An Introduction to Assurance and Financial Statement Auditing Chapter 1 An Introduction to Assurance and Financial Statement Auditing McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Analytical and logical skills Much more conceptual in nature The Study of Auditing The study of auditing is different from other accounting courses that you have taken in college because … OTHER COURSES AUDITING Rules, techniques and computations to prepare and analyze financial information Analytical and logical skills Much more conceptual in nature 1-2

The Demand for Auditing and Assurance LO# 2 The Demand for Auditing and Assurance The development of the corporate form of business and the expanding world economy over the last 200 years have given rise to an explosion in the demand for assurance provided by auditors. 1-3

LO# 2 Principals and Agents A public company is a company that sells its stocks or bonds to the public, giving the public a valid interest in the proper use, or stewardship, over the company’s resources. Managers Stockholders Agents Principals 1-4

LO# 2 The Role of Auditing Figure 1-1 Overview of the Principal-Agent Relationship Leading to the Demand for Auditing 1-5

LO# 2 The Role of Auditing Table 1-2 Summary of Management Assertions by Category The role of Auditing is to test management assertions about classes of transactions, about account balances, and about presentation and disclosure. These assertions are: Classes of Transactions - occurrence, completeness, authorization, accuracy, cutoff, classification; Account Balances - existence, rights and obligations, completeness, valuation and allocation; and Presentation and Disclosure – occurrence and rights and obligations, completeness, classification and understandability, accuracy and valuation. 1-6

Relationships among Auditing, Attest, and Assurance Services LO# 4 Relationships among Auditing, Attest, and Assurance Services 1-7

Auditing, Attest, and Assurance Services Defined LO# 5 Auditing, Attest, and Assurance Services Defined Attest Assurance Services Auditing A systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users. 1-8

Auditing, Attest, and Assurance Services Defined LO# 5 Auditing, Attest, and Assurance Services Defined Assurance Services Auditing Attest Attest services occur when a practitioner is engaged to issue ... a report on subject matter, or an assertion about subject matter, that is the responsibility of another party. 1-9

Auditing, Attest, and Assurance Services Defined LO# 5 Auditing, Attest, and Assurance Services Defined Attest Assurance Services Auditing Independent professional services that improve the quality of information, or its context, for decision makers. 1-10

Overview of the Financial Statement Audit Process LO# 6 Overview of the Financial Statement Audit Process 1-11 11

Fundamental Concepts in Conducting a Financial Statement Audit LO# 6 Fundamental Concepts in Conducting a Financial Statement Audit Materiality Audit Risk Evidence 1-12

LO# 6 Materiality Materiality is the magnitude of an omission or misstatement of accounting information that, in light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement. 1-13

LO# 6 Audit Risk Audit risk is the risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated. The auditor’s standard report states that the audit provides only reasonable assurance that the financial statements do not contain material misstatements. Reasonable assurance implies some risk that a material misstatement could be present in the financial statements and the auditor will fail to detect it. 1-14

Evidence Regarding Management Assertions LO# 6 Evidence Regarding Management Assertions Evidence that assists the auditor in evaluating management’s financial statement assertions consists of the underlying accounting data and any additional information available to the auditor, whether originating from the client or externally. Relevance – Is the information related to the specific assertion being tested? Reliability – Can the information be relied upon to signal the true state of the specific assertion being tested? 1-15

Sampling: Inferences Based on Limited Observations LO# 7 Sampling: Inferences Based on Limited Observations Auditors use (1) their knowledge about the transactions and/or (2) a sampling approach to examine the transactions. It would be too costly for the auditor to examine every transaction. 1-16

Major Phases of the Audit LO# 8 Major Phases of the Audit Client acceptance/continuance Preliminary engagement activities Plan the audit Consider and audit internal control Audit business processes and related account (e.g. revenue generation) Complete the audit Evaluate results and issue audit report 1-17

LO# 9 Issue the Audit Report The title line of the audit report includes the word “Independent,” and usually, the report is addressed to the stockholders of the company. The audit report includes an introductory paragraph, a scope paragraph, an opinion paragraph, an explanatory paragraph referring to the audit of internal control, the name of the auditor or audit firm, and the date of the audit report. Unqualified Qualified Adverse 1-18

The auditor may issue an unqualified/unmodified opinion. LO# 9 Issue the Audit Report The auditor may issue an unqualified/unmodified opinion. The auditor’s report (audit opinion) is the main product or output of the audit. The standard unqualified (clean) audit report is the most common type of report issued. In this context, unqualified means that because the financial statements are free of material misstatements, the auditor does not find it necessary to qualify his or her opinion about the fairness of the financial statements. 1-19

The auditor may issue a qualified opinion. LO# 9 Issue the Audit Report The auditor may issue a qualified opinion. Suppose a client’s financial statements contain a misstatement that the auditor considers material and the client refuses to correct the misstatement. The auditor will likely qualify the report, explaining that the financial statements are fairly stated except for the misstatement identified by the auditor. 1-20

The auditor may issue an adverse opinion. LO# 9 Issue the Audit Report The auditor may issue an adverse opinion. Suppose a client’s financial statements contain a misstatement that the auditor considers so material that it pervasively affects the interpretation of the financial statements. Given such a situation, the auditor will issue an adverse opinion, indicating that the financial statements are not fairly stated and should not be relied upon. 1-21