Copyright © 2007 Pearson Education Canada 5-1 Chapter 5: Audit Responsibilities and Objectives

Copyright © 2007 Pearson Education Canada 5-2 Chapter 5 Objectives  Consider the objective of conducting an audit of financial statements  Explain the difference between management and auditor responsibilities  What is the nature and purpose of the cycle approach?

Copyright © 2007 Pearson Education Canada 5-3 Chapter 5 Objectives (continued)  Describe management assertions  Relate management assertions to general transaction-related and balance-related audit objectives  Discuss the audit process and its four phases

Copyright © 2007 Pearson Education Canada 5-4 Objective of an Audit of Financial Statements  Expression of an opinion  Are financial statements fairly presented?  Are financial statements in conformity with GAAP?  The audit is conducted by an independent auditor

Copyright © 2007 Pearson Education Canada 5-5 Management Responsibilities with Respect to financial statements  Adoption of sound accounting policies  Maintenance of adequate internal controls  Providing fair representations in the financial statements

Copyright © 2007 Pearson Education Canada 5-6 Hillsburg Hardware Illustrates Management Responsibilities  Hillsburg Hardware Limited illustrates management responsibilities: – P. 144 Management’s Accountability report – P. 149 Management’s Discussion and Analysis – P. 143 report on internal control is optional in Canada

Copyright © 2007 Pearson Education Canada 5-7 Auditor Responsibilities with Respect to Financial Statements  Expression of an opinion  Reasonable assurance that material misstatements are absent: – Includes errors, fraud and other irregularities  Plan and perform the audit in accordance with GAAS

Copyright © 2007 Pearson Education Canada 5-8 Types of Misstatements: Some are Difficult to Detect!  Error: unintentional misstatement  Fraud and other irregularities: intentional – Theft of assets, often employee fraud – Fraudulent financial reporting, often management fraud – Computer fraud – Illegal acts (direct-effect or indirect-effect)

Copyright © 2007 Pearson Education Canada 5-9 Provide some examples  Can you think of any recent financial fiascos talked about in the newspaper?  What type of errors were presented?  Was fraud involved?

Copyright © 2007 Pearson Education Canada 5-10 The Cycle Approach  A convenient way to separate transactions for study and assessment during the audit  Related types (or classes) of transactions are part of the same cycle

Copyright © 2007 Pearson Education Canada 5-11 Cycles Used in This Text  Sales and collection  Acquisition and payment  Payroll and personnel  Inventory and warehousing  Capital acquisition and repayment

Copyright © 2007 Pearson Education Canada 5-12 What are Management Assertions?  Implied or expressed representations by management about classes of transactions  Are directly related to GAAP  Part of criteria used by management to record and disclose information in the F/S

Copyright © 2007 Pearson Education Canada 5-13 Management’s Assertions  Existence  Occurrence  Completeness  Valuation (realizable value)  Accuracy, measurement or allocation  Ownership; rights and obligations  Presentation and disclosure

Copyright © 2007 Pearson Education Canada 5-14 Management Assertions Relate to Audit Objectives  Financial statements and financial statement cycles are used to develop management assertions about accounts  Each assertion directly relates to an audit objective (either general or specific)

Copyright © 2007 Pearson Education Canada 5-15 Developing General and Specific Audit Objectives  Each management objective is related to either a GENERAL transaction-related audit objective (for transactions) or a GENERAL balance-related audit objective (for general ledger ending balances)  When applied to a specific transaction or account, it becomes a SPECIFIC audit objective

Copyright © 2007 Pearson Education Canada 5-16 Management Assertion: Existence Do assets, obligations (liabilities) and equities exist? Are they REAL?  General Balance-Related Audit Objective: Existence  Specific Balance-Related Audit Objective for Inventory: All recorded inventories exist at the balance sheet date

Copyright © 2007 Pearson Education Canada 5-17 Management Assertion: Occurrence Did included transactions actually happen? Are they REAL?  General Transaction-Related Audit Objective: Occurrence  Specific Transaction-Related Audit Objective for Sales: Recorded sales are for shipments made to nonfictitious customers

Copyright © 2007 Pearson Education Canada 5-18 Management Assertion: Completeness All transactions and amounts that happened are included? Was anything MISSED or FORGOTTEN?  General Transaction-Related Audit Objective: Completeness  Specific Transaction-Related Audit Objective for Sales: Existing sales transactions are recorded  General Balance-Related Audit Objective: Existence  Specific Balance-Related Audit Objective for Inventory: All existing inventory has been counted and included in inventory

Copyright © 2007 Pearson Education Canada 5-19 Management Assertion: Valuation Is the asset at lower of cost or net realizable value? Is the liability at cost?  General Balance-Related Audit Objective: Valuation  Specific Balance-Related Audit Objective for Inventory: Inventories have been written down where net realizable value is less than book value

Copyright © 2007 Pearson Education Canada 5-20 Management Assertion: Accuracy (Measurement, Part 1) Were transactions and amounts recorded and processed properly?  General Transaction-Related Audit Objective: Accuracy  Specific Transaction-Related Audit Objective for Sales: Recorded sales are for the amount of goods shipped and are correctly billed and recorded  General Balance-Related Audit Objective: Accuracy  Specific Balance-Related Audit Objective for Inventory: Inventory quantities agree with items physically on hand (See also Table 5-2, p. 125)

Copyright © 2007 Pearson Education Canada 5-21 Management Assertion: Classification (Measurement, Part 2) Were transactions and amounts recorded in the correct account?  General Transaction-Related Audit Objective: Classification  Specific Transaction-Related Audit Objective for Sales: Sales transactions are classified in the correct account  General Balance-Related Audit Objective: Classification  Specific Balance-Related Audit Objective for Inventory: Inventory items are properly classified as raw materials, work in process, or finished goods

Copyright © 2007 Pearson Education Canada 5-22 Management Assertion: Allocation (Measurement, Part 3) Were transactions and amounts recorded on the right dates in the correct period?  General Transaction-Related Audit Objective: Timing  Specific Transaction-Related Audit Objective for Sales: Sales are recorded on the correct dates  General Balance-Related Audit Objective: Cutoff  Specific Balance-Related Audit Objective for Inventory: Purchases at year end are recorded in the correct period (See also Table 5-2, p. 125)

Copyright © 2007 Pearson Education Canada 5-23 Management Assertion: Measurement (Measurement, Part 4) Were transactions and amounts updated and aggregated to the correct account?  General Transaction-Related Audit Objective: Posting and Summarization  Specific Transaction-Related Audit Objective for Sales: Sales transactions are updated correctly to the customer master file, and totals posted to the G. L. account correctly.  General Balance-Related Audit Objective: Detail tie-in  Specific Balance-Related Audit Objective for Inventory: Total of inventory items agrees with G. L.

Copyright © 2007 Pearson Education Canada 5-24 Management Assertion: Rights and Obligations Rights: Do the assets on hand belong to the company? Obligations: Were the obligations incurred by the company (not by someone else)?  General Balance-Related Audit Objective: Rights and obligations  Specific Balance-Related Audit Objective for Inventory: The company has title to all inventory items listed. Inventories are not pledged as collateral.

Copyright © 2007 Pearson Education Canada 5-25 Management Assertion: Presentation and Disclosure Do the statements include all relevant information in a way that financial statement users can understand?  General Balance-Related Audit Objective: Presentation and Disclosure  Specific Balance-Related Audit Objective for Inventory: Major categories of inventories and their bases of valuation are disclosed. (See also Table 5-2, p. 125)

Copyright © 2007 Pearson Education Canada 5-26 Practice problem 5-20 (p. 133)  Practice matching the specific transaction- related audit objective to the management assertion and to the general transaction- related audit objective

Copyright © 2007 Pearson Education Canada 5-27 Practice problem 5-22 (p. 134)  This problem provides a series of audit procedures  What objectives are these associated with?  It is important to understand these objectives, as you may be asked to provide audit procedures for a particular objective

Copyright © 2007 Pearson Education Canada 5-28 The Audit Process  Prior to accepting or continuing the audit, assess independence  Conduct four phases of an audit  In planning phase, prepare client risk profile and assess corporate governance

Copyright © 2007 Pearson Education Canada 5-29 Four Phases of an Audit  Phase I - Assess risk and plan the audit  Phase II - Perform tests of controls  Phase III - Perform analytical procedures and test of details of balances  Phase IV - Complete the audit and issue an auditor’s report

Copyright © 2007 Pearson Education Canada 5-30 Audit Phase I: Risk Assessment and Audit Planning  In the context of risks, balance the quantity and quality of evidence to be collected against costs of collection  Obtain knowledge of business, industry, business environment. Prepare client risk profile.  Understand internal control and assess control risk (governance, general controls, cycle controls)

Copyright © 2007 Pearson Education Canada 5-31 Practice problem 5-23 (p. 134)  To understand risks, it is important to understand ‘what could go wrong’  Here, you are asked to think like a devious client – how could you overstate net income?

Copyright © 2007 Pearson Education Canada 5-32 Audit Phase II: Perform Tests of Controls  Where the auditor plans to rely upon high quality internal controls, these controls may need to be tested (certain controls only need to be tested every three years, S )  Tests are normally linked to audit objectives (also called audit assertions)

Copyright © 2007 Pearson Education Canada 5-33 Audit Phase III: Perform Analytical Procedures and Tests of Details of Balances  Analytical procedures are both a planning tool and an actual audit test  Tests of details of balances are specific audit procedures designed to test for monetary misstatements

Copyright © 2007 Pearson Education Canada 5-34 Audit Phase IV: Complete and Issue the Auditor’s Report  Information collected during the audit needs to be combined and assessed to reach an overall conclusion with respect to the financial statements – are they fairly stated?  This assessment requires experience and professional judgment

Copyright © 2007 Pearson Education Canada 5-35 Practice problem 5-24 (p. 134)  How do we pull this together?  Identify problems that could affect the audit engagement of ABC Electronics Ltd., and provide some suggestions on how to deal with them.