary assessment of the client’s business risks and establish a preliminary 6 judgment about materiality. The audit team relies on these assessments to then assess risk relating to the likelihood of material misstatements in the financial statements. The auditor’s risk assessments and materiality judgment are used to define the scope for the audit. Plan the Audit In developing the audit plan, the auditor should be guided by (1) the procedures performed to gain and document an understanding of the entity and (2) the results of the risk assessment process. The auditor may conduct preliminary analytical procedures to identify specific transactions or account balances that should receive special attention due to an increased risk of material misstatement. The auditor should prepare a written audit plan that sets forth, in reasonable detail, the nature, extent, and timing of the audit work. The audit partner or manager should discuss with other members of the audit team the susceptibility of the entity to material misstatements due to error or fraud. Consider Internal Control When obtaining an understanding of the entity and its environment, the auditor should gain an understanding of internal control sufficient to assess the risk of material misstatement, plan the audit by performing procedures to understand the design of controls relevant to the audit, and determine whether they have been implemented. The auditor then evaluates the internal controls in order to assess the risk that they will not prevent or detect a material misstatement in the financial statements. (Note that Chapter 7 covers the audit of internal control for public companies in the U.S.) Audit Business Processes and Related Accounts Based on the knowledge of the entity and its environment, the auditor determines the audit procedures that are necessary to reduce the risk of material misstatement to a low level for the financial statement accounts affected by a particular business process. The individual audit procedures are then directed toward specific assertions in the account balance that are likely to be misstated. Complete the Audit After the auditor has completed testing the account balances, the sufficiency of the evidence gathered needs to be evaluated. The auditor must obtain sufficient appropriate evidence in order to reach and justify a conclusion on the fairness of the financial statements. The auditor also assesses the possibility of contingencies, and searches for any events subsequent to the balance sheet date that may impact the financial statements. Chapter 17 covers each of these issues in detail. 1-16 a. The major phases of the audit and their descriptions are (also see solution to 1- 15, above): 1. Client acceptance/continuance and establish the terms of the engagement. The auditor decides to accept a new client or to retain an existing client. The auditor establishes an understanding with the client regarding the services to be performed. 2. Preplanning. This phase involves (1) determining the audit engagement team requirements and (2) ensuring the independence of the audit team and audit firm. 3. Establish materiality and assess risks. The auditor establishes the preliminary judgment about materiality and makes a preliminary assessment of the client’s business risks. 4. Plan the audit. During this phase of the audit, the auditor uses the knowledge of the client to plan the audit and perform preliminary analytical procedures. The purpose is of this phase to plan an effective and efficient audit. 5. Consider internal control. The auditor understands and evaluates the client’s internal controls in order to assess the risk that they will not prevent or detect a material misstatement.