1. CHAPTER 5 OVERVIEW OF THE AUDIT PROCESS Fall 2007 u Overview of the Audit Process u Assessing Audit Risk u Audit Objectives u Materiality u Audit Procedures u Audit Risk Model

2. Overview of the Audit Process 1.Understand entity & environment 2.Anticipate where misstatement most likely to occur 3.Plan audit strategy – Nature – Timing – Extent – Staffing 4.Perform field work 5.Issue audit report & other communications

3. Understand the Entity and Its Environment Obtain an understanding of: 1. Industry, regulatory and other external factors 2. Nature of the entity including application of accounting policies 3. Objectives & strategies and the related business risks 4. Internal control 5. Measurement and review of the entity’s financial performance Why do we care about this???

4. Anticipate Misstatements and Fraud Fundamental Questions: Which accounts are most likely to be misstated? How are they likely to be misstated? Intuitively we should “do more auditing” on those accounts. New SAS’s (No’s 104-111) on linking risks with financial statement assertions with procedures

5. Anticipate Misstatements and Fraud Management Assertions: Management has asserted the financial statements are “right” How the financial statements are “right” –Transactions –Balances –Disclosures Think about where are they likely to be “wrong”

6. Transaction Audit Objectives For each recorded transaction: Occurrence Completeness Cutoff Accuracy Classification

7. Balance Audit Objectives For each balance (on the B/S) Existence Completeness Rights & Obligations Valuation & Allocation

8. Disclosure Audit Objectives For each footnote: Occurrence and Rights & Obligations Completeness Classification & Understandability Accuracy & Valuation

9. Plan Audit: Nature of Tests Procedures to Obtain an Understanding Tests of Controls Substantive Tests –Analytical Procedures –Transactions & Balances Estimates –Footnotes

10. Analytical Procedures What are they? Underlying Assumption: We assume conditions will persist in absence of information to the contrary. When are they used/required? –Planning: decide where problems might be –Field Work: test numbers –Completion: “sanity check”

11. Plan Audit: Timing of Tests Interim vs/ Year end Surprise vs. planned

12. Plan Audit: Extent of Tests Extent of testing related to materiality Materiality defined: Influence on the judgment of a reasonable person relying on the financial statements (FAS2) Influences the audit process –Planning: How much work to do. –During the audit: Evaluate the significance of findings. Considers quantitative and qualitative factors

13. Plan Audit: Staffing of Tests Generally a more experienced person yields higher quality evidence

14. Plan Audit: The Audit Risk Model Once we figure out what might cause the f/s to be misstated, we need to determine how our audit can be most efficiently and effectively tailored to address our concerns. The Audit Risk Model is our tool to do this.

15. The Audit Risk Model AR = IR x CR x DR AR: Risk that auditor issues incorrect report IR: Risk of misstatement, assuming no internal controls CR: Risk that misstatements will not be prevented or detected by the IC system DR: Risk that the auditor will not detect a material misstatement FR: Risk of fraud that is considered as part of IR & CR Each of these must be assessed for each class of transactions, account, and objective.

16. The Audit Risk Model AR = IR x CR x DR How does this relate to types of tests? Procedures to Obtain an Understanding Tests of Controls Substantive Tests –Analytical Procedures –Transactions & Balances Estimates –Footnotes

17. Risk Analysis: Example 1 You have been engaged to audit Apparel Inc., an upscale trendy clothing manufacturer that sells to small independently owned boutiques. Apparel must obtain an audit as a condition of its bank loan, which is up for renewal. Lately Apparel’s customers have been experiencing declining sales in part due to their inability to compete with large mall-chain stores. Apparel’s credit manager position has been vacant for the last 6 months and those duties have been taken over by an accounts receivable clerk with little experience. AR is a significant portion of company assets. Controls over sales transactions at the time of sale are strong. With respect to the occurrence of Accounts Receivable transactions …. AR= IRxCRxDR With respect to the valuation of Accounts Receivable balance ….. AR= IRxCRxDR

18. Risk Analysis: Example 2 Your firm has been engaged to audit Stationary Inc., a family owned business currently seeking new bank financing. Because of increasing use of email, demand for their product has been decreasing dramatically. However, their controller, a CPA, has implemented numerous procedures to ensure that inventory levels are monitored and inventory cost is conservative. There are also strict security procedures in the warehouse. With respect to the existence of inventory balance ….. AR= IRxCRxDR With respect to the valuation of inventory balance ….. AR= IRxCRxDR