Learning Objectives Identify and compare the various auditing standards that provide guidance on the audit opinion formulation process List and discuss.

Chapter 5 Professional Auditing Standards and the Audit Opinion Formulation Process

Learning Objectives Identify and compare the various auditing standards that provide guidance on the audit opinion formulation process List and discuss the foundational principles underlying the auditing standards List the phases and related activities in the audit opinion formulation process Explain the concept of accounting cycles and discuss their importance to the audit opinion formulation process

Learning Objectives Describe the assertions that are inherent to financial statements and explain their importance to the audit opinion formulation process Define audit evidence and describe the purpose and types of audit procedures used to obtain audit evidence Discuss the importance of audit documentation and provide examples Discuss audit activities in Phase I of the audit opinion formulation process

Learning Objectives Discuss audit activities in Phase II of the audit opinion formulation process Discuss audit activities in Phase III of the audit opinion formulation process Discuss audit activities in Phase IV of the audit opinion formulation process Discuss audit activities in Phase V of the audit opinion formulation process

Learning Objectives Apply the concepts related to the auditor’s assessment of internal control design effectiveness, implementation, and operating effectiveness Apply the frameworks for professional decision making and ethical decision making to issues involving conducting an audit

THE AUDIT OPINION FORMULATION PROCESS

PROFESSIONAL JUDGMENT IN CONTEXT - Importance of Adhering to Professional Auditing Standards
Adhering to the professional auditing standards is viewed as conducting a quality audit Lack of adherence heightens the risk of issuing an unqualified audit opinion on financial statements that are materially misstated Highlighted in the audits of Thornton Precision Components, Limited (TPC) performed by Ernst & Young, LLP UK (E&Y UK)

What is the role of auditing standards and their underlying principles in promoting a quality audit? (LO 1, 2) How does the fundamental concept of professional skepticism relate to audit quality? (LO 2) What audit evidence is necessary for opining on a client’s financial statements? (LO 6) How does audit documentation provide evidence related to audit quality? (LO 7)

What audit activities are conducted during the audit opinion formulation process to provide reasonable assurance about a client’s financial statements? (LO 8, 9, 10, 11, 12) How does professional judgment and ethical decision making contribute to audit quality? (LO 14)

Learning Objective 1 Identify and Compare the Various Auditing Standards that Provide Guidance on the Audit Opinion Formulation Process

Professional Auditing Standards
Auditors in the United States follow auditing guidance issued by: American Institute of Certified Public Accountants (AICPA) Public Company Accounting Oversight Board (PCAOB) International Auditing and Assurance Standards Board (IAASB) Common objective - Provide assurance to public that audits are conducted in a quality manner

Professional Auditing Standards
Require auditors to develop and communicate: Opinion on financial statements Client’s internal control over financial reporting Vary according to the nature of organization audited Audit compliance depends on: Domicile of the organization Where its stock is publicly traded

AICPA’S AUDITING STANDARDS BOARD - CLARITY PROJECT
Made standards easier to read, understand, and apply Converged its standards with the International Standards on Auditing (ISAs), issued by the IAASB Standards were written using drafting convention called the clarity format Issued the clarified standards in a single Statement on Auditing Standard (SAS No. 122) in 2012

Each standard of Clarity format presented in following sections
Introduction Purpose and scope of the standard Objective Context in which the requirements are set Definitions Relevant meanings of terms in standards Requirements Actions required to achieve objective of the standard Application and other explanatory material Cross-references to the requirements Guidance for applying requirements of standard

Auditing Standards Issued by the IAASB
Objectives Set auditing, assurance, and other related standards Facilitate convergence of international and national auditing and assurance standards Enhance quality and consistency of practice throughout the world Strengthen public confidence in the global auditing and assurance profession

Auditing Standards Issued by the IAASB
Standards should to be understandable, clear, and consistent Launched a program in 2004 to enhance clarity of its ISAs Clarity Project was completed in 2009 As of 2013, a set of its clarified standards comprises of: 36 ISAs 1 International Standard on Quality Control (ISQC)

Each standard of Clarity format presented in following sections
Introduction Purpose and scope of subject matter of ISA Objective Clear statement of the objective of the auditor Definitions For applicable terms included Requirements For each objective are provided Application and other explanatory material Explains what a requirement means or intends to cover

Auditing Standards Issued by the PCAOB
Apply to auditors of U.S. public companies Issued sixteen Auditing Standards (ASs) as of 2013 PCAOB interim standards - Standards adopted from AICPA Requirement for public company auditors, unless superseded by a PCAOB standard Standards issued by AICPA after April 16, 2003, not included

Exhibit 5.1 - Comparison of U.S. and International Auditing Standards

Learning Objective 2 List and Discuss the Foundational Principles Underlying the Auditing Standards

PCAOB Guidance - General standards
Require Audit to be performed by individuals having adequate technical training and proficiency as an auditor Auditors to be independent: In fact, i.e., in reality in terms of mental attitude and In appearance, i.e., in how the auditor is perceived by users Audit to be conducted with professional care expected of a prudent auditor

PCAOB Guidance - Fieldwork standards
Applicable to conduct of the audit Require auditors to: Properly plan and supervise the audit Develop an understanding of client’s controls Prerequisite for developing audit tests Obtain audit evidence by performing audit procedures

PCAOB Guidance - Reporting standards
Applicable to communicating auditor’s opinion Require auditors to: State whether financial statements are presented in accordance with the applicable financial reporting framework (i.e., GAAP or IFRS) Identify conditions where accounting principles are not consistently observed Review disclosures for adequacy and state in the report if disclosures are not reasonably adequate Express an opinion on financial statements as a whole or state that an opinion cannot be expressed

AICPA Guidance - Purpose and premise of audit
Purpose - Enhance degree of confidence that users can place in financial statement Premise - Management has responsibility to: Prepare financial statements Maintain internal control over financial reporting Provide auditor with relevant information and access to personnel

AICPA Guidance - Responsibilities
The auditor’s responsibilities include Having appropriate competence and capabilities to perform audit Complying with ethical requirements Maintaining professional skepticism throughout the audit

AICPA Guidance - Performance
Obtain assurance that financial statements are free from material misstatement Limitations - Lack of absolute assurance about financial statements being free from misstatement Requires an auditor to: Plan and supervise work Determine materiality levels Identify risks of material misstatement Design and implement audit responses to assessed risks

AICPA Guidance - Reporting
Expressing either of the following Financial statements are free of material misstatement Stating that an opinion cannot be expressed

Integrated audit Combines audits of an organization’s financial statements and its internal control over financial reporting In this audit: Opinion provided on effectiveness of internal control over financial reporting Additional audit work done to be able to issue that opinion

Auditing in Practice - Benefits of Integrating the Audits
Integrating audits of internal controls and of financial statements makes sense Both the tests of controls and direct tests of account balances provide evidence related to each other Example: Tests of controls provide indirect evidence that financial statements are free from misstatement Further, if material misstatements found in account balances or disclosures, it implies that there were material weaknesses in internal controls

Learning Objective 3 List the Phases and Related Activities in the Audit Opinion Formulation Process

EXHIBIT OVERVIEW OF CLIENT’S PREPARATION OF FINANCIAL STATEMENTS AND MANAGEMENT REPORT ON INTERNAL CONTROL

Exhibit 5.3 - Activities of each Phase of the Audit Opinion Formulation Process

Important Concepts Affecting Audit Opinion Formulation Process
Accounting cycles Management assertions Audit evidence and audit procedures Documentation

Learning Objective 4 Explain the Concept of Accounting Cycles and Discuss Their Importance to the Audit Opinion Formulation Process

Accounting Cycles Recording and processing transactions that affect a group of related accounts Begin when a transaction occurs and ends when it is recorded in financial statements Break the audit into manageable sections of related accounts

Accounting Cycles Auditor focuses on:
Flow of transactions within a particular cycle Identifying: Points where material misstatement can occur Controls that have been designed and implemented to mitigate those risks Understanding risks and controls within each cycle Helps determine specific audit procedures to be used and specific audit evidence to be obtained

Exhibit 5.4 - Illustrations of Cycles and Related Accounts

Learning Objective 5 Describe the Assertions that Are Inherent to Financial Statements and Explain Their Importance to the Audit Opinion Formulation Process

Financial Statement Assertions
Assertions made by management Existence Completeness Rights and obligations Valuation Presentation and disclosure Related evidence is obtained for accounts and disclosure in financial statements

MANAGEMENT’S FINANCIAL STATEMENT ASSERTIONS IN PCAOB STANDARDS
Existence or Occurrence Refers to existence of assets and liabilities Refers to occurrence of recorded transactions Completeness Refers to inclusion of all transactions and accounts in financial statements Valuation or Allocation Refers to inclusion of accounts in financial statements at appropriate amounts Rights and Obligations Refers to assets being the rights of an organization Refers to liabilities being the obligations of an organization Presentation and Disclosure Refers to components of financial statement being properly classified, described, and disclosed

Learning Objective 6 Define Audit Evidence and Describe the Purpose and Types of Audit Procedures Used to Obtain Audit Evidence

Audit Evidence and Procedures
Audit evidence: Information used by auditor in arriving at conclusions on which the opinion is based Audit procedures: Procedures designed to obtain audit evidence to support audit opinion(s) Risk assessment procedures Provide information for assessing the risks of material misstatement in the financial statements Do not provide sufficient evidence upon which to base an audit opinion Used for purposes of planning the audit

Audit Evidence and Procedures
Tests of controls: Designed for evaluating operating effectiveness of controls in preventing, or detecting and correcting, material misstatements, typically at assertion level Substantive procedures Designed for detecting material misstatements at assertion level Comprising of tests of details and substantive analytical procedures

Audit Procedures Sufficient appropriate audit evidence: Measure of the quantity of audit evidence about following factors of audit procedures Nature Timing Extent Audit program Lists audit procedures to be followed in gathering evidence Helps monitor progress and supervising work

Exhibit 5.6 - Types of Audit Procedures

Discuss the Importance of Audit Documentation and Provide Examples
Learning Objective 7 Discuss the Importance of Audit Documentation and Provide Examples

Audit Documentation Record of audit procedures performed, relevant audit evidence obtained, and conclusions the auditor reached Known as working papers or workpapers

Purposes of Audit Documentation
Assisting engagement team in: Planning and performing audit Supervising and reviewing audit work Retaining a record of matters of continuing significance to future audits Enabling internal or external inspections of completed audits Assisting auditors in understanding work performed in prior year

Examples of Audit Documentation
Audit programs Analyses prepared by client or auditor Memorandums Summaries of significant findings or issues Letters of confirmation and representation Checklists Correspondence concerning significant findings or issues

Learning Objective 8 Discuss Audit Activities in Phase I of the Audit Opinion Formulation Process

Phase I - Making Client Acceptance and Continuance Decisions
Preconditions for accepting auditing engagements Use of an acceptable financial reporting framework Agreement of management to acknowledge and understand its responsibilities

Auditing in Practice - Accepting a New Audit Engagement
Communicate with predecessor auditor Following issues should be addressed Information regarding integrity of management Disagreements with management about accounting policies, auditing procedures Communications to management and those in charge with governance regarding: Fraud and noncompliance with laws Deficiencies and material weaknesses in internal control

Audit Engagement Letter
Document specifying responsibilities of client and auditor that includes the following: Objective and scope of audit of financial statements Responsibilities of auditor and management Statement that some material misstatements may not be detected due to inherent limitations of audit and internal control Identification of applicable financial reporting framework for preparation of financial statements Reference to expected form and content of any reports to be issued

Learning Objective 9 Discuss Audit Activities in Phase II of the Audit Opinion Formulation Process

Phase II - Performing Risk Assessment
Identifying relevant risks and determining audit procedures required to address them Continuing clients - Update information from previous year’s audit New clients - the risk assessment process is more time consuming

Identifying and Assessing Risks of Material Misstatement
Essential to audit planning Requires identification of significant: Accounts Disclosures Relevant assertions Auditor establishes a materiality level overall and for specific accounts and disclosures

EXHIBIT 5.7 - Examples of Sources of Risk of Material Misstatement

Risks at assertion level
Inherent risk The susceptibility of an assertion to a misstatement, due to error or fraud, that could be material, individually or in combination with other misstatements, before consideration of any related controls Control risk The risk that a misstatement due to error or fraud that could occur in an assertion and that could be material, individually or in combination with other misstatements, will not be prevented or detected on a timely basis by the organization's internal control

Risk assessment procedures
Inquiries for information to assist in identifying risks of material misstatement due to fraud or error Preliminary analytical procedures Observation and inspection of documentation

Types of controls Entity-wide controls Transaction controls
Fraud-related controls

Auditing in Practice - Controls to Address Fraud Risk
PCAOB has identified the following Controls over significant, unusual transactions, particularly those resulting in unusual journal entries Controls over journal entries and adjustments made in the period-end financial reporting process Controls over related-party transactions Controls related to significant management estimates Controls mitigating incentives for, and pressures on, management to falsify financial results

types of procedures to assess design effectiveness
Inquiry of appropriate personnel Observation of the organization’s operations Inspection of relevant documentation Performance of walkthroughs Documentation of preliminary assessment of control design and basis for that assessment Understand the approach used by management for conclusions on effectiveness of internal control

Process of documentation uses:
AUDITING IN PRACTICE - DOCUMENTING AUDITOR’S UNDERSTANDING OF AN ORGANIZATION’S INTERNAL CONTROLS Process of documentation uses: Narratives Flowcharts Questionnaires Once documented, in subsequent years audit firms focus on: Changes in the system Effectiveness of monitoring controls

Assessing range of control risk
High control risk Weak internal controls Auditor cannot rely on controls to reduce substantive procedures for account balances Assessing control risk as low Strong internal controls Auditor will test operating effectiveness of controls to reduce substantive procedures for account balances

Requires expanding substantive tests for sales returns by:
AUDITING IN PRACTICE – EXAMPLE FOR WEAK INTERNAL CONTROL DESIGN AND LINKS TO SUBSTANTIVE AUDIT PROCEDURES Scenario - Client’s internal control design assessed as ineffective that makes a preliminary assessment of control risk as high Requires expanding substantive tests for sales returns by: Arranging to be on hand at year end to observe the taking of physical inventory Determining if receipts for items returned by customers are issued in the correct time period

Reviewing credit memos issued shortly after year end
AUDITING IN PRACTICE – EXAMPLE FOR WEAK INTERNAL CONTROL DESIGN AND LINKS TO SUBSTANTIVE AUDIT PROCEDURES Reviewing credit memos issued shortly after year end Increasing number of accounts receivable confirmations sent to the client’s customers

Additional Considerations for an Integrated Audit
Risk assessment procedures apply to: Audit of internal control over financial reporting Audit of financial statements Top-down approach - Used for audit of internal control over financial reporting to select controls to test Begins at financial statement level Focuses on entity-wide controls Works down to significant accounts and disclosures and their relevant assertions

Responding to Identified Risks of Material Misstatement
Purpose of risk assessment procedures Identify risks of material misstatement Determine where misstatements in financial statements may occur Design appropriate audit strategy Controls reliance audit: Includes tests of controls and substantive procedures Substantive audit: Includes substantive procedures and does not include tests of controls

Responding to Identified Risks of Material Misstatement
Selecting specific audit procedures to respond to identified risks Assembling an audit team having knowledge, skill, and ability needed to address assessed risks Emphasizing the need for professional skepticism Providing an appropriate level of supervision for assessed risks Incorporating elements of unpredictability in selection of audit procedures

EXHIBIT 5.8 - Responding to Identified Risks through Evidence Decisions

Additional Considerations for an Integrated Audit
Audit strategy that includes tests of controls to accomplish objectives of both audits Sufficient evidence related to operating effectiveness of controls to support auditors: Control risk assessments for purposes of the audit of financial statements Opinion on internal control over financial reporting as of year-end

Fraud Considerations Performing tests of controls and substantive procedures susceptible to fraud risks Performing procedures related to risk of management override of controls Examining journal entries Reviewing accounting estimates for biases Evaluating business rationale for significant unusual transactions

Learning Objective 10 Discuss audit activities in Phase III of the audit opinion formulation process

PHASE III - Obtaining Evidence about Internal Control Operating Effectiveness
Auditor tests controls Determine whether controls are operating effectively at year-end or throughout the year Auditor obtains more persuasive audit evidence As the reliance auditor places on effectiveness of a control increases

Auditor’s risk assessment procedures include
Auditing in Practice - Risk Assessment Procedures and Tests of Operating Effectiveness of Controls Auditor’s risk assessment procedures include Inquiring about management’s use of budgets Inspecting documentation of management’s comparison of monthly budgeted and actual expenses Inspecting reports pertaining to the investigation of variances between budgeted and actual amounts

Selecting Controls to Test
Involves choosing controls that effectively indicate capability to address the assessed risk of material misstatement for relevant assertions Auditor selects: Entity-wide controls Reduce number of control activities selected for testing Transaction controls

EXHIBIT 5.9 - Linking Financial Statement Assertions and Selecting Controls to Test

Types of Controls and Examples of Concepts Affecting Control Testing
Computerized Controls If there are changes, testing integrity of controls after changes Considering submitting test transactions through the system to determine its performance Taking a random sample of transactions for determining: a) Operations of key controls b) Completion of process Reviewing exception reports and determining: a) Proper exceptions being noted b) Exceptions go to authorized personnel with adequate follow-up Determining changes to important computer applications during the year

Manual Controls Taking a sample of transactions and examining evidence supporting that the controls are working Taking a sample of reconciliations to determine that: a) They were performed by an authorized person b) They were performed properly Reviewing documentation of selected transactions to determine: a) Proper authorization b) Recorded in correct time period Taking a sample of reports used to identify unusual transactions and review them to determine: a) Regular usage b) Identification of unusual items Documented evidence for control to be working; taking sample of transactions to determine control operation evidence Authorizations Reconciliations Reviews for unusual transactions

Controls over Adjusting Entries Taking a sample of adjusting entries and reviewing to determine: a) Supporting documentation b) Appropriate entry c) Entry made in correct accounts d) Proper authorization of entry Giving special attention to significant entries made near year end Documented evidence for controls over normal journal entries and their regular application

Controls over Accounting Estimates All entries being properly authorized Ensuring estimates are updated for current economic conditions Finding evidence that data used for estimation come from reliable sources Documented evidence for controls over estimates ensuring accuracy of data, consistency in performance, regularly updating the model

First Approach to Testing Controls
Take sample of customer orders and trace it through the system to determine whether: There was proper review of credit and Credit authorization or denial was proper Advantage - Most effective because it helps in determining that the control worked effectively Requires documentation of all credit applications and purchase orders required Based on audit sampling

Second Approach to Testing Controls
Taking a sample of recorded items and tracing back to credit approval process Provides evidence on proper credit approval for all items presently recorded Does not provide evidence as to whether other items should have been approved for credit, but had not been approved

Third Approach to Testing Controls
Uses a computer audit program and develops a print-out of account balances exceeding their credit authorization Cost-effective Requires an inference about the control Covers only the operation of the controls related to the current account balances 100% evaluation of each item currently recorded

Testing the Operating Effectiveness
Auditor tests relevant principles of components of: Control environment Risk assessment Information and communication Monitoring

Results of Tests of Controls For financial statement audit
If control deficiencies are identified Assess them to determine whether preliminary control risk assessment should be modified Record the implications for substantive procedures If no control deficiencies are identified Assess whether preliminary control risk assessment is still appropriate Determine extent that controls can provide evidence on accuracy of account balances Determine planned substantive audit procedures

Results of Tests of Controls For financial statement audit
Determine how much assurance about reliability of account balances can be obtained from the effective operation of controls Within any audit, level of assurance will vary across: Accounts Disclosures Assertions

Learning Objective 11 Discuss audit activities in Phase IV of the audit opinion formulation process

Substantive procedures include:
Phase IV - Obtaining Substantive Evidence about Accounts, Disclosures, and Assertions Substantive procedures include: Substantive analytical procedures Tests of details of account balances Considerations in determining appropriate substantive procedures: Source of potential misstatement Extent and type of potential misstatement

EXHIBIT 5.12 - Factors Affecting Substantive Procedures to be Performed

Learning Objective 12 Discuss audit activities in Phase V of the audit opinion formulation process

Phase V - Completing the Audit and Making Reporting Decisions
Completing various review and communication activities Making a decision about what types of opinions should be issued Deciding on the appropriate opinion to be issued It can be based on financial statements and internal control It can be issued in one report or in two separate reports

Learning Objective 13 APPLY THE CONCEPTS RELATED TO THE AUDITOR’S ASSESSMENT OF INTERNAL CONTROL DESIGN EFFECTIVENESS, IMPLEMENTATION, AND OPERATING EFFECTIVENESS

Management Assessment of Controls
Factors considered in deciding whether to categorize a deficiency as significant or not Risk that is being mitigated and whether other controls operate effectively Materiality of related account balances Nature of deficiency Volume of transactions affected Subjectivity of account balance that is subject to control Rate at which control fails to operate

Deficiency of segregation of duties Did not rise to a significant deficiency or a material weakness Management decides to use this deficiency as a motivation to centralize purchases

Deficiency of lack of approval considered as a significant deficiency based on the following rationale: Major departure from an approved process Could lead to purchase of unauthorized goods Could be shipped elsewhere and lead to material misstatement in financial statements

Auditor Assessment of Controls
Auditor reviews: Management’s documentation of its internal control Management’s evaluation and findings related to internal control effectiveness Auditor then gathers evidence on operating effectiveness of these controls By taking a random sample auditor needs to independently determine that the controls are working or not

Auditor Assessment of Controls
Implications for substantive procedures in financial statement audit: Auditor will do limited testing of inventory quantities at year end Auditor will assess year-end inventory for potential obsolescence Auditor will continue to examine all adjusting entries at the end of the year

Learning Objectives Identify and compare the various auditing standards that provide guidance on the audit opinion formulation process List and discuss.

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Learning Objectives Identify and compare the various auditing standards that provide guidance on the audit opinion formulation process List and discuss.

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Presentation on theme: "Learning Objectives Identify and compare the various auditing standards that provide guidance on the audit opinion formulation process List and discuss."— Presentation transcript:

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