Chapter 6: Audit Responsibilities & Objectives

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AU 110

Objective of the ordinary audit of financial statements by the independent auditor is the expression of an opinion on the fairness with which they present , in all material respects, financial position, results of operations, and cash flows in conformity to GAAP.

Management's responsibility

is to adopt sound accounting policies, maintain adequate internal control, make fair representation in the financial statements

AU 110 amended

auditor has the responsibility to plan and perform audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. The auditor is able to obtain REASONABLE NOT absolute assurance that material misstatements are detected. The auditor has no responsibility to plan or perform the audit to obtain reasonable assurance, whether caused by error or fraud, that are not material to the financial statements are detected.

Material Misstatements

if the combined uncorrected errors and fraud in the financial statements would likely have changed or influenced the decision of a reasonable person using the statements.

The Auditor is Responsible for reasonable, but NOT ABSOLUTE, assurance for several reasons...

1. Most audit evidence results from TESTING A SAMPLE of a population. Sampling inevitably includes some risk of not uncovering a material misstatement.
2. Accounting presentations contain complex estimates, which inherently involve uncertainty and can be affected by future events.
3.Fraudulently prepare financial statements are often extremely difficult for the auditor to detect

The auditor's best defense when material misstatements are not uncovered is

to have conducted the audit in accordance with auditing standards.

Error

unintentional misstatement; auditor provides reasonable assurance

Fraud

intentional misstatement; auditor provides reasonable assurance

3 Types of Fraud

1. Misappropriation of Assets
2. Fraudulent Financial Reporting
3. Illegal Acts

Misappropriation of Assets

defalcation or employee fraud; stealing; stockholders, creditors and others are harmed because assets are no longer available to their rightful owners.

Fraudulent Financial Reporting

management fraud; harms users by providing them incorrect financial statement info for their decision making

Professional Skepticism

is an attitude that includes a questioning mind and a critical assessment of audit evidence. Audit must be planned and performed with an attitude of professional skepticism in all aspects of the engagement.

Illegal Acts (AU 317)

violation of laws or govt regulations other than fraud.

Direct-Effect Illegal Acts

violations of laws & regulations that have a direct financial effect on specific account balances in the financial statements. You can trace numbers on financial statements directly. Auditor must evaluate whether or not there is evidence available to indicate material violations of federal or state tax law. REASONABLE ASSURANCE is provided

Indirect-Effect Illegal Acts

most illegal acts effect the financial statement only indirectly. Ex: material fines and sanctions from violating environmental protection laws, violations of insider securities trading regulations. Hard to trace. Auditors provide NO ASSURANCE that indirect-illegal acts will be detected.

Auditors have THREE levels of responsibility for finding and reporting illegal acts:

1. Evidence Accumulation When There is NO Reason to Believe Indirect-Effect Illegal Acts Exist
2. Evidence Accumulation & Other Actions When There IS REASON to Believe Direct or Indirect-Effect Illegal Acts May Exist
3. Actions When the Auditor KNOWS of an Illegal Act

Evidence Accumulation When There is NO Reason to Believe Indirect-Effect Illegal Acts Exist

if there is no indication that anything is wrong, conduct audit in the regular way. Auditor should ask management about policies established to prevent illegal acts. The auditor should NOT search for indirect-effect illegal acts unless there is reason to believe the may exist

Evidence Accumulation & Other Actions When There IS REASON to Believe Direct or Indirect-Effect Illegal Acts May Exist

1. inquire of management at a level above those likely to be involved in the potential illegal act
2. Consult with the client's legal counsel or other specialist who is knowledgeable about the illegal act
3.Consider accumulation additional evidence

Actions When the Auditor KNOWS of an Illegal Act

1. consider the effects on the financial statements, including adequacy of disclosures
2.consider the effect of such illegal acts on the CPA acts on the CPA's firm's relationship with management. Maybe withdraw from engagement.
3. communicate with the audit committee or others of equivalent authority to make sure that they know of the illegal act; oral or written communication
4. If the client is publicly held, the auditor must also report the matter directly to the SEC

Cycle Approach

1. Audits are performed by dividing the financial statements into smaller segments or components. The division makes the audit more manageable & aids in the assignment of tasks to diff member of the audit team.
2. After the audit of each segment is completed, including interrelationships with other segment, the results are combined. A conclusion can then be reached about the financial statements taken as a whole.
3. A common way to divide an audit is to keep closely related types (classes) of transactions and account balances in the same segment

Logic of the Cycle Approach

- ties to the way transactions are recorded in journals and summarized in the general ledger and financial statements.

Audit Cycles

1. Sales and collection
2. Acquisition and payment
3.Payroll and personnel
4. Inventory and warehousing
5. Capital acquisition and repayment
6. General Ledger/recording cycle

Trial Balance

used to prepare financial statements and is a primary focus of every audit

Part of 2 or more cycles

1. cash
2. inventory

Sales and collection cycle

is the 1stcyle listed and is a primary focus on most audits

Sales and Collection

revenue

Acquisition and Payment

expenditure and purchases

Payroll and Personnel

HR

Inventory and Warehousing

WIP, DM, making the product

Capital Acquisition and repayment

selling stock and borrowing money

General Ledger/ Recording cycle

recording transactions

Overall Assurance Can Be Increase in Almost All Audits By

Auditing the ending balance in accounts receivable.

The most efficient and effective way to conduct audits is to obtain

some combo of assurance for each class of transactions and for the ending balance in the related accounts.

Transaction-related audit objectives

For any given class of transactions, several audit objectives must be met before the auditor can conclude that the transactions are properly recorded

Balance-related audit objectives

several audit objectives must be met for each account balance

Presentation and disclosure related audit objectives

relates to the presentation and disclosure of information in the financial statements

Management Assertions

-implied or expressed representations by management about classes of transactions and the related accounts and disclosures in the financial statements. In most cases they are implied.
-These assertions apply to classes of transaction, account balances, and presentation disclosures.

Management assertions are directly related to

GAAP

Audit Assertion Categories (AU 326)

1. classes of transactions & events for the period under audit
2. account balances at period end
3. presentation and disclosure

Assertions about classes of transactions & events

1. Occurrence
2. Completeness
3. Accuracy
4. Classification
5. Cutoff

Assertions about account balances

1. Existence
2. Completeness
3. Valuation and Allocation
4. Rights and Obligations

Assertions about presentation and disclosure

1. Occurrence and rights and obligation
2. Completeness
3. Accuracy and Valuation
4. Classification and Understandability

Occurrence (T&E)

transaction and events that HAVE been recorded have occurred and pertain to the entity

Completeness (T&E)

all transactions and events that should have been recorded have been recorded

Accuracy (T&E)

amounts and other data relating to recorded transactions and events have been recorded appropriately

Classification (T&E)

Transactions & events have been recorded in the proper accounts

Cutoff (T&E)

transactions & events have been recorded in the correct accounting period

Existence (AB)

Assets, liabilities, and equity interests exist

Completeness (AB)

all assets, liabilities and equity interests that should have been recorded have been recorded

Valuation and allocation (AB)

assets, liabilities, and equity interest are included in the financial statements at appropriate amounts and any resulting valuation adjustments are appropriately recorded

Rights and obligations (AB)

the entity holds or controls the rights to assets and liabilities are the obligation of the entity

Occurrence and rights and obligations (P&D)

disclosed events and transactions have occurred and pertain to the entity

Completeness (P&D)

all disclosures that should have been included in the financial statements have been included

Accuracy and Valuation (P&D)

financial and other information are disclosed appropriately and at appropriate amounts

Classification & Understandability (P&D)

financial and other information is appropriately presented and described and disclosures are clearly expressed

Relevant Assertions

- auditor should consider the relevance of ea assertion for ea significant class of transactions, account balance, and presentation disclosure
- have a meaningful bearing on whether account is fairly stated and are used to assess the risk of material misstatement and the design and performance of audit procedures

Transaction Related Audit Objectives

Posting and Summarization
Completeness
Classification
Occurence
Accuracy
Timing

Occurrence (T&E-AO)

recorded sales are for shipments made to nonfictitious customers.

Completeness (T&E-AO)

existing sales transactions are recorded

Accuracy (T&E-AO)

Recorded sales are for the amount of goods shipped & are correctly billed and recorded

Posting and summarization (T&E-AO)

sales transactions are properly included in the master file and are correctly summarized

Classification (T&E-AO)

sales transactions are properly classified

Timing (T&E-AO)

sales transactions are recorded on the corrected dates

Balance Related Audit Objectives

Rights and Obligations
Existence
Accuracy
Detail tie-in

Classification
Completeness
Cut-off
Realization Value

Existence (AB-AO)

all recorded inventory exists at the balance sheet date

Completeness (AB-AO)

all existing inventory has been counted and included in the inventory summary

Accuracy (AB-AO)

inventory quantities on the client's perpetual records agree with items physically on hand

Classification (AB-AO)

inventory items are properly classified as to RM, AIP, and FG

Cutoff (AB-AO)

Purchase cutoff at year-end is proper. Sales cutoff at year-end is proper.

Detail tie-in (AB-AO)

Total inventory items agrees with general ledger

Realizable value (AB-AO)

Inventories have been written down where net realizable value is impaired

Rights and obligations (AB-AO)

The company has title to all inventory items listed. Inventories are not pledged as collateral

Presentation and Disclosure Related Audit Objectives

Classification and understandability
Completness
Occurrence and rights and obligations
Allocation and valuation

Occurrence and right and obligations (DR-AO)

notes payable as described in the footnotes exist and are obligations of the company.

Completeness (DR-AO)

All required disclosures related to notes payable are included in the financial statement footnotes

Valuation and allocation (DR-AO)

Footnote disclosures related to notes payable are accurate.

Classification and Understandability (DR-AO)

Notes payable are appropriately classified as to short-term and long-term obligations and related financial statement disclosures are understandable.

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