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Electronic Presentations in Microsoft ® PowerPoint ® Prepared by Brad MacDonald SIAST © 2003 McGraw-Hill Ryerson Limited
Copyright © 2003 McGraw-Hill Ryerson Limited Chapte r 4 2 Audit Objectives, Procedures, and Working Papers
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 3 Chapter 4 Overview Pre- engagement arrangements Activities Management assertions & audit objectives Basic Concepts Understand the clients business Obtain the financial statements Sufficient appropriate evidence General audit procedures Audit working papers
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 4 Learning Objective 1 Describe the activities auditors undertake before beginning an audit.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 5 Pre-engagement Arrangements Auditors undertake two types of activities before beginning an audit: –Risk management: Auditors try to reduce the risk (probability of something going wrong) by carefully managing the engagement. –Quality management: Auditors manage audit in accordance with quality control standards.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 6 Pre-engagement Arrangements Client selection and retention: –An important element of an accounting firms quality control policies and procedures is a system for deciding (a) to accept a new client, and (b) whether to resign from audit engagements. –Accounting firms are not obligated to accept undesirable clients, nor retain existing audit clients.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 7 Client Acceptance and Retention Policies Client acceptance and retention procedures should include: –Obtain and review financial information about prospective client. –Enquire of bankers, legal counsel, other. –Communication with predecessor auditor. –Consider unusual risks. –Evaluate independence. –Consider needs for special skills.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 8 Communication Between Predecessor and Successor Auditors When companies change auditors, the former auditor is the predecessor auditor, and the new auditor is the successor auditor. –Rules of professional conduct require the successor auditor to contact the predecessor auditor. Ask if there are issues that should be considered in accepting the client. Obtain information from the predecessor auditor for planning the audit. –Predecessor auditor is required by the rules of conduct to respond to the communication.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 9 Communication Between Predecessor and Successor Auditors Successor auditor should ask the client to consent to discussions with the predecessor auditor. –Consent is not required, the communication must take place. –Consent allows the predecessor auditor to relay more information. Predecessor auditor still has a duty to maintain confidentiality. Audit files belong to the auditor, not the client. –Auditor should be wary of any client who refuses consent.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 10 Engagement Letters When a new audit client is accepted an engagement letter should be obtained. –The engagement letter forms the contract for the audit. Engagement letters are highly recommended to reduce the risk of misunderstandings. –A new engagement letter should be obtained every year of a continuing audit.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 11 Pre-engagement Arrangements Staff assignment: –When the new client is obtained, accounting firms assign a full-service team to the new client. Engagement partner Audit manager One or more senior audit staff members Staff assistants Specialists A tax partner, a consulting services partner and a second audit partner –For a small firm or client, audit team may be just one or two people.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 12 Pre-engagement Arrangements Time budget: –The partner or manager propose a plan for the timing of the work (interim and year-end). –Time reports are recorded by budget categories for evaluation of the efficiency of audit team members billing the client planning of the next audit –Time budget allows the audit firm to spread its workload between interim and year-end periods. Interim – before the statement date Year-end – at or after the statement date
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 13 Example Time Budget
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 14 Learning Objective 2 Identify the procedures and sources of information that auditors can use to obtain knowledge of a clients business and industry.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 15 Understanding the Clients Business Auditing standards require a sufficient understanding of the business to plan and perform audit work. –Objectives: Effective audit: identify and address all significant risks of material misstatement Efficient audit: provides sufficient appropriate audit evidence in an economical manner Enhance accuracy of auditors evaluation Provide better ancillary services to client
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 16 Strategic Systems Approaches to Auditing A recent trend in audit practice, referred to as strategic systems approach (SSA), is to base more of the audit on knowledge of the business. –Used by two of the Big four firms, but has not yet filtered down to smaller firms. –SSA is a top-down approach. Starts with corporate strategy to determine effects on financial statements (Ch. 13). –Traditional audits use a bottom-up approach. Gather evidence on individual transactions and aggregate to financial statement level.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 17 Understanding the Clients Business Methods and sources of information: –For continuing audits, information is available in the permanent files. –Enquiry and interview with client management and personnel to obtain information for computer based audit work determine needs of users of the statements –Observation and tour of companys physical facilities –Study and review of published materials, guides and reference materials on the industry and the client.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 18 Understanding the Clients Business Other aspects of understanding the business: –First-time audits require more work. –Audit efficiency can be realized by working in tandem with the internal auditors. –Analysis of client financial statements and ratios contribute a significant understanding of the business. –Understanding enables the auditor to determine the need for specialists.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 19 Learning Objective 3 Name the principal accounts in each cycle in accounting and business processes.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 20 Managements Financial Statements There are two important points to remember about client financial statements: Management is responsible for preparing them, and they contain managements assertions about economic actions and events. The financial statement numbers are produced by the company's accounting system and summarized by the trial balance.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 21 Managements Financial Statements To simplify the audit plan, auditors typically group the accounts into several cycles. –This text contains four cycles: (1) revenues and collection (2) acquisition and expenditure (3) production and conversion (4) finance and investment –The purpose of using cycles is to group together related accounts by transactions that normally affect them all.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 22 Trial Balance Accounts are organized by cycle Should list comparative period
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 23 Learning Objective 4 Describe and define the five principal management assertions in financial statements, and explain their role for establishing audit objectives.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 24 Management Assertions and Audit Objectives Existence or occurrence: –Establish with evidence that assets, liabilities and equities actually exist and that revenue and expense transactions actually occurred as of a proper date. –Cut-off: No transactions from the next period are recorded at the statement date.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 25 Management Assertions and Audit Objectives Completeness: –Establish with evidence that all transactions and accounts that should be presented in the financial reports are included. –Cut-off: All transactions from the period are recorded in the period.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 26 Management Assertions and Audit Objectives Rights and obligations: –Establish with evidence that amounts reported as assets of the company represent property rights and the amounts reported as liabilities represent obligations. Valuation or allocation: –Determine whether proper values have been assigned to assets, liabilities, equities, revenues, and expenses.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 27 Management Assertions and Audit Objectives Presentation and disclosure: –Determine whether the accounting principles are properly selected and applied and whether disclosures are adequate.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 28 Management Assertions and Audit Objectives A compliance assertion: –Management asserts compliance with laws and regulations. –Not normally listed as a separate management assertion. Importance of assertions –Financial statement assertions are the focal points for audit procedures.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 29Assertions 7 assertions listed in CICA Handbook Existence Occurrence -> transactions Completeness Ownership Valuation Measurement Statement presentation 5 textbook categories of assertions Existence or occurrence Completeness Rights & obligations Valuation or allocation Presentation & disclosure
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 30 Learning Objective 5 Explain audit evidence in terms of its appropriateness and relative strength of persuasiveness.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 31 Appropriateness of Evidence To be considered appropriate, evidence must be relevant and reliable. –Relevant: audit evidence must relate to one of the management assertions. –Reliability: of audit evidence depends on nature and source. Reliability combined with relevance determine the persuasiveness of evidence. The following hierarchy of evidence can be used to judge reliability.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 32 Reliability of Evidence 1. Auditors direct, personal knowledge: –Gained though observation and recalculation –This is the most reliable evidence. 2. External evidence: –Documentary evidence that is obtained directly from independent sources. –Very reliable evidence
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 33 Reliability of Evidence 3. External-internal evidence: –Documentary evidence that originates outside the clients system, but that has been received and processed by the client: –This is reliable evidence (although circumstances of internal control are important). 4. Internal evidence: –Evidence that is produced within the clients system. –Low reliability, but used extensively under satisfactory internal control conditions. –Plentiful and easy to obtain, less costly than other evidence.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 34 Reliability of Evidence 5. Spoken and written representations: –Evidence that comes from the clients officers, directors, management, and employees in response to enquiry. –Generally considered the weakest form of evidence. Representations should be corroborated with other types of evidence.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 35 Sufficiency of Evidence Sufficiency of evidence is a question of how much appropriate evidence is enough. –No official standard, the auditor must use professional judgement. Test of sufficiency is whether you can persuade someone else that you have collected enough evidence to support your conclusion.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 36 Learning Objective 6 List and describe six general types of audit techniques for gathering evidence.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 37 General Audit Procedures The third examination standard identifies six techniques for gathering evidence: –computation –observation –confirmation –enquiry –inspection –analysis
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 38 General Audit Procedures Computation: –Performing independent calculations or recalculating the clients calculations. Computation produces highly reliable mathematical evidence. Computation addresses existence and valuation for calculated amounts.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 39 General Audit Procedures Observation: –Looking at the application of policy or procedures by others. Reliable evidence as to performance at the time of observation. Produces a general awareness of events.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 40 General Audit Procedures Confirmation: –Consists of (written) enquiry to verify accounting records. Confirmation with independent parties is used widely for a variety of transactions and balances. Confirmation can produce evidence regarding existence, ownership, valuation and cut-off.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 41 General Audit Procedures Confirmation procedures: –Confirmations should be printed on the clients letterhead, signed by a client officer. –Auditor needs to ensure that the address on the confirmation is legitimate. –The recipient should be able to provide the information. –The auditor must mail the confirmations. –Responses must be returned directly to the auditor.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 42 General Audit Procedures Forms of confirmations: –Positive confirmations: request a reply in all cases. Follow-up is required for all exceptions reported, and for all unreturned confirmations. –Negative confirmations: request a reply only where information is incorrect. Only exceptions need to be followed up.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 43 General Audit Procedures Enquiry: –Involves the collection of oral evidence from the client and independent third parties. Evidence from enquiry requires corroboration. Evidence from enquiry is important in understanding the clients business. SSA audits put increasing stress on enquiry.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 44 General Audit Procedures Inspection: –Looking at records, documents, or assets having physical substance. Reliable evidence for existence, supports valuation. Documents can be prepared by independent outside parties as either formal authoritative or ordinary documents. Documents can also be prepared by the entity under audit.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 45 Particular Inspection Techniques Vouching: –Information is selected from an account or other summary of information and the auditor goes back through the control system to find the source documentation. Vouching supports existence. Source documents Account / other summary Vouch
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 46 Particular Inspection Techniques Tracing: –Auditor selects source documents and proceeds forward through the control system to the final recording of the transaction. Tracing supports completeness Source documents Account / other summary Vouch Trace
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 47 Particular Inspection Techniques Scanning: –An eyes-open approach of looking for anything unusual. Does not produce direct evidence, but can raise questions. Computers can be used to scan electronic data files. Scanning can be used to reduce sampling risk by scanning the items not selected.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 48 General Audit Procedures Analysis: –Evaluation of financial items in determining other audit programs and performing analytic procedures that compare recorded amounts to expectations. Analysis is the other category in the list of audit techniques. Analytical procedures are both important and effective. Analysis is used in planning, execution, and completion of the audit.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 49 Analytic Procedures Some typical analytic procedures: –Compare current year to prior year. –Compare current year to budget. –Evaluate current year balances against other current year balances. –Compare financial ratios to industry standards. –Study relationship of balances and non- financial information.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 50 Learning Objective 7 Discuss the effectiveness of various audit procedures.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 51 Effectiveness of Audit Procedures Audits are designed to provide reasonable assurance of detecting misstatements that are material to the financial statements. –Soft procedures (enquiry and analysis) account for 45% to 50% of discovered errors. Note: these procedures are applied first. –Detail procedures are also effective. Misstatements uncovered by soft procedures will be quantified by detail procedures.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 52 Learning Objective 8 Review an audit working paper for proper form and content.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 53 Audit Working Papers Working papers are the auditors record of compliance with GAAS. –Working papers should contain support for the decisions made in the course of the audit. –The auditor is the owner of the working papers. Confidentiality requires client consent before the file is opened to third parties. –There are three categories of working papers, generally stored in two files.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 54 Audit Working Papers Permanent file: –Permanent file papers: information of continuing interest. Current file: –Audit administrative papers: documentation of early planning. –Audit evidence papers: evidence obtained and decisions made.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 55 Working Paper Arrangement and Indexing Working papers (W/P) are grouped in order according to financial statement captions. –Each page in the file must have: Index: A page number that allows a W/P to be removed and replaced properly. Cross-referencing: Connects information between pages in the W/P file. Heading: Includes the entity under audit, period being audited, and a descriptive title.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 56 Working Paper Arrangement and Indexing W/P are grouped in order according to financial statement captions. –Each page in the file must have: Initials: from the auditor and the reviewer. Dates: of the preparation and review. Tick marks: to indicate the work performed. Tick marks should be appropriately described.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 57 Audit W/P Software Specialized W/P software is becoming very popular. Advantages include: –increase in productivity by automating tasks –integration with client database (extraction of trial balance or transactions) –facilitation of analysis, links to other databases, and websites
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 58 Framework for Strategic Analysis (Appendix 4A) PEST analysis: –Political factors Stability, tax policy, spending, international –Economic factors Inflation, employment, interest rates, GNP –Social and cultural factors Demographics, education, lifestyle, income –Technological factors New developments, speed of technology transfer, rate of obsolescence
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 4 59 Porters Five Forces Model (Appendix 4A) Firm Industry competitors Intensity of rivalry New Entrants Threat of new entrants Suppliers Bargaining power of suppliers Substitutes Threat of substitutes Buyers Bargaining power of buyers
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