1. 5-1 MODULE 4 MODULE 4 Park Avenue CPA Review Joseph A. Maffia, CPA Park Avenue CPA Review Joseph A. Maffia, CPA

2. 5-2 JMaffia@ParkAveCPAReview.com Joseph A. Maffia, CPA JMaffia@ParkAveCPAReview.com

3. 5-3 2 rd Standard of fieldwork  The audit must obtain sufficient understanding of the entity and its environment, including its internal control structure to assess the risk of material misstatement of the financial statements due to error, fraud, and to design the nature, timing and extent of further audit procedures. Auditors must obtain sufficient appropriate audit evidence to reduce audit risk to a low level in every audit.

4. 5-4 Financial Statement Assertions  Relevant assertions are those that, without regard for controls, have a reasonable possibility of containing a material misstatement; types Assertions about account balances (Accounts) Assertions about classes of transactions and events (Transactions) Assertions about presentation and disclosure (Disclosures)

5. 5-5 Financial Statement Assertions: Auditing Standards Board and International Standards AccountsTransactionsDisclosures ExistenceOccurrence Rights and obligations Completeness Valuation and allocation AccuracyAccuracy and valuation Cutoff ClassificationClassification and understandability

6. 5-6 Combined Assertions Used in this Text Combined Assertions Used in this Text  Existence or Occurrence--Assets, liabilities, and equity interests exist and recorded transactions have occurred  Rights and Obligations--The company holds rights to the assets, and liability are the obligations of the company  Completeness--All assets, liabilities, equity interests, and transactions that should have been recorded have been recorded  Cutoff—Transactions and events have been recorded in the correct accounting period  Valuation, Allocation and Accuracy—All transactions, assets, liabilities and equity interests are included in the financial statements at proper amounts  Presentation and Disclosure--Accounts are described and classified in accordance with generally accepted accounting principles, and financial statement disclosures are complete, appropriate, and clearly expressed

7. 5-7 Audit Risk  The possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated This is the risk that the auditors will issue an unqualified opinion on financial statements that contain a material departure from GAAP.  Auditors must obtain sufficient appropriate audit evidence to reduce audit risk to a low level in every audit.

8. 5-8 Audit Risk Risk of Material Risk That the Audit Risk = Misstatement * Auditors Fail to the Misstatement = Inherent Control Detection Risk * Risk * Risk  Inherent Risk--Risk of a material misstatement occurring in an assertion assuming no related internal controls.  Control Risk--Risk that a material misstatement in an assertion will not be prevented or detected on a timely basis by the company’s internal control.  Detection Risk--Risk that the auditors’ procedures will lead them to conclude that a material misstatement does not exist in an assertion when in fact such misstatement does exist.

9. 5-9 Audit Risk Formula AR = IR * CR * DR AR = Audit risk IR = Inherent risk CR = Control risk DR = Detection risk

10. 5-10 Inherent Risk  Factors that affect inherent risk: Nature of the client and its environment Nature of the particular financial statement element  Business characteristics indicative of high inherent risk: Inconsistent profitability of client Operating results highly sensitive to economic factors Going concern problems Large known and likely misstatements detected in prior audits Substantial turnover, questionable reputation, or inadequate accounting skills of management

11. 5-11 Assertions with high inherent risk  Involve: Difficult to audit transactions or balances Complex calculations Difficult accounting issues Significant judgment by management Valuations that vary significantly based on economic factors

12. 5-12 Types of Transactions  Routine Recurring financial statement activities recorded in the accounting records in the normal course of business Lower inherent risk  Nonroutine Involve activities that occur only periodically such as the taking of physical inventories High inherent risk  Estimation transactions Activities that create accounting estimates Higher inherent risk

13. 5-13 Appropriateness of Audit Evidence Auditor must obtain sufficient appropriate audit evidence.  To be appropriate audit evidence must be: Relevant Reliable  Principles—Audit evidence is ordinarily more reliable when it is Obtained from knowledgeable independent sources outside the company rather than nonindependent sources Generated internally through a system of effective controls rather than ineffective controls. Obtained directly by the auditor rather than indirectly or by inference Documentary in form rather than oral Provided by original documents rather than copies

14. 5-14 Reliability of Certain Types of Audit Evidence RELIABILITYTYPEEXAMPLE HighPhysicalInventory Observation Documentary ExternalCutoff Bank Statement External/InternalPurchase Invoice InternalSales Invoice LowClient RepresentationsManagement Representation Letter

15. 5-15 Types of Audit Evidence 1. Accounting information system 2. Documentary evidence 3. Third-party representations 4. Physical evidence 5. Computations 6. Data interrelationships 7. Client representations

16. 5-16 Common Audit Procedures

17. 5-17 Overall Types of Audit Procedures  Risk assessment procedures To obtain an understanding of the client and its environment, including its internal control, to assess the risks of material misstatement  Further Audit Procedures Tests of controls When appropriate, to test the operating effectiveness of controls in preventing material misstatements Substantive procedures To detect material misstatements at relevant assertion level. Substantive procedures include (a) analytical procedures, (b) tests of details of account balances, transactions and disclosures

18. 5-18 Substantive Procedures  Analytical procedures  Tests of details Tests of account balances Tests of classes of transactions Tests of disclosures One may change the scope of audit procedures by changing the (NTE, or re- ordered as NET): Nature (type and form) Timing (when performed) Extent (quantity of evidence obtained)

19. 5-19 Nature and Timing of Procedures Holding the extent of procedures constant, one may increase the scope of procedures (make them more effective) by either changing the Nature-- obtain more reliable evidence often externally generated evidence. Timing--wait until year-end to obtain evidence from entire set of transactions as contrasted to performing interim testing, say two months prior to year-end and simply updating those procedures.

20. 5-20 Extent of Procedures Holding other factors such as the nature and timing of procedures constant: The greater the risk of material misstatement, the greater the needed extent of substantive procedures The main way to increase the extent of audit procedures is to examine more items Sample sizes should reduce detection risk so as to restrict audit risk to a low level

21. 5-21 Typical Procedures Presentation and disclosures Review disclosures Inquiry about disclosures Existence or Occurrence Confirmation Observation Trace/Vouch Rights and Obligations Authorization

22. 5-22 Typical Procedures Completeness Analytical procedures Cutoff Valuation, allocation and accuracy Foot schedules Agree schedules balances to G/L Agree financial statement balances to schedules

23. 5-23 Directional testing Vouching = existence Tracing = completeness  Tacing– from source document to ledger.  Vouching – from Ledger to source document.

24. 5-24 General on Analytical Procedures (1 of 3)  Timing of analytical procedures Risk assessment (sometimes referred to as planning analytical procedures) Substantive procedures Final review  Steps involved Develop expectation of account (or ratio) balance Determine amount of difference that can be accepted without investigation Compare the company’s account (ratio) with the expectation Investigate and evaluate significant differences

25. 5-25 General on Analytical Procedures (2 of 3)  Developing an expectation Prior period information Anticipated results Relationships among elements of financial information within a period Industry information Relationships between financial information and relevant nonfinancial data.

26. 5-26 General on Analytical Procedures (3 of 3)  Types of Expectations Trend analysis—analyze changes in accounts of a company over time Ratio analysis – compare relationships between two or more financial statement accounts or comparisons of account balances to nonfinancial data Liquidity (e.g., current ratio) Leverage (e.g., debt to equity) Profitability (e.g., gross profit percentage) Activity (e.g., inventory turnover)

27. 5-27 Ratio Analysis  Approaches to ratio analysis Horizontal analysis Review ratios over time Cross sectional analysis Analyze ratios of similar firms at a point in time Vertical analysis Analyze relationships within a period “Common size” statements prepared Other methods Regression analysis, reasonableness test

28. 5-28 Audit procedures  F OOTING AND CROSSFOOTING  I NQUIRY  V OUCHING  E XAMINE   C ONFIRMATION  A NALYTICAL PROCEDURES  R ECONCILE  R ECALCULATE  O BSERVATION  T RACING  S UBSEQUENT EVENTS

29. 5-29 Identifying Potential Misstatements

30. 5-30 Basic Approaches to Auditing Accounting Estimates  Review and test management’s process for developing the estimate.  Independently develop an estimate to compare to management’s estimate.  Review subsequent events or transactions bearing on the estimate.

31. 5-31 Auditing Fair Values  Inputs to use in applying valuation techniques (FAS 157) Level 1 – inputs of observable quoted prices in active markets for identical assets or liabilities Ex. A closing stock price in WSJ Level 2 – inputs of observable quoted prices, generally for similar assets or liabilities in active markets Ex. Company discounts future cash flows on its not publicly traded debt securities at rate used by market for publicly traded debt securities Level 3 – inputs that are unobservable for the assets or liability Ex. A private company uses judgment to determine a proper rate to discount the future cash flows of its not publicly traded securities

32. 5-32 Related Party Transactions  Disclosure requirements must be met  Primary challenge is identifying undisclosed related party transactions Determine related parties Inquiries of management Review SEC filings, stockholder’s listings and conflict-of-interest statements Be alert for transactions with related parties and any transactions with unusual terms

33. 5-33 Functions of Audit Documentation  Primary functions: Support the auditors’ compliance with auditing standards Support the auditors’ opinion  Secondary functions: Assist continuing and new audit team members in planning and performing the audit Serves as a record of matters of continuing audit interest Assists in supervision and review of the audit Demonstrates the accountability of team members Assists internal reviewers, external peer reviewers, PCAOB inspectors, and successor auditors in performing their roles

34. 5-34 Sufficiency of Audit Documentation  Audit documentation should be sufficient to: Enable an experienced auditor to understand the work performed and the significant conclusions reached Identify who performed and reviewed the work Show that the accounting agree or reconcile to the financial statements  Audit documentation should include all significant audit findings and the actions taken to address them

35. 5-35 Audit Documentation  AICPA 5 years 60 days  PCAOB 7 years 45 days  NYS 7 years 45 days

36. 5-36 Types of Working Papers  Audit administrative working papers  Working trial balance  Lead schedules  Adjusting journal entries and reclassification entries  Supporting schedules  Analysis of a ledger account  Reconciliations  Computational working papers  Corroborating documents

37. 5-37

38. 5-38 Preparation of a Working Paper – Figure 5.8

39. 5-39 Types of Working Files  Current files Current year working papers Index and cross-referencing  Permanent files Items of continuing audit interest

40. 5-40 Rep letter  Required by GAAS Final step Dating of report  Purpose Put oral representations in writing  Format Signed by ceo and cfo

41. 5-41 Inquiry of client’s lawyer  Corroborate mgmt’s assertions Final step Dating of report  Near end of audit

42. 5-42 Other matters  Going Concern  Subsequent events  Use of a specialist  Illegal acts  Litigation

43. 5-43 Other matters  Kitting  Bank transfer schedule  Lapping  Confirmation  Inventory observation  Audit completion procedures