1. AUDITING CHAPTER 7 Audit Process & Detecting Fraud By David N. Ricchiute

2. GBW 8th ed., Ch. 7 2 TOPICS Audit process Client acceptance, client strategies, planning, interim & year end work Auditor’s responsibility to detect, report fraud

3. GBW 8th ed., Ch. 7 3 PRELIMINARY STEPS IN AUDIT PROCESS Communication with audit committee Accepting, continuing engagements Understand client’s business strategies Planning Interim, year-end audit work

4. GBW 8th ed., Ch. 7 4 AUDIT COMMITTEES: History 1940 SEC ASR #19 encouraged 1978 required by NYSE 1999 recommendations from Blue Ribbon on audit committee effectiveness Consistency of accounting principles Clarity, completeness of financial statements

5. GBW 8th ed., Ch. 7 5 SEC & SARBANES-OXLEY RULES: Post 2000 Mandates Reviews of public company financial statement interim reports Disclosure in proxy statements whether audit committee discussed  Financial statements with management  Estimates, uncertainties, unusual transactions, new accounting principles, independence with auditor

6. GBW 8th ed., Ch. 7 6 QUALITY OF EARNINGS Auditor must discuss quality not just acceptability of accounting principles & earnings with Audit committee (SAS 89) Consistency in use of accounting principles Clarity, completeness of financial statements

7. GBW 8th ed., Ch. 7 7 ACCEPTING, CONTINUING ENGAGEMENTS Establish policies, procedures to accept, continue clients (Stmt. Quality Control Stds. No. 1 ) For new client Evaluate ability to service client Review financial statements Inquire about reputation, bankruptcy Investigate key managers

8. GBW 8th ed., Ch. 7 8 COMMUNICATIONS WITH PREDECESSOR Successor auditor initiates communication Predecessor auditor obtains permission to disclose confidential information (Rule 301) Is prior auditor’s resignation, replacement linked to (SAS 84) Disagreement with management? Management integrity? Other reasons?

9. GBW 8th ed., Ch. 7 9 UNDERSTANDING WITH CLIENT Objectives & limitations of engagement Management’s responsibilities Example: financial statement audit Objective: express opinion whether statements  Present fairly  In all material respects  In conformity with GAAP SAS 83 & SSAE 7

10. GBW 8th ed., Ch. 7 10 MANAGEMENT’S RESPONSIBILITIES Financial statements Establishing, maintaining effective internal over financial reporting Assuring compliance with laws & regulations Making records, information available Confirming representations made during engagement

11. GBW 8th ed., Ch. 7 11 ENGAGEMENT LETTERS Drafted by auditor for CEO’s signature Written agreement to state purpose of engagement & role of auditor Optional but recommended by SAS 84 which requires some form of written understanding in work papers

12. GBW 8th ed., Ch. 7 12 PROPOSED ADJUSTING JOURNAL ENTRIES (AJE) SAS 88 “Audit Adjustments” Management’s responsibility to record material proposed adjustments Management must confirm responsibility for adjustments at year end in representation letter Auditor informs audit committee of management’s responsibilities for adjustments

13. GBW 8th ed., Ch. 7 13 UNDERSTANDING CLIENT’S BUSINESS Auditor considers effects of client business & strategies on Risks Strategies to overcome risk Transactions, events as products of management’s strategies

14. GBW 8th ed., Ch. 7 14 CLIENT STRATEGY TEMPLATE-Strategies Growth strategy Financial goals & operating priorities

15. GBW 8th ed., Ch. 7 15 CLIENT STRATEGY TEMPLATE-Characteristics Characteristics of business Major business units Markets Products Customers Competitors Strategic alliances & joint ventures Potential adverse influences

16. GBW 8th ed., Ch. 7 16 BUSINESS: Units, Markets, Products, Customers Demonstrate value of product R&D to develop new products

17. GBW 8th ed., Ch. 7 17 FINANCIAL GOALS, OPERATING PRIORITIES: Merck Remain in top quartile Maximize revenue growth Preserve profitability of core business Achieve full potential

18. GBW 8th ed., Ch. 7 18 ERRORS VS. FRAUD Errors Unintentional misstatements or omissions in financial statements Fraud Fraudulent financial reporting: intentional misstatement or omission Misappropriation of assets: theft

19. GBW 8th ed., Ch. 7 19 PLANNING Risk of misstatement from fraud First quarter planning Second quarter planning

20. GBW 8th ed., Ch. 7 20 RISK OF FRAUD : Auditor’s Responsibility Discuss risk with staff Obtain pertinent information Identify & assess risks Plan according to assessment Evaluate evidence

21. GBW 8th ed., Ch. 7 21 RISK OF FRAUD: Other Aspects Professional skepticism No presumption of dishonesty balanced with possibility of misstatement due to fraud Fraud screens Some financial ratios help  Asset quality  Total accruals to total assets  Days sales in receivables

22. GBW 8th ed., Ch. 7 22 IDENTIFYING, ASSESSING RISK OF FRAUD Fraud triangle Incentives, pressures to commit fraud Opportunities to commit fraud Management’s rationalizations for committing fraud

23. GBW 8th ed., Ch. 7 23 FIRST-QUARTER PLANNING Review prior-year audit work Review 1 st quarter results Prepare preliminary audit time budget Consider adverse influences

24. GBW 8th ed., Ch. 7 24 SECOND-QUARTER PLANNING Review 2 nd quarter results Finalize budget Perform analytical procedures Prepare preliminary planning memo Coordinate staff with client Prepare interim audit programs

25. GBW 8th ed., Ch. 7 25 INTERIM AUDIT WORK: Controls & Programs Understand internal control Perform tests of controls Assess control risk Prepare preliminary audit programs

26. GBW 8th ed., Ch. 7 26 YEAR-END AUDIT WORK Coordinate with client Finalize audit program Perform substantive tests, analytical procedures Evaluate audit test results Material errors, fraud Subsequent events

27. GBW 8th ed., Ch. 7 27 YEAR-END AUDIT DOCUMENTATION Management, legal representations Audit documentation review Staff work reviewed Audit reports