3/29/15. Module 3: Audit objectives, evidence, procedures, and documentation

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1 Assignment reminder: Assignment #1 (see Module 5) is due at the end of Week 5 (see Course Schedule). You may wish to take a look at it now in order to familiarize yourself with the requirements and to prepare for any necessary work in advance Module 3: Audit objectives, evidence, procedures, and documentation 3.1 Audit objectives 3.2 Specific audit objectives 3.3 Evidence-gathering audit procedures 3.4 Audit evidence 3.5 Documentation 3.6 Pre-engagement arrangements 3.7 Engagement letters 1

2 Starting to get into the real practical side of auditing. 3.1 Audit objectives Describe the auditor s responsibility to consider fraud and error and the consequences of illegal acts, in order to achieve the objective of financial statement audits. (Level 2) Overall objective of an audit is to express an appropriate opinion as to whether the f/s present fairly, in all material aspects, the financial position, results of operations and cash flows. Essentially means are the statements free from material misstatement 2

3 Management is responsible for preparing the financial statements and to design and implement controls to prevent and/or detect errors or fraud Material misstatements can arise in two different ways: Errors (unintentional mistakes) Fraud (intentional either misrepresentation of f/s, or appropriation of assets) The auditor is responsible for detecting material misstatements due to errors or fraud in order to derive appropriate opinion. Professional skepticism comes into play have to be alert to possibility of fraud or error and potential factors that would increase the risk of material misstatement. 3

4 It is not always possible to detect errors or fraud. There are certain inherent limitations on the auditors ability to detect material misstatement. (ie collusion) Any evidence suggesting errors or fraud would result in heightened level of professional skepticism and more procedures designed to prove or dispel the findings. Part of auditing is making sure you have a clear understanding of what your client does. Auditors must also have an understanding of what laws and regulations your client s business is bound by. Management is responsible for compliance with laws and regulations as well as preventing and detecting illegal acts. Audit procedures must be designed so as to obtain sufficient evidence regarding compliance. Communication is very key in auditing. The auditor has a responsibility to report all material misstatements to the appropriate level of management. 4

5 Significant misstatements must be presented to management in writing in a clear and concise manner to avoid misinterpretation. Possible illegal acts must be communicated to the audit committee or other appropriate levels of governance. Auditor also required to report any question of management (in)competence or integrity 3.2 Specific audit objectives Explain the various types of management assertions and their relationship to specific audit objectives. (Level 1) THIS IS ULTRA IMPORTANT...THE QUESTION IS HOW MUCH MORE IMPORTANT COULD THIS BE AND THE ANSWER IS...NONE...NONE MORE IMPORTANT!! 5

6 Definition Assertion Noun a confident and forceful statement of fact or belief the action of stating something or exercising authority confidently and forcefully synonyms: declaration, contention, statement, claim, opinion, proclamation, announcement, pronouncement, protestation Five Principal Assertions Existence(occurrence) Completeness Ownership (rights and obligations) Valuation (measurement and allocation) Presentation (classification and disclosure) The bracketed terms related to Income Statement. CAS 315 Details the audit assertions Separated into three categories: Classes of transactions and events (Income statement) Balance sheet items Presentation and disclosure 6

7 Detailed Assertions Page 170 of the text shows how the detailed assertions relate to the 5 principal assertions When we talk about assertions, we mean that management is making these assertions about amounts and disclosures in the financial statements. Detailed assertions are the varied terms when specifically relating to transactions, account balances and disclosure. Classes of Transactions and events (Income Statement) Occurrence did the T & E that have been recorded actually occur and did they really pertain to the organization (Existence) Completeness all T & E that should have been recorded have been recorded Accuracy amounts and other data are accurate (Valuation) Classes of Transactions and events (Income Statement) cont d Cutoff T & E have been recorded in correct accounting period errors result in over/under statement relate to Existence and Completeness Classification T & E are recorded in proper accounts (Presentation) 7

8 Balance sheet Existence assets, liabilities and equity exists Rights & obligations holds or controls rights to assets and liabilities are the obligations of the entity Completeness all A, L & E that should have been recorded, are recorded Valuation and allocation A, L & E are at appropriate amounts Presentation and disclosure Occurrence and rights and obligations disclosed T & E and other matters actually occurred and pertain to the entity Completeness all disclosures that should have been included in the F/S have been included The textbook also talks about compliance assertion this is not usually an assertion within a financial statement audit. More commonly an assertion when doing a compliance audit. 8

9 Super important New to the text book this year is Exhibit 5-8. It spans 4 pages and it gives you examples of typical account balances and transaction types and an assertion statement for each of the 5 main assertions. Also gives one example of what could go wrong. REALLY helpful. 3.3 Evidence-gathering audit procedures Identify and apply evidence-gathering audit procedures commonly used to obtain audit evidence, and describe the strengths and weaknesses of each procedure. (Level 1) So, what are the procedures? What are they, what do we get from them and what assertions do they support? This section is also ULTRA important. It will take you a long way in understanding the mechanics of conducting an audit what you really do and why... 9

10 The procedures We ve got six of them: Recalculation/reperformance Observation Confirmation Enquiry Inspection Analysis Wait...back up... Those are the procedures but what are we using them for? Obtaining audit evidence we perform: Risk assessment, then: Tests of controls and/or Substantive tests Ah, that s what the procedures are for... The procedures are what we utilize when we test the controls of an entity or when we do substantive testing (of details) and analytical procedures. 10

11 Procedure detail Recalculation independently recalculating mathematical balances highly reliable evidence addresses existence and valuation Reperformance part of testing of controls independent execution of an internal control procedure Observation really means the auditor is there in person observing performance of procedures or controls for example observing inventory counts. A weakness of this procedure is that the presence of the auditor can affect the performance of employees (yep we can make em nervous so they may take more care in doing the job than they may under more normal circumstances or they may make more mistakes) 11

12 Observation is reliable but is limited to the time of the observation Provides good understanding of the processes of the entity a key element of auditing understanding your audit client Confirmation external confirmation we ask the bank or the customers to provide written confirmation of the balance (ie balances of all bank accounts and loan facilities or confirmation that the customer owes what the A/R subledger says they owe) Provides evidence of existence, ownership, valuation and cut-off Enquiry ask and ye shall receive... Oral evidence from auditee and independent third parties Enquiry requires corroboration Auditing standards are now putting heavy emphasis on enquiry to improve the auditor s understanding of strategy, risks and control (good for understanding the business) 12

13 Inspection this is a big one Physically examining records and documents (in any form paper, electronic, internal, external) Can also be physical inspection of an asset Reliable evidence for existence and valuation Inspection techniques These are important know these!! Vouching start at the account and go through the control system to arrive at the source documentation Tracing the reverse of vouching start with source documentation and follow forward through the control system to the account Scanning does not provide direct evidence but can help to raise questions or reduce sampling risk by looking at items not selected Scanning is looking for unusual items (ie credit balance in asset account or expense account). Does not provide direct evidence but directs the auditor where evidence can be found or needs to be found. 13

14 Analysis can be used to determine other audit programs and to compare actual with expected results Analytical procedures are both important and effective. Analysis is used in planning, execution, and completion of the audit. Analytical procedures Some typical analytic procedures: Compare current year to prior year.(horizontal) Compare current year to budget. Evaluate current year balances against other current year balances.(vertical) Compare financial ratios to industry standards. Study relationship of balances and nonfinancial information.(ie balance sheet has book value of vehicles compare to the actual physical condition of the vehicles and compare to like condition vehicles on the market is book value appropriate or is the asset impaired and requiring a write-down?) 14

15 Strong analytical procedures can reduce the need for additional procedures (not eliminate though) When relying on analytical procedures as main evidence as opposed to corroborating evidence, the results must provide a higher level of assurance. CAS 520 is all about analytical procedures I ll read some highlights from this section(maybe) Accounting estimates and service organizations CAS 540 deals with the difficult nature of auditing management estimates Auditor must gain understanding on what estimates might be relevant to organization under reporting framework, how management identifies and comes up with the estimates 15

16 Again I will pick out some highlights from CAS 540 (if time) CAS 402 provides guidance on dealing with service organizations (for example an external payroll provider) As auditors we can rely on the information provided by service organizations however we still need to gain an understanding of the service and how it affects the entity Highlights from CAS

17 3.4 Audit evidence Explain how an auditor determines what and how much evidence is required. (Level 1) We always talk about sufficient and appropriate audit evidence to support the audit objectives It is not cost-effective to do a 100% audit so it is not possible to eliminate all risk of material misstatement. Audit evidence therefore is more persuasive rather than conclusive Appropriateness Relates to the nature and timing of audit procedures In order to be appropriate, evidence must be relevant and reliable Check out Exhibit 8-5 on page 297 for the Hierarchy of Audit Evidence Reliability 17

18 Sufficiency Relates to extent of audit procedures and quantity of audit evidence Auditor does not examine all evidence available See CAS 500.A1 to 500.A6 outlines reasons for limiting amounts of evidence. Sufficiency is achieved through adequate quantity of evidence obtained by testing both specific and representative items Always remember that corroborating evidence is always stronger (ie increases the assurance) especially if obtained from source outside/independent of the entity compared to single items of evidence. (easy example bank statement is single item of evidence ok evidence; bank confirmation corroborating evidence from independent 3 rd party (bank) excellent evidence) 18

19 3.5 Documentation Explain the purpose and key elements of audit working papers, and describe the form and content of documentation required in a professional engagement. (Level 1) Purpose CAS 230 requires auditors to document matters that, in their professional judgment are important in providing evidence to support the content of the audit report. Describes the purpose and outlines the form and content Working papers document what you have done and should support the conclusions reached Incomplete or hurried working papers can be inefficient and risky 19

20 Form and content Permanent file and current file Permanent file may consist of: Articles of incorporation Corporate charters/bylaws Documentation that has extended usefulness such as lease agreements, contracts, excerpts of minutes, schedules, etc. Good source for new auditors on an engagement Current file Audit administrative and evidence papers See textbook pages Caseware is probably most common computer working paper software You will use Caseware in BC2 I ll give you a quick tour... 20

21 3.6 Pre-engagement arrangements Identify the main pre-engagement activities and the factors to consider when deciding whether to accept a new audit engagement. (Level 1) Pre-engagement Determine whether to accept (new client) or continue (existing client) engagement Does client need an audit? If yes, ensure independence in fact and appearance Review available financial info to assess size of client and potential users of f/s Review prior year audit reports for reservations resulting from scope limitation or GAAP departure One of most important activities: Contact predecessor auditor (in writing takeover letter) to enquire as to why client is changing auditors as well as any limitations, difficulties, etc 21

22 Set up meeting with client to determine complexity of organization and transactions ie specialized knowledge required, potential scope limitations, time constraints, etc. Auditor is under no obligation to accept undesirable clients 3.7 Engagement letters Describe the purpose and main features of an engagement letter. (Level 2) Purpose Defines the terms of the audit engagement Minimize risk of misunderstanding between auditor and client Mandatory for all new clients must be signed before audit work begins For existing clients must get new letter if the nature, size or structure of the organization changes significantly 22

23 Features Page or CAS 210 appendix 1 Nature of financial statement audit Managements responsibility for financial statements and adequate internal control Scope of the audit referencing applicable professional standards(gaas) Risk that material misstatement may not be detected because audit is on a test basis, together with inherent limitations of internal control Fee structure details Confirmation of acceptance of terms by client Til we meet again... Use your resources Review your assignment to see what information from Module 3 may be applicable Have a great week! 23