2 Audit Objectives, Procedures, and Working Papers
3 Understand the client’s business Chapter 4 OverviewActivitiesPre-engagementarrangementsUnderstand the client’s businessObtain thefinancial statementsBasic ConceptsPage 99Managementassertions &audit objectivesSufficientappropriateevidenceGeneralauditproceduresAudit workingpapers
4 Learning Objective 1Describe the activities auditors undertake before beginning an audit.
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.Page 99
6 Pre-engagement Arrangements Client selection and retention:An important element of an accounting firm’s 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.Pages
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.Pages
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.Page 101
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.Page 100
10 Engagement LettersWhen 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.Pages
11 Pre-engagement Arrangements Staff assignment:When the new client is obtained, accounting firms assign a full-service team to the new client.Engagement partnerAudit managerOne or more senior audit staff membersStaff assistantsSpecialistsA tax partner, a consulting services partner and a second audit partnerFor a small firm or client, audit team may be just one or two people.Page 102
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 forevaluation of the efficiency of audit team membersbilling the clientplanning of the next auditTime budget allows the audit firm to spread its workload between interim and year-end periods.Interim – before the statement dateYear-end – at or after the statement datePages
14 Learning Objective 2Identify the procedures and sources of information that auditors can use to obtain knowledge of a client’s business and industry.
15 Understanding the Client’s 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 misstatementEfficient audit: provides sufficient appropriate audit evidence in an economical mannerEnhance accuracy of auditor’s evaluationProvide better ancillary services to clientPage 105
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.Pages
17 Understanding the Client’s Business Methods and sources of information:For continuing audits, information is available in the permanent files.Enquiry and interview with client management and personnel toobtain information for computer based audit workdetermine needs of users of the statementsObservation and tour of company’s physical facilitiesStudy and review of published materials, guides and reference materials on the industry and the client.PagesA list of sources of business/industry information is printed on page 107
18 Understanding the Client’s 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.Page 108
19 Learning Objective 3Name the principal accounts in each cycle in accounting and business processes.
20 Management’s Financial Statements There are two important points to remember about client financial statements:Management is responsible for preparing them, and they contain management’s assertions about economic actions and events.The financial statement numbers are produced by the company's accounting system and summarized by the trial balance.Page 109
21 Management’s 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 investmentThe purpose of using cycles is to group together related accounts by transactions that normally affect them all.Page 109
22 Trial Balance Accounts are organized by cycle Should list comparative period
23 Learning Objective 4Describe and define the five principal management assertions in financial statements, and explain their role for establishing audit objectives.
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.Page
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.Page 113
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.Page 113
27 Management Assertions and Audit Objectives Presentation and disclosure:Determine whether the accounting principles are properly selected and applied and whether disclosures are adequate.Page 114
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 assertionsFinancial statement assertions are the focal points for audit procedures.Page 114
29 Assertions 7 assertions listed in CICA Handbook ExistenceOccurrence -> transactionsCompletenessOwnershipValuationMeasurementStatement presentation5 textbook categories of assertionsExistence or occurrenceCompletenessRights & obligationsValuation or allocationPresentation & disclosurePage 114
30 Learning Objective 5Explain audit evidence in terms of its appropriateness and relative strength of persuasiveness.
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.Page 115
32 Reliability of Evidence 1. Auditors direct, personal knowledge:Gained though observation and recalculationThis is the most reliable evidence.2. External evidence:Documentary evidence that is obtained directly from independent sources.Very reliable evidencePage 115
33 Reliability of Evidence 3. External-internal evidence:Documentary evidence that originates outside the client’s 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 client’s system.Low reliability, but used extensively under satisfactory internal control conditions.Plentiful and easy to obtain, less costly than other evidence.Page 115
34 Reliability of Evidence 5. Spoken and written representations:Evidence that comes from the client’s 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.Page 116
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.Page 116
36 Learning Objective 6List and describe six general types of audit techniques for gathering evidence.
37 General Audit Procedures The third examination standard identifies six techniques for gathering evidence:computationobservationconfirmationenquiryinspectionanalysisPage 117
38 General Audit Procedures Computation:Performing independent calculations or recalculating the client’s calculations.Computation produces highly reliable mathematical evidence.Computation addresses existence and valuation for calculated amounts.Page 117
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.Page 117
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.Page 118
41 General Audit Procedures Confirmation procedures:Confirmations should be printed on the client’s 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.Page 118
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.Page 118
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 client’s business.SSA audits put increasing stress on enquiry.Page 119
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.Page 120
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.Page 121Source documentsAccount / other summaryVouch
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 completenessPage 121Source documentsAccount / other summaryVouchTrace
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.Page 121
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.Pages
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.Pages
50 Learning Objective 7Discuss the effectiveness of various audit procedures.
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.Pages
52 Learning Objective 8Review an audit working paper for proper form and content.
53 Audit Working PapersWorking 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.Pages
54 Audit Working Papers Permanent file: Current 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.PageSee listing of administrative papers on page 127
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.Page 130
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.Page 130
57 Audit W/P SoftwareSpecialized W/P software is becoming very popular. Advantages include:increase in productivity by automating tasksintegration with client database (extraction of trial balance or transactions)facilitation of analysis, links to other databases, and websitesPage 130
58 Framework for Strategic Analysis (Appendix 4A) PEST analysis:Political factorsStability, tax policy, spending, internationalEconomic factorsInflation, employment, interest rates, GNPSocial and cultural factorsDemographics, education, lifestyle, incomeTechnological factorsNew developments, speed of technology transfer, rate of obsolescencePage 137
59 Porter’s Five Forces Model (Appendix 4A) New EntrantsThreat of new entrantsSuppliersBargaining power of suppliersIndustry competitorsBuyersBargaining power of buyersFirmPagesIntensity of rivalrySubstitutesThreat of substitutes