8/8/2024

LECTURE 1
AUDITING: INTEGRAL TO THE ECONOMY

LEARNING OBJECTIVES

1. Define the objective of external auditing and

describe its role in meeting society’s demands for
reliable financial and internal control information
2. Identify parties involved in preparing and auditing
financial statements and briefly describe their roles
3. List the types of audit service providers and the
skills and knowledge needed by professionals
entering the external auditing profession
4. Identify organizations that affect the external
auditing profession and the nature of their effects
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LEARNING OBJECTIVES

5. Define audit quality and identify drivers of audit

quality as specified by the Financial Reporting
Council’s Audit Quality Framework
6. Identify professional requirements that help to
achieve audit quality and minimize auditor
exposure to lawsuits

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LEARNING OBJECTIVE 1

DEFINE THE OBJECTIVE OF EXTERNAL AUDITING AND DESCRIBE

ITS ROLE IN MEETING SOCIETY’S DEMANDS FOR RELIABLE
FINANCIAL AND INTERNAL CONTROL INFORMATION

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EXTERNAL AUDITING PROFESSION

Financial statement audit

• 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

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EXTERNAL AUDITING PROFESSION

• Objectives of external auditing is to provide opinions

on:
• Reliability of financial statements
• Internal control effectiveness
• Integrated audit: Provided when an external auditor
is engaged to perform an audit of the effectiveness
of internal control over financial reporting that is
integrated with an audit of financial statements

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EXTERNAL AUDITING PROFESSION

• External audit is intended to enhance confidence

that users can place on management-prepared
financial statements
• Unqualified audit report: When the auditor issues
this type of report, it implies that the auditor has no
reservations about management’s financial
statements or internal controls

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EXTERNAL AUDITING PROFESSION

• When the auditor has reservations about the fair

presentation of the financial statements
• Audit report is modified to explain the nature of the
reservations
• Adverse opinion is expressed when auditors believe
that:
• Financial statements taken as a whole are not
presented fairly in conformity with GAAP and/or
• Client’s internal controls not effective

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EXHIBIT 1.2 - USERS OF AUDITED FINANCIAL STATEMENTS

AND DECISIONS THEY MAKE BASED ON THE REPORTS

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NEED FOR UNBIASED REPORTING AND

INDEPENDENT ASSURANCE - FACTORS
Why is there a risk that information provided by
management may not always be reliable?
• Potential bias
• Management has incentives to bias financial
information to convey a better impression of financial
data than real circumstances might merit
• Remoteness
• Organization and users of its financial information are
distant from each other in terms of either geographic
distance or the extent of information available to the
both parties
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NEED FOR UNBIASED REPORTING AND

INDEPENDENT ASSURANCE - FACTORS
• Complexity
• Difficulty in determining a proper presentation of
complex transactions, information, and processing
systems
• Consequences
• With unreliable information, investors lose a significant
source of information needed to make important
decisions

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OVERALL OBJECTIVES IN CONDUCTING

AN AUDIT
• Obtaining assurance about financial statements
being free from material misstatement
• Reporting on financial statements based on
auditor’s findings

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OVERALL OBJECTIVES IN CONDUCTING

AN AUDIT
• In completing these objectives, the auditor:
• Complies with relevant ethical requirements
• Plans and performs an audit with professional skepticism
• Exercises professional judgment
• Obtains sufficient appropriate evidence on which to base
the auditor’s opinion
• Conducts audit in accordance with professional auditing
standards

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EXHIBIT 1.3 - THE AUDIT OPINION

FORMULATION PROCESS

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LEARNING OBJECTIVE 2

IDENTIFY PARTIES INVOLVED IN PREPARING

AUDITED FINANCIAL STATEMENTS AND BRIEFLY
DESCRIBE THEIR ROLES

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EXHIBIT 1.4 - PARTIES INVOLVED IN PREPARING

AND AUDITING FINANCIAL STATEMENTS

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LEARNING OBJECTIVE 3

LIST THE TYPES OF AUDIT SERVICE PROVIDERS AND

THE SKILLS AND KNOWLEDGE NEEDED BY
PROFESSIONALS ENTERING THE EXTERNAL
AUDITING PROFESSION

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PROVIDERS OF EXTERNAL AUDITING

SERVICES
• External auditing profession includes:
• Sole-practitioner firms
• Local and regional firms
• Large multinational professional services firms

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PROVIDERS OF EXTERNAL AUDITING

SERVICES
• Organizational hierarchy of audit firms
• Responsible for overall conduct of each audit
Partners/Owners • Responsible for many audit engagements
being conducted simultaneously
• Review audit work of seniors and staff
Managers • Responsible for fewer audit engagements
being conducted simultaneously
• Responsible for overseeing day-to-day
Seniors activities on a specific audit
• Oversee performance of auditing procedures

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SKILLS AND KNOWLEDGE NEEDED FOR

EXTERNAL AUDITING PROFESSION
• Technical knowledge and expertise
• Auditors must:
• Understand accounting and auditing authoritative
literature
• Develop industry and client-specific knowledge
• Develop and apply computer skills
• Evaluate internal controls
• Assess and respond to fraud risk

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SKILLS AND KNOWLEDGE NEEDED FOR

EXTERNAL AUDITING PROFESSION
• Leadership, teamwork, and professional skills
• Auditors:
• Make presentations to management and audit
committee members
• Exercise logical reasoning
• Communicate decisions to users
• Manage and supervise by providing meaningful feedback
• Act with integrity and ethics and Interact in a team
environment
• Collaborate and maintain a professional personal
presence
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AUDITING IN PRACTICE - SHOULD I WORK

FOR A LARGE OR A SMALL AUDIT FIRM?
• Difference between large and small audit firms

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LEARNING OBJECTIVE 4

IDENTIFY ORGANIZATIONS THAT AFFECT THE

EXTERNAL AUDITING PROFESSION AND THE
NATURE OF THEIR EFFECTS

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CONGRESS

• Due to various failures in auditing profession during

early 2000s Congress passed the Sarbanes-Oxley Act
of 2002
• This legislation had an impact on audit firms through:
• Increasing auditor independence
• Enhancing the role and importance of audit committee
• Requiring reporting on internal control over financial
reporting
• Providing new oversight of external auditing profession
by Public Company Accounting Oversight Board
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PUBLIC COMPANY ACCOUNTING

OVERSIGHT BOARD (PCAOB)
• Private sector, nonprofit organization
• Oversees auditors of public companies
• Goal of the PCAOB
• To protect the interests of investors and further the
public interest in the preparation of informative, fair,
and independent audit reports

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PUBLIC COMPANY ACCOUNTING

OVERSIGHT BOARD (PCAOB)
• Primary responsibilities related to auditors
• Registration of audit firms that audit public companies
• Periodic inspections of registered audit firms
• Establishment of auditing and related standards for
registered audit firms
• Investigation and discipline of registered audit firms for
violations of relevant laws or professional standards

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SECURITIES AND EXCHANGE

COMMISSION (SEC)
• Governmental body established by Congress in 1934
• Regulates the capital market system
• Has authority to establish GAAP for companies
whose stock is publicly traded
• Responsible to prosecute public companies and their
auditors for violating SEC laws

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AMERICAN INSTITUTE OF CERTIFIED

PUBLIC ACCOUNTANTS (AICPA)
• Primary governing organization of the public
accounting profession
• Develops standards for audits of nonpublic
companies
• Responsible for a peer review program
• Provides continuing education programs
• Prepares and administers the Uniform CPA
Examination - through its Board of Examiners

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CENTER FOR AUDIT QUALITY (CAQ)

• Organization affiliated with AICPA

• Dedicated to enhance investor confidence and trust
in financial markets
• A thought leader in:
• Fostering audit quality
• Collaborating with auditors and financial statement
users about emerging issues
• Advocating for accounting and auditing standards that
promote auditors’ effectiveness

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INTERNATIONAL AUDITING AND

ASSURANCE STANDARDS BOARD (IAASB)
• Part of the International Federation of Accountants
(IFAC)
• A global organization for the accounting profession
• Sets International Standards on Auditing (ISAs)
• Facilitates convergence of national and international
auditing standards

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COMMITTEE OF SPONSORING ORGANIZATIONS

OF THE TREADWAY COMMISSION (COSO)

• Provider of thought leadership and guidance on:

• Internal control
• Enterprise risk management
• Fraudulent deterrence
• Provides the internal control framework
• Serves as benchmark for auditors

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COMMITTEE OF SPONSORING ORGANIZATIONS

OF THE TREADWAY COMMISSION (COSO)

• Sponsored by the following organizations:

• Financial Executives International
• The American Institute of Certified Public Accountants
• The American Accounting Association
• The Institute of Internal Auditors
• The Association of Accountants and Financial
Professionals in Business (IMA)

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ACCOUNTING STANDARD SETTERS

• Generally accepted accounting principles (GAAP)

• Has general acceptance and provides criteria by which
to assess the fairness of a financial statement
presentation
• GAAP traditionally been set by FASB, with approval by
the SEC in the United States

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ACCOUNTING STANDARD SETTERS

• International accounting standards (IFRS -

International Financial Reporting Standards)
• Set by the IFRS Foundation of IASB
• Their goal is to develop a single set of international
financial reporting standards that is:
• Understandable
• Enforceable
• Globally accepted

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STATE BOARDS OF ACCOUNTANCY

• Certified Public Accountants (CPAs)

• Licensed by state boards of accountancy which are
charged with regulating the profession at the state
level
• Required by all state boards for passage of Uniform
CPA Examination as one criterion for licensure

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THE COURT SYSTEM

• Acts as a quality-control mechanism for the auditing

profession
• Third parties may sue CPAs under federal securities
laws, various state statutes, and common law for
substandard audit work

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LEARNING OBJECTIVE 5

DEFINE AUDIT QUALITY AND IDENTIFY DRIVERS OF AUDIT

QUALITY AS SPECIFIED BY THE FINANCIAL REPORTING
COUNCIL’S AUDIT QUALITY FRAMEWORK

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AUDIT QUALITY

• Performing an audit in accordance with accepted

auditing standards (GAAS)
• Providing assurance that audited financial statements
and disclosures are presented in accordance with
GAAP
• Providing assurance that those financial statements are
not materially misstated whether due to errors or
fraud

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EXHIBIT 1.5 - DRIVERS OF AUDIT

QUALITY
• Primary drivers of audit quality included in Audit
Quality Framework developed by Financial Reporting
Council (FRC)

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DRIVERS OF AUDIT QUALITY

• Audit firm culture contributes to audit quality when

leadership:
• Creates work culture where audit quality is valued and
rewarded
• Emphasizes that ‘doing the right thing’ is appropriate
from a public interest perspective
• Ensures that employees have time and resources to
address difficult issues
• Ensures that monetary considerations do not adversely
affect audit quality
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DRIVERS OF AUDIT QUALITY

• Promotes benefits of audit partners seeking guidance
on difficult issues
• Ensures that audit firm has quality systems in place
• Fosters evaluation and compensation practices
• Ensures that audit quality is monitored within audit
firm with appropriate consequences in case of
loopholes

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DRIVERS OF AUDIT QUALITY

• Skills and qualities required of engagement team

• Understanding clients’ business and adhering to
auditing and ethical standards
• Exhibiting professional skepticism and addressing
issues identified during audit
• Ensuring that staff has appropriate experience and is
properly supervised
• Ensuring that lower level staff is provided with
mentoring and on the job training opportunities
• Attending to and learning during training
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DRIVERS OF AUDIT QUALITY

• There is effectiveness of the audit process when:

• Audit methodology is well structured and:
• Encourages partners and managers to work diligently in
planning the audit
• Provides a framework and procedures to obtain sufficient
appropriate audit evidence in an effective and efficient
manner
• Requires appropriate audit documentation
• Provides for complying with auditing standards, but does
not inhibit professional judgment

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DRIVERS OF AUDIT QUALITY

• Ensuring that audit work is effectively reviewed
• Audit quality control procedures are effective,
understood, and applied
• Quality technical support is available when auditors
encounter unfamiliar situations
• Ethical standards are communicated and achieved
• Auditors’ evidence collection not constrained by
financial pressures

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DRIVERS OF AUDIT QUALITY

• Reliability and usefulness of audit reporting include:

• Audit reports
• Auditors appropriately concluding as to the truth and
fairness of financial statements

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DRIVERS OF AUDIT QUALITY

• Auditors communicating with audit committee about
the following:
• Audit scope
• Threats to auditor objectivity
• Important risks identified and judgments made in
reaching audit opinion
• Qualitative aspects of client’s accounting and possible
ways of improving financial reporting

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FACTORS OUTSIDE THE CONTROL OF

AUDITORS
• Client corporate governance
• Regulatory environment

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LEARNING OBJECTIVE 6

IDENTIFY PROFESSIONAL REQUIREMENTS THAT

HELP TO ACHIEVE AUDIT QUALITY AND
MINIMIZE AUDITOR EXPOSURE TO LAWSUITS

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ACHIEVING AUDIT QUALITY AND

MINIMIZING LAWSUITS
• Professional requirements that help to achieve audit
quality
• Maintaining auditor independence
• Participating in review programs
• Issuing engagement letters
• Making appropriate client acceptance
• Evaluating the audit firm’s limitations
• Maintaining quality audit documentation

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PCAOB INDEPENDENCE
REQUIREMENTS
• Applicable to auditors of public companies
• Designed to address requirements in Sarbanes-Oxley
Act of 2002

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SEC INDEPENDENCE REQUIREMENTS

• Taking principles-based approach

• Applicable to auditors of public companies
• Principles dictate that auditor independence is
impaired when:
• Mutual or conflicting interest between accountant and
audit client
• Accountant auditing own work
• Accountant acting as management or employee of
audit client
• Accountant being an advocate for audit client
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AICPA INDEPENDENCE REQUIREMENTS

• Threats to independence
• Self-review threat
• Advocacy threat
• Adverse interest threat
• Familiarity threat
• Undue influence threat
• Financial self-interest threat
• Management participation threat

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LECTURE 2
THE RISK OF FRAUD AND MECHANISMS TO
ADDRESS FRAUD: REGULATION, CORPORATE
GOVERNANCE, AND AUDIT QUALITY

LEARNING OBJECTIVES

1. Define the various types of fraud that affect

organizations
2. Define the fraud triangle and describe the three
elements of the fraud triangle
3. Describe implications for auditors of recent
fraudulent financial reporting cases and the third
COSO report on fraud
4. Discuss auditors’ fraud-related responsibilities and
users’ related expectations

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THE AUDIT OPINION FORMULATION

PROCESS

2-3

LEARNING OBJECTIVE 1

DEFINE THE VARIOUS TYPES OF FRAUD THAT

AFFECT ORGANIZATIONS

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FRAUD

• An intentional act involving use of deception that

results in a material misstatement of financial
statements
• Two types of misstatements
• Misappropriation of assets
• Fraudulent financial reporting
• Different from errors
• Errors occur unintentionally

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ASSET MISAPPROPRIATION

• Involves theft or misuse of organization’s assets

• Examples
• Skimming cash
• Stealing inventory
• Payroll fraud
• A dominant fraud scheme perpetrated against small
businesses
• Perpetrators commonly being employees

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ASSET MISAPPROPRIATION

Manipulate accounts to cover up cash thefts

Commonly
occurs
when Manipulate cash disbursements through fake
employees companies

Steal inventory or other assets and manipulate

financial records

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FRAUDULENT FINANCIAL REPORTING

• The intentional manipulation of reported financial

results to misstate the economic condition of the
organization
• Common ways
• Manipulation, falsification, or alteration of accounting
records or supporting documents
• Misrepresentation or omission of events or
transactions
• Misapplication of accounting principles

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LEARNING OBJECTIVE 2

DEFINE THE FRAUD TRIANGLE AND DESCRIBE

THE THREE ELEMENTS OF THE FRAUD TRIANGLE

EXHIBIT 2.2 - THE FRAUD TRIANGLE

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INCENTIVES OR PRESSURES TO
COMMIT FRAUD
• Management compensation schemes
• Financial pressures for improved earnings or an
improved balance sheet
• Debt covenants
• Pending retirement or stock option expirations
• Personal wealth tied to either financial results or
survival of company
• Greed

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INCENTIVES OR PRESSURES TO
COMMIT FRAUD
• Personal factors
• Pressure from family, friends, or culture
• Addictions to gambling or drugs

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OPPORTUNITIES TO COMMIT FRAUD

• Significant related-party transactions

• Company’s industry position
• Management’s inconsistency involving subjective
judgments
• Complex transactions
• Complex or difficult to understand transactions
• Ineffective monitoring of management by the board
• Complex or unstable organizational structure
• Weak or nonexistent internal controls
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RATIONALIZING THE FRAUD

• Rationalization involves reconciling unlawful or

unethical behavior
• Rationalization for fraudulent financial reporting
• “Saving” a company
• Rationalization for asset misappropriation
• Mistreatment by the company
• Sense of entitlement by the individual perpetrating the
fraud

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LEARNING OBJECTIVE 3

DESCRIBE IMPLICATIONS FOR AUDITORS OF

RECENT FRAUDULENT FINANCIAL REPORTING
CASES AND THE THIRD COSO REPORT ON FRAUD

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IMPLICATIONS TO KEEP IN MIND

WHEN CONDUCTING AN AUDIT
• Pressure created for top management by the analyst
following and earnings expectations
• Before completing an audit, sufficient time should be
allowed to examine major year-end transactions:
• Especially if there are potential problems with revenue
• Understanding complex transaction to determine:
• Their economic substance
• The parties that have economic obligations

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IMPLICATIONS TO KEEP IN MIND

WHEN CONDUCTING AN AUDIT
• Understanding and analyzing weaknesses in an
organization’s internal controls
• To determine where and how a fraud may take place
• Developing audit procedures to address specific
opportunities for fraud to take place

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AUDITING IN PRACTICE -
PROFESSIONAL SKEPTICISM
• Center for Audit Quality (CAQ) describes professional
skepticism as follows in its 2010 report on fraud
• Skepticism involves the validation of information
through probing questions, critical assessment of
evidence, and attention to inconsistencies
• Skepticism is not meant to create a hostile atmosphere
or to imply micromanagement
• Skepticism increases not only the likelihood that fraud
will be detected, but also the perception that fraud will
be detected, which reduces the risk that fraud will be
attempted
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AUDITING IN PRACTICE -
PROFESSIONAL SKEPTICISM
• Defined by international auditing standards
• An attitude that includes a questioning mind and a
critical assessment of audit evidence
• Requires an ongoing questioning of whether the
information and audit evidence obtained suggests that
a material misstatement due to fraud may exist

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AUDITING IN PRACTICE -
PROFESSIONAL SKEPTICISM
• The Standard states:
• Auditor’s previous experience with an entity
contributes to a better understanding of the entity
• However, maintenance of professional skepticism is
important because there may have been changes in
circumstances
• Auditors should not be satisfied with less-than-
persuasive audit evidence based on a belief that
management and those charged with governance are
honest and have integrity
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LEARNING OBJECTIVE 4

DISCUSS AUDITORS’ FRAUD-RELATED

RESPONSIBILITIES
AND USERS’ RELATED EXPECTATIONS

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MITIGATING THE RISK OF FRAUDULENT

FINANCIAL REPORTING
• Center for Audit Quality recommends three ways in
which individuals involved in the financial reporting
process can mitigate risk of fraudulent reporting
• Need to acknowledge the existence of a strong, highly
ethical tone at the top of an organization
• Need to consistently exercise professional skepticism in
evaluating and/or preparing financial reports
• Need to understand the role of strong communication
in the financial reporting process

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MESSAGE TO AUDITORS

• Assume greater responsibility for detecting fraud

• Provide assurance that financial statements are free
of material fraud

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LEARNING OBJECTIVE 6

DEFINE CORPORATE GOVERNANCE, IDENTIFY

THE PARTIES INVOLVED, AND DESCRIBE THEIR
RESPECTIVE ACTIVITIES

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CORPORATE GOVERNANCE

• A process by which owners and creditors exert

control and require accountability for resources
entrusted to organizations
• Owners elect board of directors to provide:
• Oversight of organizations’ activities
• Accountability to stakeholders

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EXHIBIT 2.5 - OVERVIEW OF CORPORATE GOVERNANCE

RESPONSIBILITIES AND ACCOUNTABILITIES

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PARTIES INVOLVED IN CORPORATE

GOVERNANCE
• Board of directors: The major representative of
stockholders, who ensure that the organization is run
according to the organization’s charter and that there
is proper accountability
• Audit committee: A subcommittee of the board of
directors responsible for monitoring audit activities
and serving as a surrogate for the interests of
shareholders

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PARTIES INVOLVED IN CORPORATE

GOVERNANCE
• Board of directors and its audit committee oversee
management
• Expected to protect stockholders’ rights
• Ensure that controls exist to prevent and detect fraud
• Stakeholders: Anyone who is influenced, either
directly or indirectly, by actions of a company

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PRINCIPLES RELATED TO BOARDS AND

MANAGEMENT
• Objective is to build long-term sustainable growth in
shareholder value
• Responsible for creating a culture of performance
with integrity and ethical behavior
• Effective corporate governance should be integrated
with company’s business strategy

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PRINCIPLES RELATED TO BOARDS AND

MANAGEMENT
• Make efforts to ensure that companies have sound
disclosure policies and practices – transparency is
very critical
• Independence and objectivity are necessary
attributes of board members

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RESPONSIBILITIES OF AUDIT
COMMITTEES
• Appointment, compensation, and oversight of work
of registered accounting firms
• Must be independent
• Establish whistleblowing mechanisms within
companies
• Authority to engage their own independent counsel
• Companies must provide adequate funding for audit
committees

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LECTURE 3
INTERNAL CONTROL OVER FINANCIAL REPORTING:
MANAGEMENT’S RESPONSIBILITIES AND
IMPORTANCE TO THE EXTERNAL AUDITORS

LEARNING OBJECTIVES

1. Articulate the importance of internal control over

financial reporting for organizations and their
external auditors
2. Define internal control as presented in COSO’s
updated Internal Control, Integrated Framework
and identify the components of internal control
3. Describe the control environment component of
internal control, list its principles, and provide
examples of each principle

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LEARNING OBJECTIVES

4. Describe the risk assessment component of internal

control, list its principles, and provide examples of
each principle
5. Describe the control activities component of
internal control, list its principles, and provide
examples of each principle
6. Describe the information and communication
component of internal control, list its principles,
and provide examples of each principle

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LEARNING OBJECTIVES

7. Describe the monitoring component of internal

control, list its principles, and provide examples of
each principle
8. Identify management’s responsibilities related to
internal control over financial reporting, including
the factors management considers when assessing
control deficiencies

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THE AUDIT OPINION FORMULATION

PROCESS

3-5

LEARNING OBJECTIVE 1

ARTICULATE THE IMPORTANCE OF INTERNAL

CONTROL OVER FINANCIAL REPORTING FOR
ORGANIZATIONS AND THEIR EXTERNAL AUDITORS

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IMPORTANCE OF INTERNAL CONTROL

OVER FINANCIAL REPORTING
• Internal control helps:
• Mitigate risks of not achieving organizational
objectives
• Provide confidence regarding reliability of financial
information
• Reduce occurrence of unforeseen circumstances
• Improve quality of information

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AUDITING IN PRACTICE - CONTROL DEFICIENCIES AND

POOR DECISIONS AT RELIABLE INSURANCE CO.

• Reliable Insurance Co. introduced an insurance policy

to provide supplemental coverage to Medicare
benefits for the elderly
• The company’s internal control system failed to
record claims on a timely basis
• It underpriced the policies and misrepresented its
financial condition to shareholders and lenders
• It led to:
• Unreliable financial statements
• Failure of the business
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IMPORTANCE OF INTERNAL CONTROL

TO THE EXTERNAL AUDIT
• Auditors are required to identify and assess risks of
material misstatement due to fraud or error
• For this, the auditor needs to understand the
company’s internal controls to determine appropriate
audit procedures
• Integrated audit: Occurs when an auditor provides
an opinion on:
• The effectiveness of the client’s internal control over
financial reporting and
• The financial statements
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LEARNING OBJECTIVE 2

DEFINE INTERNAL CONTROL AS PRESENTED IN COSO’S

UPDATED INTERNAL CONTROL, INTEGRATED FRAMEWORK
AND IDENTIFY THE COMPONENTS OF INTERNAL CONTROL

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INTERNAL CONTROL, INTEGRATED

FRAMEWORK
• Most widely used internal control framework
• Published by COSO (Committee of Sponsoring
Organizations)
• COSO’s updated Internal Control, Integrated
Framework
• Comprehensive framework of internal control
• Used to assess effectiveness of:
• Internal control over financial reporting
• Controls over operational and compliance objectives

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INTERNAL CONTROL - INTEGRATED

FRAMEWORK
• COSO defines internal control as a process:
• Effected by an entity’s board of directors,
management, and other personnel
• Designed to provide reasonable assurance regarding
achievement of objectives relating to operations,
reporting, and compliance

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EXHIBIT 3.1 - COSO FRAMEWORK FOR

INTERNAL CONTROL

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COMPONENTS OF INTERNAL CONTROL

• Risk assessment: Process for identifying and

assessing risks that may affect organizations from
achieving objectives
• Control environment
• Set of standards, processes, and structures that
provides the basis for carrying out internal control
across the organization
• Includes the tone at the top regarding importance of:
• Internal control
• Expected standards of conduct
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 8/8/2024

COMPONENTS OF INTERNAL CONTROL

• Control activities: Actions established by policies and

procedures
• Help ensure that management’s directives regarding
internal control are carried out
• Information and communication
• Information can come from internal and external
sources
• Communication is the process of providing, sharing,
and obtaining necessary information

3-15

15

COMPONENTS OF INTERNAL CONTROL

• Monitoring: Helps determine whether the controls

are present and continuing to function effectively
• Effective internal controls need to:
• Be effectively designed and implemented
• Operate effectively

3-16

16

8
 8/8/2024

ENTITY-WIDE CONTROLS

• Operate across an entity and affect multiple

processes, transactions, accounts, and assertions
• Controls related to control environment
• Controls over management override
• Organizations’ risk assessment process
• Centralized processing and controls
• Controls to monitor results of operations
• Controls over period-end financial reporting process
• Policies that address business control and risk management
practices
3-17

17

TRANSACTION CONTROLS

• Control activities implemented to mitigate

transaction processing risk
• Affect certain processes, transactions, accounts, and
assertions
• Do not have an entity-wide effect

3-18

18

9
 8/8/2024

LEARNING OBJECTIVE 3

DESCRIBE THE CONTROL ENVIRONMENT

COMPONENT OF INTERNAL CONTROL, LIST ITS
PRINCIPLES, AND PROVIDE EXAMPLES OF EACH
PRINCIPLE

19

EXHIBIT 3.2 - INTERNAL CONTROL

COMPONENTS AND PRINCIPLES

3-20

20

10
 8/8/2024

EXHIBIT 3.2 - INTERNAL CONTROL

COMPONENTS AND PRINCIPLES

3-21

21

COSO COMPONENT: CONTROL

ENVIRONMENT
• Foundation for all other components of internal
control
• A strong control environment protects against risks
related to reliability of financial statements
• Examples of control environment deficiencies
• Low level of control consciousness within an
organization
• Audit committee not having independent members
• Absence of an ethics policy within an organization

3-22

22

11
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COMMITMENT TO INTEGRITY AND

ETHICAL VALUES - COSO PRINCIPLE 1
• Demonstrated through the tone set by the board and
management
• Organizations should have:
• Standards of conduct regarding expectations for
integrity and ethical values
• Processes in place to determine if individuals are
performing in accordance with expected standards of
conduct
• Processes for identifying and addressing any deviations
in expected conduct
3-23

23

BOARD OF DIRECTORS EXERCISES OVERSIGHT

RESPONSIBILITY - COSO PRINCIPLE 2

• Board of directors includes various committees

• Audit committee oversees management
• Compensation committee
• Reviews and approves compensation of top officers
• Oversees organization’s benefit plans
• Makes recommendations regarding board compensation
• Board of directors is required to exercise objective
oversight for the development and performance of
internal control

3-24

24

12
 8/8/2024

BOARD OF DIRECTORS EXERCISES OVERSIGHT

RESPONSIBILITY - COSO PRINCIPLE 2

• The board should have:

• Sufficient knowledge and skills to fulfill its oversight
responsibilities
• Sufficient number of independent members to ensure
the board’s objectivity

3-25

25

MANAGEMENTS ESTABLISH STRUCTURE, AUTHORITY,

AND RESPONSIBILITY - COSO PRINCIPLE 3

• Retains authority over decisions

Board
• Reviews management’s assignments

• Establishes directives, guidance, and controls

Senior
Management

• Guides and facilitates senior’s directives

Management

• Understand internal control requirements

Personnel

• Follow management’s scope of authority and responsibility for all

Outsourced nonemployees engaged
Service Providers

3-26

26

13
 8/8/2024

ORGANIZATION DEMONSTRATES COMMITMENT

TO COMPETENCE - COSO PRINCIPLE 4

• Commitment towards competence is demonstrated

through policies and procedures to:
• Attract
• Train
• Mentor
• Evaluate
• Retain employees

3-27

27

ORGANIZATION ENFORCES
ACCOUNTABILITY - COSO PRINCIPLE 5
• Individuals held accountable for internal control
responsibilities
• Accountability mechanisms
• Establishing and evaluating performance measures
• Providing appropriate incentives and rewards

3-28

28

14
 8/8/2024

LEARNING OBJECTIVE 4

DESCRIBE THE RISK ASSESSMENT COMPONENT

OF INTERNAL CONTROL, LIST ITS PRINCIPLES,
AND PROVIDE EXAMPLES OF EACH PRINCIPLE

29

COSO COMPONENT - RISK

ASSESSMENT
Internal sources of risk External sources of risks
• Changes in management • Economic recessions
responsibilities decrease product or service
• Changes in internal demand
information technology • Increase in competition
• Poorly conceived business • Changes in regulation that
model make the business model
unsustainable
• Changes in the reliability of
source goods that reduce
profitability
3-30

30

15
 8/8/2024

SPECIFIES RELEVANT OBJECTIVES -

COSO PRINCIPLE 6
• When specifying the objectives of reliable financial
reporting, management should take steps for
financial reporting to reflect underlying transactions
and events
• Financial reporting objectives should be consistent
with accounting principles
• Management should consider level of materiality when
specifying objectives

3-31

31

IDENTIFIES AND ANALYZES RISK - COSO

PRINCIPLE 7
• Appropriate levels of management need to be
involved in the identification and analysis of risk
• Risk identification should include both internal and
external factors
• External - Economic changes that may impact barriers
to competitive entry
• Internal - Change in management responsibilities that
could affect the way certain controls operate

3-32

32

16
 8/8/2024

ASSESSES FRAUD RISK - COSO

PRINCIPLE 8
• Risks related to misappropriation of assets and
fraudulent financial reporting
• Assessment of fraud risk considers:
• Ways in which the fraud could occur
• Fraud risk factors that impact financial reporting
• Incentives and pressures that might lead to fraud
• Opportunities for fraud
• Personnel who might engage in or rationalize fraud
activities

3-33

33

IDENTIFIES AND ANALYZES SIGNIFICANT

CHANGE - COSO PRINCIPLE 9
• As internal and external conditions change, an
organization’s internal controls need to change
• Example - The introduction of new information system
technologies
• An organization needs a process for identifying and
assessing changes in internal and external factors
that can affect its ability to produce reliable financial
reports

3-34

34

17
 8/8/2024

LEARNING OBJECTIVE 5

DESCRIBE THE CONTROL ACTIVITIES COMPONENT OF

INTERNAL CONTROL, LIST ITS PRINCIPLES, AND
PROVIDE EXAMPLES OF EACH PRINCIPLE

35

COSO COMPONENT: CONTROL

ACTIVITIES
• Ensure that management’s directives regarding
controls are accomplished
• Performed within processes
• Performed at all levels of an organization

3-36

36

18
 8/8/2024

SELECTS AND DEVELOPS CONTROL

ACTIVITIES - COSO PRINCIPLE 10
• No universal set of control activities applicable to all
organizations
• Organizations select and develop control activities that
are specific to the risks they identify during risk
assessment

3-37

37

EXHIBIT 3.3 - TRANSACTION PROCESSING

UNDER CONTROL ACTIVITIES
• Application controls (also referred to as transaction
controls): Activities implemented to mitigate
transaction processing risk that affect only certain
processes, transactions, accounts, and assertions

3-38

38

19
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TRANSACTION PROCESSING UNDER

CONTROL ACTIVITIES
• Control objectives desired by an organization
• Recorded transactions exist and have occurred
• All transactions are recorded
• Transactions are properly valued
• Transactions are properly presented and disclosed
• Transactions relate to rights or obligations of the
organization

3-39

39

TRANSACTION PROCESSING UNDER

CONTROL ACTIVITIES
• Accounting estimates should be based on underlying
processes and data that have been successful in
providing accurate estimates in the past
• Controls should be built around the processes to
provide reasonable assurance that:
• The data are accurate
• The estimates are faithful to the data
• The underlying estimation model reflects current
economic conditions and has proven to provide
reasonable estimates in the past
3-40

40

20
 8/8/2024

TRANSACTION PROCESSING UNDER

CONTROL ACTIVITIES
• Controls over adjusting, closing, and other unusual
entries
• Documented support for all entries
• Reference to underlying supporting data with a well-
developed transaction trail
• Transaction trail: Records that allow auditors to trace
transactions from origination through final disposition, or
vice versa
• Review by CFO or controller

3-41

41

AUTOMATED AND MANUAL

TRANSACTION CONTROLS
• Application controls mitigate risks, whether
automated or manual
• Input controls
• Designed to ensure that:
• Authorized transactions are correct and complete
• Only authorized transactions can be input

3-42

42

21
 8/8/2024

AUTOMATED AND MANUAL

TRANSACTION CONTROLS
• Types of inputs controls
• Input validation tests (also referred to as edit tests):
Built into an application to examine input data for
obvious errors
• Self-checking digits: Developed to test for transposition
errors associated with identification numbers
• Operate by computing an extra digit, or several digits, that
are added into a numeric identifier

3-43

43

AUTOMATED AND MANUAL

TRANSACTION CONTROLS
• Processing controls
• Designed to ensure that:
• Correct program used for processing
• All transactions are processed
• Transactions update appropriate files
• Output controls
• Designed to ensure that:
• All data are completely processed
• Output is distributed only to authorized recipients

3-44

44

22
 8/8/2024

OTHER IMPORTANT CONTROL

ACTIVITIES
• Segregation of duties: Protect against risk that
individuals may collude to conceal a fraud
• Requires that a minimum of two employees be
involved such that one does not have:
• Authority and ability to process transactions
• Custodial responsibilities
• Physical controls over assets: Protect and safeguard
assets from accidental or intentional destruction and
theft

3-45

45

OTHER IMPORTANT CONTROL

ACTIVITIES
• Preventive controls: Designed to prevent occurrence
of a misstatement
• Most cost efficient
• Detective controls: Designed to discover errors that
occur during processing

3-46

46

23
 8/8/2024

DEPLOYS THROUGH POLICIES AND

PROCEDURES - COSO PRINCIPLE 12
• Policies should:
• Outline what is expected
• Establish clear responsibility and accountability
• Procedures should:
• Put policies into action
• Be performed diligently, consistently, and by
appropriate and competent personnel in a timely
manner

3-47

47

LEARNING OBJECTIVE 6

DESCRIBE THE INFORMATION AND

COMMUNICATION COMPONENT OF INTERNAL
CONTROL, LIST ITS PRINCIPLES, AND PROVIDE
EXAMPLES OF EACH PRINCIPLE

48

24
 8/8/2024

COSO COMPONENT - INFORMATION

AND COMMUNICATION
• Information - Required by an organization from
internal and external sources to carry out its internal
control responsibilities
• Communication
• Process of providing, sharing, and obtaining
information internally
• Requires two-way communication with external parties

3-49

49

USES RELEVANT INFORMATION - COSO

PRINCIPLE 13
• Identify and obtain internal and external information
to:
• Support internal control
• Achieve objective of reliable financial reporting

3-50

50

25
 8/8/2024

COMMUNICATES INTERNALLY - COSO

PRINCIPLE 14
• Internal communication of information occurs
throughout organizations through:
• Periodic newsletters
• Posters in the break rooms
• Formal communications from senior management
• Whistleblower function - Special line of
communication needed for anonymous or
confidential communications

3-51

51

COMMUNICATES EXTERNALLY - COSO

PRINCIPLE 15
• Two-way communication with external parties
• Shareholders
• Business partners
• Customers
• Regulators
• External communication should include messages
regarding:
• Importance of internal control
• Organization’s values and culture

3-52

52

26
 8/8/2024

LEARNING OBJECTIVE 7

DESCRIBE THE MONITORING COMPONENT OF

INTERNAL CONTROL, LIST ITS PRINCIPLES, AND
PROVIDE EXAMPLES OF EACH PRINCIPLE

53

COSO COMPONENT - MONITORING

• Process that provides feedback on effectiveness of

each of the five components of internal control
• For its accomplishment, managers select either of
the following or a combination of both
• Mix of ongoing evaluations
• Separate evaluations
• Requires that identified deficiencies in internal
control be communicated to the personnel
concerned with follow-up action taken

3-54

54

27
 8/8/2024

CONDUCTS ONGOING AND/OR SEPARATE

EVALUATIONS - COSO PRINCIPLE 16
• Ongoing evaluations: Procedures built into the
normal recurring activities of an entity
• Computerized monitoring undertaken by organizations
to review large volume of transactions
• Separate evaluations: Conducted periodically by:
• Objective management personnel
• Internal auditors
• External consultants

3-55

55

EVALUATES AND COMMUNICATES

DEFICIENCIES - COSO PRINCIPLE 17
• Control deficiencies identified need to be
communicated to appropriate personnel to take
appropriate corrective actions on a timely basis

3-56

56

28
 8/8/2024

LEARNING OBJECTIVE 8

IDENTIFY MANAGEMENT’S RESPONSIBILITIES RELATED TO

INTERNAL CONTROL OVER FINANCIAL REPORTING,
INCLUDING THE FACTORS MANAGEMENT CONSIDERS
WHEN ASSESSING CONTROL DEFICIENCIES

57

DOCUMENTATION OF INTERNAL
CONTROL
• Provide clarity and communication of standards and
expectations
• Can be either paper or electronic
• Advantages
• Help train new personnel
• Serve as a reference tool for all employees
• Provide evidence that the controls are operating
• Enable proper monitoring activities
• Support reporting on internal control effectiveness
3-58

58

29
 8/8/2024

DOCUMENTATION OF INTERNAL
CONTROL
• Used by external auditors to understand client’s
internal control system
• Documents supporting management’s assessment as
an audit evidence required
• Documents required for supporting financial
transactions
• Authorization of transactions
• Existence of transactions
• Support for journal entries
• Financial commitments made
3-59

59

GUIDELINES FOR DEVELOPING

RELIABLE DOCUMENTATION
• Prenumbered paper or computer-generated
documents facilitate control of, and accountability
for, transactions
• Timely preparation
• Improves credibility and accountability of documents
• Decreases rate of errors on all documents
• Authorization of a transaction
• Transaction trail
• Tracing a transaction from its origination through to its
final disposition, or vice versa
3-60

60

30
 8/8/2024

IMPORTANT ASPECTS OF ELECTRONIC

TRANSACTION TRAIL
• Unique identification of transaction
• Date and time of transaction
• Individual responsible for the transaction
• Location from which the transaction originated
• Details of the transaction
• Cross-reference to other transactions
• Authorization or approval of the transaction

3-61

61

EXHIBIT 3.6 - STEPS IN MANAGEMENT’S EVALUATION

OF INTERNAL CONTROL OVER FINANCIAL REPORTING

3-62

62

31
 8/8/2024

EVALUATING INTERNAL CONTROL

OVER FINANCIAL REPORTING
• Management identifies significant risks to reliable
financial reporting
• Significant account: Possibility of material
misstatement without considering effect of internal
controls
• Relevant assertion: Judgment in valuing an account
without considering effect of internal controls

3-63

63

EVALUATING INTERNAL CONTROL

OVER FINANCIAL REPORTING
• Management conducts a walkthrough to focus on
design and operating effectiveness of controls
• Walkthrough: Process whereby management follows a
transaction from origination through organization’s
processes until it is reflected in organization’s financial
records
• Includes a combination of:
• Inquiry
• Observation
• Inspection of documentation making up transaction trail
• Reperformance of controls
3-64

64

32
 8/8/2024

EXHIBIT 3.7 - EXAMPLES OF APPROACHES TO MANAGEMENT

TESTING OF OPERATING EFFECTIVENESS OF CONTROL

3-65

65

ASSESSING INTERNAL CONTROL

DEFICIENCIES
• Control deficiency: Shortcoming in internal controls
such that objective of reliable financial reporting may
not be achieved
• Design deficiency - Control necessary to meet control
objective missing
• Operation deficiency - Properly designed control does
not operate as designed

3-66

66

33
 8/8/2024

ASSESSING INTERNAL CONTROL

DEFICIENCIES
• Categories of control deficiencies:
• Material weakness
• A deficiency, or a combination of deficiencies, in
internal control over financial reporting, such that
there is a reasonable possibility that a material
misstatement of the company’s annual or interim
financial statements will not be prevented or detected
on a timely basis

3-67

67

ASSESSING INTERNAL CONTROL

DEFICIENCIES
• Categories of control deficiencies:
• Significant deficiency
• A deficiency, or a combination of deficiencies, in internal
control over financial reporting that is less severe than a
material weakness, yet important enough to merit
attention by those responsible for oversight of the
company’s financial reporting
• Not needed to be reported to external users
• Not included in management’s report on internal control
effectiveness

3-68

68

34
 8/8/2024

EXHIBIT 3.8 - EXAMPLES OF MATERIAL

WEAKNESSES IN INTERNAL CONTROL
• Weaknesses in the design of controls

3-69

69

EXHIBIT 3.8 - EXAMPLES OF MATERIAL

WEAKNESSES IN INTERNAL CONTROL
• Weaknesses in the operation of controls

3-70

70

35
 8/8/2024

DIFFERENCES BETWEEN MATERIAL WEAKNESSES

AND SIGNIFICANT DEFICIENCIES

• Professional judgment used by management in

assessing the identified control deficiencies
• Severity of a deficiency depends on:
• Magnitude of the potential misstatement resulting
from the deficiency
• Whether there is a reasonable possibility that the
organization’s controls will fail to prevent, or detect
and correct a misstatement
• Consideration of specific facts and circumstances
surrounding the identified deficiency
3-71

71

36
 8/8/2024

LECTURE 4
PROFESSIONAL AUDITING STANDARDS AND THE
AUDIT OPINION FORMULATION PROCESS

LEARNING OBJECTIVES

1. Identify and compare the various auditing standards

that provide guidance on the audit opinion
formulation process
2. List and discuss the foundational principles
underlying the auditing standards
3. List the phases and related activities in the audit
opinion formulation process
4. Explain the concept of accounting cycles and
discuss their importance to the audit opinion
formulation process
5-2

1
 8/8/2024

LEARNING OBJECTIVES

5. Describe the assertions that are inherent to

financial statements and explain their importance
to the audit opinion formulation process
6. Define audit evidence and describe the purpose
and types of audit procedures used to obtain audit
evidence
7. Discuss the importance of audit documentation and
provide examples
8. Discuss audit activities in Phase I of the audit
opinion formulation process
5-3

LEARNING OBJECTIVES

9. Discuss audit activities in Phase II of the audit

opinion formulation process
10. Discuss audit activities in Phase III of the audit
opinion formulation process
11. Discuss audit activities in Phase IV of the audit
opinion formulation process
12. Discuss audit activities in Phase V of the audit
opinion formulation process

5-4

2
 8/8/2024

LEARNING OBJECTIVES

13. Apply the concepts related to the auditor’s

assessment of internal control design effectiveness,
implementation, and operating effectiveness
14. Apply the frameworks for professional decision
making and ethical decision making to issues
involving conducting an audit

5-5

THE AUDIT OPINION FORMULATION

PROCESS

5-6

3
 8/8/2024

LEARNING OBJECTIVE 1

IDENTIFY AND COMPARE THE VARIOUS

AUDITING STANDARDS THAT PROVIDE
GUIDANCE ON THE AUDIT OPINION
FORMULATION PROCESS

EXHIBIT 5.1 - COMPARISON OF U.S. AND

INTERNATIONAL AUDITING STANDARDS

5-8

4
 8/8/2024

LEARNING OBJECTIVE 2

LIST AND DISCUSS THE FOUNDATIONAL

PRINCIPLES UNDERLYING THE AUDITING
STANDARDS

PCAOB GUIDANCE - GENERAL

STANDARDS
• Require
• Audit to be performed by individuals having adequate
technical training and proficiency as an auditor
• Auditors to be independent:
• In fact, i.e., in reality in terms of mental attitude and
• In appearance, i.e., in how the auditor is perceived by
users
• Audit to be conducted with professional care expected
of a prudent auditor

5-10

10

5
 8/8/2024

PCAOB GUIDANCE - FIELDWORK

STANDARDS
• Applicable to conduct of the audit
• Require auditors to:
• Properly plan and supervise the audit
• Develop an understanding of client’s controls
• Prerequisite for developing audit tests
• Obtain audit evidence by performing audit procedures

5-11

11

PCAOB GUIDANCE - REPORTING

STANDARDS
• Applicable to communicating auditor’s opinion
• Require auditors to:
• State whether financial statements are presented in
accordance with the applicable financial reporting
framework (i.e., GAAP or IFRS)
• Identify conditions where accounting principles are not
consistently observed
• Review disclosures for adequacy and state in the report if
disclosures are not reasonably adequate
• Express an opinion on financial statements as a whole or
state that an opinion cannot be expressed
5-12

12

6
 8/8/2024

AICPA GUIDANCE - PURPOSE AND

PREMISE OF AUDIT
• Purpose - Enhance degree of confidence that users
can place in financial statement
• Premise - Management has responsibility to:
• Prepare financial statements
• Maintain internal control over financial reporting
• Provide auditor with relevant information and access
to personnel

5-13

13

AICPA GUIDANCE - RESPONSIBILITIES

• The auditor’s responsibilities include

• Having appropriate competence and capabilities to
perform audit
• Complying with ethical requirements
• Maintaining professional skepticism throughout the
audit

5-14

14

7
 8/8/2024

AICPA GUIDANCE - PERFORMANCE

• Obtain assurance that financial statements are free

from material misstatement
• Limitations - Lack of absolute assurance about financial
statements being free from misstatement
• Requires an auditor to:
• Plan and supervise work
• Determine materiality levels
• Identify risks of material misstatement
• Design and implement audit responses to assessed risks

5-15

15

AICPA GUIDANCE - REPORTING

• Expressing either of the following

• Financial statements are free of material misstatement
• Stating that an opinion cannot be expressed

5-16

16

8
 8/8/2024

INTEGRATED AUDIT

• Combines audits of an organization’s financial

statements and its internal control over financial
reporting
• In this audit:
• Opinion provided on effectiveness of internal control
over financial reporting
• Additional audit work done to be able to issue that
opinion

5-17

17

LEARNING OBJECTIVE 3

LIST THE PHASES AND RELATED ACTIVITIES IN

THE AUDIT OPINION FORMULATION PROCESS

18

9
 8/8/2024

EXHIBIT 5.2 - OVERVIEW OF CLIENT’S PREPARATION OF FINANCIAL

STATEMENTS AND MANAGEMENT REPORT ON INTERNAL CONTROL

5-19

19

EXHIBIT 5.3 - ACTIVITIES OF EACH PHASE OF THE

AUDIT OPINION FORMULATION PROCESS

5-20

20

10
 8/8/2024

IMPORTANT CONCEPTS AFFECTING AUDIT

OPINION FORMULATION PROCESS
• Accounting cycles
• Management assertions
• Audit evidence and audit procedures
• Documentation

5-21

21

LEARNING OBJECTIVE 4

EXPLAIN THE CONCEPT OF ACCOUNTING

CYCLES AND DISCUSS THEIR IMPORTANCE TO
THE AUDIT OPINION FORMULATION PROCESS

22

11
 8/8/2024

ACCOUNTING CYCLES

• Recording and processing transactions that affect a

group of related accounts
• Begin when a transaction occurs and ends when it is
recorded in financial statements
• Break the audit into manageable sections of related
accounts

5-23

23

ACCOUNTING CYCLES

• Auditor focuses on:

• Flow of transactions within a particular cycle
• Identifying:
• Points where material misstatement can occur
• Controls that have been designed and implemented to
mitigate those risks
• Understanding risks and controls within each cycle
• Helps determine specific audit procedures to be used and
specific audit evidence to be obtained

5-24

24

12
 8/8/2024

EXHIBIT 5.4 - ILLUSTRATIONS OF CYCLES

AND RELATED ACCOUNTS

5-25

25

LEARNING OBJECTIVE 5

DESCRIBE THE ASSERTIONS THAT ARE INHERENT TO

FINANCIAL STATEMENTS AND EXPLAIN THEIR
IMPORTANCE TO THE AUDIT OPINION
FORMULATION PROCESS

26

13
 8/8/2024

FINANCIAL STATEMENT ASSERTIONS

• Assertions made by management

• Existence
• Completeness
• Rights and obligations
• Valuation
• Presentation and disclosure
• Related evidence is obtained for accounts and
disclosure in financial statements

5-27

27

MANAGEMENT’S FINANCIAL STATEMENT

ASSERTIONS IN PCAOB STANDARDS
Existence or Occurrence
• Refers to existence of assets and liabilities
• Refers to occurrence of recorded transactions
Completeness
• Refers to inclusion of all transactions and accounts in financial statements

Valuation or Allocation
• Refers to inclusion of accounts in financial statements at appropriate
amounts
Rights and Obligations
• Refers to assets being the rights of an organization
• Refers to liabilities being the obligations of an organization
Presentation and Disclosure
• Refers to components of financial statement being properly classified,
described, and disclosed
5-28

28

14
 8/8/2024

LEARNING OBJECTIVE 6

DEFINE AUDIT EVIDENCE AND DESCRIBE THE

PURPOSE AND TYPES OF AUDIT PROCEDURES
USED TO OBTAIN AUDIT EVIDENCE

29

AUDIT EVIDENCE AND PROCEDURES

• Audit evidence: Information used by auditor in

arriving at conclusions on which the opinion is based
• Audit procedures: Procedures designed to obtain
audit evidence to support audit opinion(s)
• Risk assessment procedures
• Provide information for assessing the risks of material
misstatement in the financial statements
• Do not provide sufficient evidence upon which to base an
audit opinion
• Used for purposes of planning the audit
5-30

30

15
 8/8/2024

AUDIT EVIDENCE AND PROCEDURES

• Tests of controls: Designed for evaluating operating

effectiveness of controls in preventing, or detecting
and correcting, material misstatements, typically at
assertion level
• Substantive procedures
• Designed for detecting material misstatements at
assertion level
• Comprising of tests of details and substantive
analytical procedures

5-31

31

AUDIT PROCEDURES

• Sufficient appropriate audit evidence: Measure of the

quantity of audit evidence about following factors of
audit procedures
• Nature
• Timing
• Extent
• Audit program
• Lists audit procedures to be followed in gathering
evidence
• Helps monitor progress and supervising work
5-32

32

16
 8/8/2024

EXHIBIT 5.6 - TYPES OF AUDIT

PROCEDURES

5-33

33

LEARNING OBJECTIVE 7

DISCUSS THE IMPORTANCE OF AUDIT

DOCUMENTATION AND PROVIDE EXAMPLES

34

17
 8/8/2024

AUDIT DOCUMENTATION

• Record of audit procedures performed, relevant

audit evidence obtained, and conclusions the auditor
reached
• Known as working papers or workpapers

5-35

35

PURPOSES OF AUDIT
DOCUMENTATION
• Assisting engagement team in:
• Planning and performing audit
• Supervising and reviewing audit work
• Retaining a record of matters of continuing
significance to future audits
• Enabling internal or external inspections of
completed audits
• Assisting auditors in understanding work performed
in prior year
5-36

36

18
 8/8/2024

EXAMPLES OF AUDIT
DOCUMENTATION
• Audit programs
• Analyses prepared by client or auditor
• Memorandums
• Summaries of significant findings or issues
• Letters of confirmation and representation
• Checklists
• Correspondence concerning significant findings or
issues

5-37

37

LEARNING OBJECTIVE 8

DISCUSS AUDIT ACTIVITIES IN PHASE I OF THE

AUDIT OPINION FORMULATION PROCESS

38

19
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PHASE I - MAKING CLIENT ACCEPTANCE

AND CONTINUANCE DECISIONS
• Preconditions for accepting auditing engagements
• Use of an acceptable financial reporting framework
• Agreement of management to acknowledge and
understand its responsibilities

5-39

39

AUDITING IN PRACTICE - ACCEPTING A

NEW AUDIT ENGAGEMENT
• Communicate with predecessor auditor
• Following issues should be addressed
• Information regarding integrity of management
• Disagreements with management about accounting
policies, auditing procedures
• Communications to management and those in charge
with governance regarding:
• Fraud and noncompliance with laws
• Deficiencies and material weaknesses in internal control

5-40

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20
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AUDIT ENGAGEMENT LETTER

• Document specifying responsibilities of client and

auditor that includes the following:
• Objective and scope of audit of financial statements
• Responsibilities of auditor and management
• Statement that some material misstatements may not be
detected due to inherent limitations of audit and internal
control
• Identification of applicable financial reporting framework
for preparation of financial statements
• Reference to expected form and content of any reports to
be issued
5-41

41

LEARNING OBJECTIVE 9

DISCUSS AUDIT ACTIVITIES IN PHASE II OF THE

AUDIT OPINION FORMULATION PROCESS

42

21
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PHASE II - PERFORMING RISK

ASSESSMENT
• Identifying relevant risks and determining audit
procedures required to address them
• Continuing clients - Update information from
previous year’s audit
• New clients - the risk assessment process is more
time consuming

5-43

43

IDENTIFYING AND ASSESSING RISKS OF

MATERIAL MISSTATEMENT
• Essential to audit planning
• Requires identification of significant:
• Accounts
• Disclosures
• Relevant assertions
• Auditor establishes a materiality level overall and for
specific accounts and disclosures

5-44

44

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EXHIBIT 5.7 - EXAMPLES OF SOURCES

OF RISK OF MATERIAL MISSTATEMENT

5-45

45

RISKS AT ASSERTION LEVEL

• Inherent risk
• The susceptibility of an assertion to a misstatement, due to
error or fraud, that could be material, individually or in
combination with other misstatements, before
consideration of any related controls
• Control risk
• The risk that a misstatement due to error or fraud that
could occur in an assertion and that could be material,
individually or in combination with other misstatements,
will not be prevented or detected on a timely basis by the
organization's internal control
5-46

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RISK ASSESSMENT PROCEDURES

• Inquiries for information to assist in identifying risks

of material misstatement due to fraud or error
• Preliminary analytical procedures
• Observation and inspection of documentation

5-47

47

TYPES OF CONTROLS

• Entity-wide controls
• Transaction controls
• Fraud-related controls

5-48

48

24
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TYPES OF PROCEDURES TO
ASSESS DESIGN EFFECTIVENESS
• Inquiry of appropriate personnel
• Observation of the organization’s operations
• Inspection of relevant documentation
• Performance of walkthroughs
• Documentation of preliminary assessment of control
design and basis for that assessment
• Understand the approach used by management for
conclusions on effectiveness of internal control

5-49

49

AUDITING IN PRACTICE - DOCUMENTING AUDITOR’S

UNDERSTANDING OF AN ORGANIZATION’S INTERNAL
CONTROLS

• Process of documentation uses:

• Narratives
• Flowcharts
• Questionnaires
• Once documented, in subsequent years audit firms
focus on:
• Changes in the system
• Effectiveness of monitoring controls

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50

25
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ASSESSING RANGE OF CONTROL RISK

• High control risk

• Weak internal controls
• Auditor cannot rely on controls to reduce substantive
procedures for account balances
• Assessing control risk as low
• Strong internal controls
• Auditor will test operating effectiveness of controls to
reduce substantive procedures for account balances

5-51

51

ADDITIONAL CONSIDERATIONS FOR AN

INTEGRATED AUDIT
• Risk assessment procedures apply to:
• Audit of internal control over financial reporting
• Audit of financial statements
• Top-down approach - Used for audit of internal control
over financial reporting to select controls to test
• Begins at financial statement level
• Focuses on entity-wide controls
• Works down to significant accounts and disclosures and
their relevant assertions

5-52

52

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RESPONDING TO IDENTIFIED RISKS OF

MATERIAL MISSTATEMENT
• Purpose of risk assessment procedures
• Identify risks of material misstatement
• Determine where misstatements in financial
statements may occur
• Design appropriate audit strategy
• Controls reliance audit: Includes tests of controls
and substantive procedures
• Substantive audit: Includes substantive procedures
and does not include tests of controls

5-53

53

RESPONDING TO IDENTIFIED RISKS OF

MATERIAL MISSTATEMENT
• Selecting specific audit procedures to respond to
identified risks
• Assembling an audit team having knowledge, skill,
and ability needed to address assessed risks
• Emphasizing the need for professional skepticism
• Providing an appropriate level of supervision for
assessed risks
• Incorporating elements of unpredictability in
selection of audit procedures
5-54

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EXHIBIT 5.8 - RESPONDING TO IDENTIFIED RISKS

THROUGH EVIDENCE DECISIONS

5-55

55

FRAUD CONSIDERATIONS

• Performing tests of controls and substantive

procedures susceptible to fraud risks
• Performing procedures related to risk of
management override of controls
• Examining journal entries
• Reviewing accounting estimates for biases
• Evaluating business rationale for significant unusual
transactions

5-56

56

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LEARNING OBJECTIVE 10

DISCUSS AUDIT ACTIVITIES IN PHASE III OF THE

AUDIT OPINION FORMULATION PROCESS

57

PHASE III - OBTAINING EVIDENCE ABOUT

INTERNAL CONTROL OPERATING EFFECTIVENESS

• Auditor tests controls

• Determine whether controls are operating effectively
at year-end or throughout the year
• Auditor obtains more persuasive audit evidence
• As the reliance auditor places on effectiveness of a
control increases

5-58

58

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AUDITING IN PRACTICE - RISK ASSESSMENT PROCEDURES

AND TESTS OF OPERATING EFFECTIVENESS OF CONTROLS

• Auditor’s risk assessment procedures include

• Inquiring about management’s use of budgets
• Inspecting documentation of management’s
comparison of monthly budgeted and actual expenses
• Inspecting reports pertaining to the investigation of
variances between budgeted and actual amounts

5-59

59

SELECTING CONTROLS TO TEST

• Involves choosing controls that effectively indicate

capability to address the assessed risk of material
misstatement for relevant assertions
• Auditor selects:
• Entity-wide controls
• Reduce number of control activities selected for testing
• Transaction controls

5-60

60

30
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EXHIBIT 5.9 - LINKING FINANCIAL STATEMENT

ASSERTIONS AND SELECTING CONTROLS TO TEST

5-61

61

TYPES OF CONTROLS AND EXAMPLES OF

CONCEPTS AFFECTING CONTROL TESTING
Manual Controls

Documented evidence for control

to be working; taking sample of
transactions to determine control
operation evidence

Reviewing Taking a sample of

Taking a sample of
Taking a sample of documentation of reports used to
reconciliations to
transactions and selected identify unusual
determine that:
examining transactions to transactions and
a) They were determine: review them to
evidence
performed by an determine:
supporting that the a) Proper
authorized person
controls are authorization a) Regular usage
working b) They were
b) Recorded in b) Identification of
performed properly
correct time period unusual items

Authorizations Reconciliations Reviews for unusual transactions

5-62

62

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TYPES OF CONTROLS AND EXAMPLES OF

CONCEPTS AFFECTING CONTROL TESTING
Controls over Accounting
Estimates

Documented evidence for

controls over estimates ensuring
accuracy of data, consistency in
performance, regularly updating
the model

Ensuring estimates are Finding evidence that data

All entries being properly
updated for current used for estimation come
authorized
economic conditions from reliable sources

5-63

63

FIRST APPROACH TO TESTING

CONTROLS
• Take sample of customer orders and trace it through
the system to determine whether:
• There was proper review of credit and
• Credit authorization or denial was proper
• Advantage - Most effective because it helps in
determining that the control worked effectively
• Requires documentation of all credit applications and
purchase orders required
• Based on audit sampling
5-64

64

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SECOND APPROACH TO TESTING

CONTROLS
• Taking a sample of recorded items and tracing back
to credit approval process
• Provides evidence on proper credit approval for all
items presently recorded
• Does not provide evidence as to whether other items
should have been approved for credit, but had not
been approved

5-65

65

THIRD APPROACH TO TESTING

CONTROLS
• Uses a computer audit program and develops a print-
out of account balances exceeding their credit
authorization
• Cost-effective
• Requires an inference about the control
• Covers only the operation of the controls related to
the current account balances
• 100% evaluation of each item currently recorded

5-66

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TESTING THE OPERATING

EFFECTIVENESS
• Auditor tests relevant principles of components of:
• Control environment
• Risk assessment
• Information and communication
• Monitoring

5-67

67

RESULTS OF TESTS OF CONTROLS FOR

FINANCIAL STATEMENT AUDIT
• If control deficiencies are identified
• Assess them to determine whether preliminary control
risk assessment should be modified
• Record the implications for substantive procedures
• If no control deficiencies are identified
• Assess whether preliminary control risk assessment is still
appropriate
• Determine extent that controls can provide evidence on
accuracy of account balances
• Determine planned substantive audit procedures
5-68

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RESULTS OF TESTS OF CONTROLS FOR

FINANCIAL STATEMENT AUDIT
• Determine how much assurance about reliability of
account balances can be obtained from the effective
operation of controls
• Within any audit, level of assurance will vary across:
• Accounts
• Disclosures
• Assertions

5-69

69

LEARNING OBJECTIVE 11

DISCUSS AUDIT ACTIVITIES IN PHASE IV OF THE

AUDIT OPINION FORMULATION PROCESS

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PHASE IV - OBTAINING SUBSTANTIVE EVIDENCE ABOUT

ACCOUNTS, DISCLOSURES, AND ASSERTIONS

• Substantive procedures include:

• Substantive analytical procedures
• Tests of details of account balances
• Considerations in determining appropriate
substantive procedures:
• Source of potential misstatement
• Extent and type of potential misstatement

5-71

71

EXHIBIT 5.12 - FACTORS AFFECTING

SUBSTANTIVE PROCEDURES TO BE PERFORMED

5-72

72

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LEARNING OBJECTIVE 12

DISCUSS AUDIT ACTIVITIES IN PHASE V OF THE

AUDIT OPINION FORMULATION PROCESS

73

PHASE V - COMPLETING THE AUDIT

AND MAKING REPORTING DECISIONS
• Completing various review and communication
activities
• Making a decision about what types of opinions
should be issued
• Deciding on the appropriate opinion to be issued
• It can be based on financial statements and internal
control
• It can be issued in one report or in two separate
reports

5-74

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LEARNING OBJECTIVE 13

APPLY THE CONCEPTS RELATED TO THE AUDITOR’S

ASSESSMENT OF INTERNAL CONTROL DESIGN
EFFECTIVENESS, IMPLEMENTATION, AND OPERATING
EFFECTIVENESS

75

MANAGEMENT ASSESSMENT OF
CONTROLS
• Factors considered in deciding whether to categorize
a deficiency as significant or not
• Risk that is being mitigated and whether other controls
operate effectively
• Materiality of related account balances
• Nature of deficiency
• Volume of transactions affected
• Subjectivity of account balance that is subject to
control
• Rate at which control fails to operate
5-76

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MANAGEMENT ASSESSMENT OF
CONTROLS
• Deficiency of segregation of duties
• Did not rise to a significant deficiency or a material
weakness
• Management decides to use this deficiency as a
motivation to centralize purchases

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77

MANAGEMENT ASSESSMENT OF
CONTROLS
• Deficiency of lack of approval considered as a
significant deficiency based on the following
rationale:
• Major departure from an approved process
• Could lead to purchase of unauthorized goods
• Could be shipped elsewhere and lead to material
misstatement in financial statements

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AUDITOR ASSESSMENT OF CONTROLS

• Auditor reviews:
• Management’s documentation of its internal control
• Management’s evaluation and findings related to
internal control effectiveness
• Auditor then gathers evidence on operating
effectiveness of these controls
• By taking a random sample auditor needs to
independently determine that the controls are working
or not

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79

AUDITOR ASSESSMENT OF CONTROLS

• Implications for substantive procedures in financial

statement audit:
• Auditor will do limited testing of inventory quantities
at year end
• Auditor will assess year-end inventory for potential
obsolescence
• Auditor will continue to examine all adjusting entries at
the end of the year

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LECTURE 5
AUDIT EVIDENCE

LEARNING OBJECTIVES

1. Discuss the importance of the evidence concepts

of appropriateness and sufficiency
2. Identify factors affecting the appropriateness of
audit evidence
3. Make professional judgments about the type and
timing of audit procedures to use to obtain audit
evidence
4. Discuss the use of, and apply, substantive analytical
procedures

6-2

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LEARNING OBJECTIVES

5. Identify factors affecting the sufficiency of audit

evidence
6. Identify issues related to audit evidence needed for
accounts involving management estimates
7. Determine situations requiring the auditor to use a
specialist/expert and describe the auditor’s
responsibilities related to that specialist/expert
8. Describe the evidence needs for related-party
transactions

6-3

LEARNING OBJECTIVES
9. Describe the characteristics of quality audit
documentation
10. Explain the nature, design, and purposes of audit
programs
11. Apply the frameworks for professional decision
making and ethical decision making to issues
involving audit evidence

6-4

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THE AUDIT OPINION FORMULATION

PROCESS

6-5

LEARNING OBJECTIVE 1

DISCUSS THE IMPORTANCE OF THE EVIDENCE

CONCEPTS OF APPROPRIATENESS AND
SUFFICIENCY

3
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AUDIT EVIDENCE DEFINED BY AS 15

• Information that is used by the auditor in arriving at

conclusions on which auditor’s opinion is based
• Consists of information that either supports or
contradicts management’s assertions regarding:
• Financial statements
• Internal control over financial reporting

6-7

EXHIBIT 6.1 - INTERRELATIONSHIP OF RISK AND

EVIDENCE APPROPRIATENESS AND SUFFICIENCY

6-8

4
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LEARNING OBJECTIVE 2

IDENTIFY FACTORS AFFECTING THE

APPROPRIATENESS OF AUDIT EVIDENCE

APPROPRIATENESS OF AUDIT
EVIDENCE
• Measure of quality of audit evidence that includes:
• Relevance: Evidence that provides insight on the
validity of the assertion being tested
• Reliability: Measure of quality of underlying evidence
influenced by:
• Risk
• Potential management bias
• Quality of internal control system

6-10

10

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RELEVANCE OF AUDIT EVIDENCE

• Affected by the following factors

• Purpose of procedure being performed
• Direction of testing
• Specific procedure or set of procedures being
performed

6-11

11

PURPOSE OF AN AUDIT PROCEDURE

• Risk assessment - Identifies risks of material

misstatement
• Tests of controls - Evaluates effectiveness of controls
in detecting and correcting, material misstatements
• Substantive procedures - Provides direct evidence
about presence of material misstatements

6-12

12

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DIRECTIONAL TESTING

• Approach to test account balances that considers:

• Type of misstatement likely to occur
• Corresponding evidence provided by other accounts
that have been tested
• Assets and expenses for overstatement and liabilities
and revenues for understatement because:
• There is major risks of misstatements
• Tests of other accounts provide evidence of possible
misstatements in other direction

6-13

13

EXHIBIT 6.2 - ILLUSTRATION OF TESTING

FOR EXISTENCE AND COMPLETENESS

6-14

14

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TESTING FOR EXISTENCE

• Vouching: Taking a sample of recorded transactions

and obtaining original source documents supporting
recorded transaction
• Addresses overstatement
• Provides evidence on the assertion that recorded
transactions are valid

6-15

15

TESTING FOR COMPLETENESS

• Tracing: Taking a sample of original source

documents and ensuring that transactions related to
source documents have been recorded in
appropriate journal and general ledger
• Called reprocessing
• Addresses understatement

6-16

16

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TYPE OF PROCEDURE

• Specific audit procedure required to provide audit

evidence that is relevant to certain assertions, but
not others
• Example - Walking through client’s warehouse to
inspect inventory would result in evidence related to
existence of inventory, but not to valuation

6-17

17

DIRECT AND INDIRECT EVIDENCE

• Direct
• Relevant to a specific assertion
• Requires only one inference to reach a conclusion
about the assertion being tested
• Indirect
• Not directly relevant to a specific assertion
• Insufficient, when high risk of material misstatement
exists
• Requires a linkage of inferences to provide assurance

6-18

18

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RELIABILITY OF AUDIT EVIDENCE

• Judged by its ability to provide convincing evidence

related to the audit objective being evaluated
• According to the text of ISA 500 (A31)
• The reliability of the audit evidence is influenced by:
• Its source and its nature
• Circumstances under which it is obtained
• Includes the controls for preparation and maintenance
• Generalizations about reliability of various kinds of
audit evidence are subject to important exceptions

6-19

19

GENERALIZATIONS ESTABLISHED BY
IAASB, IN ISA 500

6-20

20

10
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INTERNAL DOCUMENTATION

• Reliability varies depending on:

• Effectiveness of internal controls
• Management motivation to misstate individual
accounts
• Formality of documentation
• Example - Acknowledgment of its validity by parties
independent of the accounting function
• Independence of those preparing documentation from
those recording transactions

6-21

21

EXTERNAL DOCUMENTATION

• Considered highly reliable

• Reliability varies depending on whether the
documentation:
• Was prepared by a knowledgeable and independent
outside party
• Is received directly by auditor
• Is directed to the client

6-22

22

11
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TYPES OF INTERNAL AND EXTERNAL

DOCUMENTS
• Internal
• Legal documents
• Business documents
• Accounting documents
• Other planning and control documents
• External
• Business documents
• Third-party documents
• General business information
6-23

23

EVIDENCE FROM A MANAGEMENT’S

SPECIALIST
• Management’s specialist
• Individual or organization possessing expertise in a
field other than accounting or auditing
• Assists in preparing financial statements
• Consider the following factors
• Competence, capabilities, and objectivity
• Work performed
• Appropriateness of his or her work as audit evidence
for relevant assertion

6-24

24

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LEARNING OBJECTIVE 3

MAKE PROFESSIONAL JUDGMENTS ABOUT THE

TYPE AND TIMING OF AUDIT PROCEDURES TO
USE TO OBTAIN AUDIT EVIDENCE

25

EXHIBIT 6.5 - TYPE OF AUDIT

PROCEDURES

Ex 6.5.png

6-26

26

13
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ACCOUNTING RECORDS

• Initial accounting entries and supporting records

• Include:
• Evidence of internal controls over financial reporting,
as well as supporting records
• The general and subsidiary ledgers
• Journal entries
• Worksheets supporting cost allocations, computations,
reconciliations, and disclosures

6-27

27

CORROBORATING INFORMATION

• Validates underlying accounting records

• Includes the following evidence
• Minutes of meetings
• Confirmations from independent parties
• Industry data
• Inquiry
• Observation
• Inspection of documents

6-28

28

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EXHIBIT 6.6 - TYPES OF RECALCULATIONS

PERFORMED BY AUDITOR

6-29

29

EXHIBIT 6.7 - MANAGEMENT ASSERTIONS AND

EXAMPLES OF RELATED AUDIT PROCEDURES

Ex 6.7.png

6-30

30

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ASSESSING THE CONSISTENCY OF

EVIDENCE
• Consider all sources of information and consistency
of information
• AS 15 requirement
• Consider internal consistency of evidence gathered
• Consider consistency of internal evidence generated
with external evidence gathered
• Expand evidence-gathering procedures for areas
where results are inconsistent
• Document conclusions based on evidence gathered
6-31

31

COST–BENEFIT CONSIDERATIONS
WHEN SELECTING AUDIT PROCEDURES
• Should balance following objectives
• Profitability
• Managing risk
• Each audit procedure takes time, effort, and
ultimately money to perform
• Rigorous audit procedures providing higher quality
evidence are more costly to perform
• Determining appropriate mix of evidence based on
auditor’s professional judgment
6-32

32

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EXHIBIT 6.8 - COST OF AUDIT

PROCEDURES AND EVIDENCE QUALITY

Ex 6.8.png

6-33

33

TIMING OF PROCEDURES

• At the balance sheet date

• Interim date: Earlier than balance sheet date
• After the balance sheet date
• Decision based on:
• Assessment of risk associated with account
• Effectiveness of internal controls
• Nature of the account
• Availability of audit staff

6-34

34

17
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TIMING OF PROCEDURES

• Performing procedures after year end may provide

most convincing evidence
• Performing procedures prior to the balance sheet
date
• Allows earlier completion of audit
• Might require less overtime of the audit staff
• Might meet management’s desire to distribute financial
statements shortly after year end
• May increase in risk of failing to detect material
misstatements that occur between interim date and year
end
6-35

35

TIMING OF PROCEDURES

• Roll-forward period: Period between the

confirmation date and the balance sheet date
• Cutoff period: Covers several days before and after
client’s balance sheet date
• Risk- Recording transactions in wrong period
• Cutoff tests: Applied to transactions recorded during
cutoff period
• Provide evidence, as to whether transactions have been
recorded in the proper record period

6-36

36

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TIMING OF PROCEDURES

6-37

37

LEARNING OBJECTIVE 4

DISCUSS THE USE OF, AND APPLY, SUBSTANTIVE

ANALYTICAL PROCEDURES

38

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EXHIBIT 6.9 - ALTERNATIVE APPROACHES

TO SUBSTANTIVE PROCEDURES

6-39

39

CONSIDERATIONS IN PERFORMING
SUBSTANTIVE ANALYTICAL PROCEDURES
• Does the company have adequate internal controls
over the account?
• Is the risk of material misstatement low enough that
inferences from indirect evidence are appropriate to
make conclusions about an account?
• Are the underlying data used in evaluating an
account both relevant and reliable?
• Are the relationships among the data logical and
justified by current economic conditions?

6-40

40

20
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THE PROCESS FOR PERFORMING

ANALYTICAL PROCEDURES
Developing an expectation

Defining when the difference between the auditor’s expectation

and what the client has recorded would be considered significant

Computing the difference between the auditor’s expectation and

what the client has recorded

Following up on significant differences

6-41

41

IMPROVING THE EFFECTIVENESS OF

SUBSTANTIVE ANALYTICAL PROCEDURES
• Providing reliable evidence depends on:
• Nature of assertion being tested
• Plausibility and predictability of relationships in data
• Availability and reliability of data used
• Precision of expectation ,which requires the auditor to
use disaggregated data
• Disaggregation: Breaking data down into their component
parts based on time periods, geographical locations,
customer type, or product lines
• Rigor of analytical procedure employed

6-42

42

21
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TYPES OF LESS RIGOROUS ANALYTICAL

PROCEDURES EMPLOYED
• Trend analysis - Analysis of changes over time
• Rigor improved by:
• Including more periods in the trend
• Using disaggregated data
• Using relevant external benchmarks
• Ratio analysis - Comparison of relationships between
accounts and between an account and nonfinancial
data

6-43

43

TYPES OF LESS RIGOROUS ANALYTICAL

PROCEDURES EMPLOYED
• Rigor improved by:
• Using disaggregated data
• Using relevant external benchmarks
• Scanning - Detects unusual or unexpected balances
or transactions in account balances, listings of
transactions and journals
• Expectations based on:
• Knowledge of the client
• Knowledge of accounting
• Common sense
6-44

44

22
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MORE RIGOROUS ANALYTICAL

PROCEDURES EMPLOYED
• Reasonableness test
• Development of an expected value of an account by
using data partly or wholly independent of the client’s
accounting information system
• Regression analysis - Expected value is determined
using a statistical technique whereby one or more
factors are used to predict an account balance

6-45

45

APPLICATION OF SUBSTANTIVE
ANALYTICAL PROCEDURES
• Difficult decision-making process
• Designed to provide evidence about the correctness
of an account balance
• Should be used when procedures are:
• Reliable
• More cost-effective than other substantive procedures

6-46

46

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QUANTIFICATION AND
CORROBORATION
• Quantification: Determining whether
management’s explanation for observed differences
can account for the observed difference
• Corroboration: Obtaining sufficient evidence that
management’s explanation is accurate

6-47

47

LEARNING OBJECTIVE 5

IDENTIFY FACTORS AFFECTING THE

SUFFICIENCY OF AUDIT EVIDENCE

48

24
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SUFFICIENCY OF EVIDENCE

• Measure of the quantity of audit evidence

• Quantity of audit evidence needed is affected by:
• Assessment of risks of material misstatement
• Quality of such audit evidence
• Amount of evidence must:
• Be sufficient to convince audit team of effectiveness of
internal control or accuracy of an account
• Stand on its own such that another unbiased
professional would reach same conclusion

6-49

49

DETERMINING SAMPLE SIZES

• Requires applying a statistically based formula

• Requires auditor’s professional judgment
• Factors considered
• Risk of material misstatement
• Assurance obtained from other procedures

6-50

50

25
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ADDITIONAL SAMPLE SIZE CONSIDERATIONS

FOR TESTS OF CONTROLS

• Type of control being tested

• Frequency with which control is performed
• Controls over adjusting entries require additional
consideration due to high risk of material
misstatement
• The better the control environment, the smaller the
sample size

6-51

51

LEARNING OBJECTIVE 6

IDENTIFY ISSUES RELATED TO AUDIT EVIDENCE

NEEDED FOR ACCOUNTS INVOLVING
MANAGEMENT ESTIMATES

52

26
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EVIDENCE NEEDED FOR AUDITING

MANAGEMENT ESTIMATES
• Management judgments must be established by
independent, objective, and verifiable data that
support estimates
• Understand processes used by management in
developing estimates
• Controls over the process
• Reliability of underlying data in developing estimate
• Use of outside experts by management
• Reviewing procedure for results of estimates for
reasonableness
6-53

53

OPTIONS FOR OBTAINING EVIDENCE NEEDED

FOR AUDITING MANAGEMENT ESTIMATES
• Determining whether events occurring up to the date
of auditor’s report provide audit evidence
• Testing how management made the accounting
estimate and data on which it is based
• Testing the operating effectiveness of controls over
process management
• Developing a point estimate or range to evaluate
management’s point estimate

6-54

54

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LEARNING OBJECTIVE 7

DETERMINE SITUATIONS REQUIRING THE AUDITOR TO USE

A SPECIALIST/EXPERT AND DESCRIBE THE AUDITOR’S
RESPONSIBILITIES RELATED TO THAT SPECIALIST/EXPERT

55

USING A SPECIALIST/EXPERT TO ASSIST

WITH OBTAINING EVIDENCE
• Certain accounts require expertise in another field to
obtain appropriate audit evidence
• Examples
• Valuation of land and buildings, plant and machinery,
works of art, antiques, and intangible assets
• Estimation of oil and gas reserves
• Responsibility for audit opinion lies with the auditor

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EVALUATING PROFESSIONAL
QUALIFICATIONS OF A SPECIALIST
• Professional certification, license, or other
recognition of competence in his or her field
• Reputation and standing of the specialist in the views
of peers familiar with the specialist’s capability
• Specialist’s experience in the type of work under
consideration

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57

UNDERSTANDING NATURE OF WORK

PERFORMED BY A SPECIALIST
• Obtaining an understanding of methods and
assumptions used
• Making appropriate tests of data provided to
specialist, taking into account auditor’s assessment
of control risk
• Evaluating whether specialist’s findings support the
related assertions in financial statements

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LEARNING OBJECTIVE 8

DESCRIBE THE EVIDENCE NEEDS FOR RELATED-

PARTY TRANSACTIONS

59

RELATED-PARTY TRANSACTIONS

• Client transactions with other organizations or

people related to either the client or client’s senior
management
• Parents and subsidiaries
• An entity and its owners
• An entity and other organizations in which it has part
ownership, such as joint ventures
• An entity and an assortment of special-purpose
entities (SPEs)

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RELATED-PARTY TRANSACTIONS

• Higher risks of material misstatement of financial

statements
• May not be conducted under normal market terms
and conditions
• Auditors need to identify all related parties and
account for all related-party transactions

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61

EXHIBIT 6.10 – A Sample of Relevant Audit

Procedures for Related-Party Transactions

Ex 6.10.png

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LEARNING OBJECTIVE 9

DESCRIBE THE CHARACTERISTICS OF QUALITY

AUDIT DOCUMENTATION

63

DOCUMENTING AUDIT EVIDENCE

• It forms the basis for an auditor’s representations

and conclusions
• Helps plan, perform, and supervise audit process
• Forms basis for reviewing work quality
• Includes:
• Records of planning and performance of work
• Procedures performed
• Evidence obtained
• Conclusions reached by the auditor
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DOCUMENTING AUDIT EVIDENCE

• AS 3 requires audit documentation be:

• Prepared in detail to provide a clear understanding of
its purpose, source, and the conclusions reached
• Appropriately organized to provide a clear link to the
significant findings or issues

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65

DOCUMENTING PLANNING AND RISK

ASSESSMENT PROCEDURES
• An auditor should document:
• Overall audit strategy and audit plan
• Overall planned responses to address assessed risks of
material misstatement
• Nature, timing, and extent of further audit procedures
• Linkage of those procedures with assessed risks at
relevant assertion level

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EXHIBIT 6.11 - EXAMPLES OF INFORMATION

DOCUMENTED FROM RISK ASSESSMENT PROCEDURES

Ex 6.11.png

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DOCUMENTATION USED TO DEMONSTRATE

AUDIT WORK PERFORMED
• Client’s trial balance and any auditor-proposed
adjustments to it
• Copies of selected internal and external documents
• Memos describing auditor’s approach to gathering
evidence and reasoning process in support of
account balances
• Results of analytical procedures and tests of client
records, and individuals responsible for performance,
and subsequently the review, of procedures

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DOCUMENTATION USED TO DEMONSTRATE

AUDIT WORK PERFORMED
• Correspondence with specialists who provided:
• Evidence significant to the evaluation or accounting
evaluation or accounting for assets/liabilities
• Related revenue expense effects
• Auditor-generated analysis of account balances

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SIGNIFICANT ISSUES

• Substantive matters that are important to the

procedures performed, evidence obtained, or
conclusions reached on an audit
• Called audit findings
• Examples provided by AS 3
• Selection, application, and consistency of accounting
principles, including related disclosures
• Results indicating a need for modification of:
• Planned auditing procedures

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SIGNIFICANT ISSUES
• Material misstatements
• Omissions in financial statements
• Significant deficiencies
• Material weaknesses in internal control
• Audit adjustment: Correction of a misstatement of
financial statements proposed by the auditor
• Disagreements of engagement team about conclusions
on accounting or auditing matters

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71

TYPES OF DOCUMENTATION FOR IDENTIFICATION

OF SIGNIFICANT ISSUES AND THEIR RESOLUTION

• Correspondence with national office experts

• Clear articulation of auditor’s judgment and
reasoning process that led to the judgment on
fairness of financial statements

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COPIES OF DOCUMENTS

• Important client documents

• Documents having legal significance
• Documents from outside parties
• Documents of management representations that
acknowledge accuracy of its verbal or written
assertions

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CHARACTERISTICS OF QUALITY AUDIT

DOCUMENTATION
• Serves as primary evidence of audit
• Should include:
• Heading including name of audit client, an explanatory
title, and balance sheet date
• Initials or electronic signature of the:
• Auditor and the date the test was completed
• Manager or partner who reviewed the documentation
and the date the review was completed
• Workpaper page number
• Description of tests performed
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CHARACTERISTICS OF QUALITY AUDIT

DOCUMENTATION
• Tick marks and a tick mark legend indicating nature of
work performed by auditor
• Assessment of whether the tests indicate possibility of
material misstatement in an account
• Cross-reference to related documentation
• Section identifying all significant issues that arose
during the audit and how they were resolved
• Comprehensive and clear memorandum outlining
auditor’s analysis regarding financial presentation

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EXHIBIT 6.12 - WORKING PAPER FOR

INVENTORY PRICE TEST

Ex 6.12.png

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LEARNING OBJECTIVE 10

EXPLAIN THE NATURE, DESIGN, AND PURPOSES

OF AUDIT PROGRAMS

77

AUDIT PROGRAM

• Documents the procedures to be performed in

gathering audit evidence
• Records successful completion of each audit step
• Provides an effective means for:
• Organizing and distributing audit work
• Monitoring the audit process and progress
• Recording audit work performed and those responsible
• Reviewing completeness and persuasiveness of
procedures performed

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EXHIBIT 6.13 - PARTIAL AUDIT PROGRAM

FOR ACCOUNTS RECEIVABLE

Ex 6.13.png

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LECTURE 6
PLANNING THE AUDIT: IDENTIFYING AND
RESPONDING TO THE RISKS OF MATERIAL
MISSTATEMENT

LEARNING OBJECTIVES

1. Define the concept of material misstatement and

discuss the importance of materiality judgments in
the audit context
2. Identify the risks of material misstatement and
describe how they relate to audit risk and detection
risk
3. Assess factors affecting inherent risk
4. Assess factors affecting control risk

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LEARNING OBJECTIVES

5. Use preliminary analytical procedures and

brainstorming to identify areas of heightened risk of
material misstatement
6. Describe how auditors make decisions about
detection risk and audit risk

7-3

LEARNING OBJECTIVES

7. Respond to the assessed risks of material

misstatement and plan the procedures to be
performed on an audit engagement
8. Apply the frameworks for professional decision
making and ethical decision making to issues
involving materiality, risk assessment, and risk
responses

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THE AUDIT OPINION FORMULATION

PROCESS

7-5

PROFESSIONAL JUDGMENT IN CONTEXT - RISKS

ASSOCIATED WITH FINANCIAL STATEMENT
MISSTATEMENTS
• Risk: Expresses uncertainty about events and/or their
outcomes having a material effect on the organization
• According to ISA 315 the risks:
• Are associated with operational and financial reporting
decisions
• Are sometimes hard to quantify and are judgmental in nature
• Are present but the organization does not have material
misstatements, thus making it difficult for auditors to know
when a risk factor truly is leading to a material misstatement
for their particular clients

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LEARNING OBJECTIVE 1

DEFINE THE CONCEPT OF MATERIAL MISSTATEMENT

AND DISCUSS THE IMPORTANCE OF MATERIALITY
JUDGMENTS IN THE AUDIT CONTEXT

ASSESSING MATERIALITY

• Misstatement: An error, either intentional or

unintentional, that exists in a transaction or financial
statement account balance
• Essential to understand materiality in the context of
designing and conducting a quality audit

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ASSESSING MATERIALITY

Materiality

• Magnitude of an omission or misstatement

of accounting information that, in view 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

7-9

ASSESSING MATERIALITY
• According to ISA 320, • According to the
Materiality in Planning Supreme Court of the
and Performing an United States
Audit • Fact should be viewed by
• Auditors’ judgments reasonable investors as
about materiality should having significantly
be made based on a altered total mix of
consideration of information made
information needs of available
users as an overall group

7-10
Copyright © 2014 South-Western/Cengage Learning

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MATERIALITY GUIDANCE

• Audit firms provide auditors with:

• Specific written guidance
• Decision aids
• Levels considered by auditors
• Materiality for the financial statements as a whole
• Performance materiality for particular classes of
transactions, account balances, or disclosures

7-11

11

MATERIALITY GUIDANCE

• Performance materiality: Amount set by auditor at

less than materiality level for financial statements as
a whole or for particular classes of transactions,
account balances, or disclosures
• Used to:
• Assess risks of material misstatement
• Determine the nature, timing, and extent of audit
procedures

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MATERIALITY GUIDANCE

• Tolerable misstatement: Amount of misstatement in

an account balance that the auditor could tolerate
and still not judge underlying account balance to be
materially misstated
• Clearly trivial amount (posting materiality)
• Inconsequential, whether:
• Taken individually or in the aggregate
• Judged by any criteria of size, nature, or circumstances

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SEC VIEWS ON MATERIALITY

• Criticisms of the auditing profession

• Netting material misstatements
• Not applying materiality concept to swings in
accounting estimates
• Consistently passing on individual adjustments that
may not be considered material

7-14

14

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SEC VIEWS ON MATERIALITY

• Qualitative reasons for considering quantitatively

small misstatement material
• Hiding failure to meet analysts’ consensus
expectations
• Changing a loss into income, or vice versa
• Concerning a segment playing significant role in
operations or profitability
• Affecting compliance with regulatory requirements
• Affecting compliance with loan covenants
• Effecting the increases in management’s
compensation 7-15

15

SITUATIONS NECESSITATING CHANGE

IN MATERIALITY JUDGMENTS
• Initial materiality judgments were based on
estimated or preliminary financial statement
amounts, which are different from the audited
amounts
• Financial statement amounts initially used in the
making of materiality judgments have changed

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CHANGES IN MATERIALITY
JUDGMENTS
• Auditors make professional judgments about size of
material misstatements providing a basis for:
• Determining nature and extent of risk assessment
procedures
• Identifying and assessing risks of material
misstatement
• Determining nature, timing, and extent of tests of
controls and substantive audit procedures

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17

LEARNING OBJECTIVE 2

IDENTIFY THE RISKS OF MATERIAL

MISSTATEMENT AND DESCRIBE HOW THEY
RELATE TO AUDIT RISK AND DETECTION RISK

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EXHIBIT 7.1 - RISKS RELEVANT TO AN

AUDIT

7-19

19

RISK OF MATERIAL MISSTATEMENT

• Exists at the financial statement level and assertion

level
• Categories of risk within these levels
• Inherent risk
• Control risk
• Risk of material misstatement high - Auditor accepts
less audit risk
• Risk of material misstatement lower - Auditor
accepts more audit risk

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RISK OF MATERIAL MISSTATEMENT

• Detection risk: Level of audit effort that auditor will

expend on engagement depends on level of
detection risk

Increase in
When risk of
evidence obtained
material Detection risk is set
through
misstatement is lower
substantive audit
higher
procedures

7-21

21

AUDITING IN PRACTICE - WHAT MAKES

A RISK SIGNIFICANT?
• AU-C 315:
• Whether the risk is a risk of fraud
• Whether the risk is related to recent significant economic,
accounting, or other developments and, requires specific
attention
• Complexity of transactions
• Whether the risk involves transactions with related parties
• Degree of subjectivity in measurement of financial
information related to risk
• Whether the risk involving significant transactions outside
normal course of business
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LEARNING OBJECTIVE 3

ASSESS FACTORS AFFECTING INHERENT RISK

23

FACTORS FOR ASSESSMENT OF INHERENT RISK

AT THE ASSERTION LEVEL AT A HIGHER LEVEL

• Account represents an asset that can be easily stolen

• Account balance made up of complex transactions
• Account balance requires a high level of estimation
to value
• Account balance subject to adjustments that are not
in the ordinary processing routine
• Account balanced composed of a high volume of
nonroutine transactions

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BUSINESS RISKS

• Inherent risk at financial statement level that affects

business operations and potential outcomes of
organizational activities
• Factors affecting such risk
• Overall economic climate
• Technological changes
• Competitor actions
• Geographic locations of suppliers

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25

FACTORS FOR ASSESSMENT OF INHERENT

RISK OF OPERATIONS AT HIGHER LEVEL
• Lack of expertise to deal with changes in industry
• Uncertain likelihood of successful introduction of
new product and acceptance by market
• Information technology being incompatible across
systems
• Expansion of business for which demand not
accurately estimated
• Implementation of incomplete business strategy
• New regulatory requirements increase legal exposure
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FACTORS FOR ASSESSMENT OF INHERENT

RISK OF OPERATIONS AT HIGHER LEVEL
• Alternative products, services, competitors, or
providers posing a threat to current business
• Significant supply chain risks
• Complex production and delivery processes
• Mature and declining industry
• Inability to control costs with possibility of
unforeseen costs
• Producing products that have multiple substitutes

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27

SOURCES OF INFORMATION FOR

ASSESSING BUSINESS RISKS
• Management inquiries • Online searches
• Review of client’s • Review of SEC filings
budget • Company Web sites
• Tour of client’s plant • Economic statistics
and operations • Professional practice
• Review government bulletins
regulations and client’s • Stock analysts’ reports
legal obligations
• Company earnings calls
• Knowledge
management systems
7-28
Copyright © 2014 South-Western/Cengage Learning

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INHERENT RISK AT FINANCIAL STATEMENT

LEVEL - FINANCIAL REPORTING RISKS
• When assessing this risk, auditors consider all items
on a company’s financial statements that are
subjective and based on judgment
• Inherent risk at the financial statement level is affected
by:
• Competence and integrity of management
• Potential incentives to misstate the financial statements

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29

SOURCES OF INFORMATION
REGARDING MANAGEMENT INTEGRITY
• Predecessor auditor
• Other professionals in business community
• Other auditors within audit firm
• News media and Web searches
• Public databases
• Preliminary interviews with management
• Audit committee members
• Inquiries of federal regulatory agencies
• Private investigation firms
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AUDITING IN PRACTICE - AN EXAMPLE OF

INHERENT RISK AT FINANCIAL STATEMENT LEVEL

• Former CFO of Maxim Integrated Products was held

liable for securities fraud for engaging in a scheme to
backdate stock option grants
• Aided Maxim’s failure to maintain accurate accounting
records, resulting in inaccurate financial reporting
• Management integrity was a fundamental problem
leading to this fraud
• Assessing management integrity is no easy task

7-31

31

LEARNING OBJECTIVE 4

ASSESS FACTORS AFFECTING CONTROL RISK

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CONTROL RISK

• Relates to susceptibility that a misstatement will not

be prevented or detected on a timely basis by
internal control system
• It’s assessment can be made at:
• Overall financial statement level
• Account or assertion level

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33

ASSESSING FACTORS AFFECTING

CONTROL RISK
• Poor controls in specific countries or locations
• Difficulty gaining access to the organization or
determining the controllers of the organization
• Little interaction between senior management and
operating staff
• Weak tone at the top leading to a poor control
environment
• Inadequate accounting staff and information systems

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ASSESSING FACTORS AFFECTING

CONTROL RISK
• Growth of organization exceeding accounting system
infrastructure
• Disregard of regulations for prevention of illegal acts
• No internal audit function, or lack of respect for
internal audit function by management
• Weak design, implementation, and monitoring of
internal controls
• Lack of supervision of accounting personnel

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35

TECHNIQUES TO UNDERSTANDING
MANAGEMENT’S RISK ASSESSMENT
• Understand processes used by the board and
management to manage risk
• Review risk-based approach used by internal audit
function with its director and audit committee
• Interviewing management about:
• Risk approach
• Risk preferences
• Risk appetite
• Relationship of risk analysis to strategic planning

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LEARNING OBJECTIVE 6

DESCRIBE HOW AUDITORS MAKE DECISIONS

ABOUT DETECTION RISK AND AUDIT RISK

37

DETERMINING DETECTION RISK AND

AUDIT RISK
• Auditor determines level of detection risk on the
basis of:
• Assessment of risk of material misstatement at all
levels
• Consideration of desired level of audit risk
• Determining detection risk influences nature,
amount, and timing of substantive audit procedures

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DETECTION RISK AND AUDIT RISK

• Detection risk is affected by:

• Effectiveness of substantive auditing procedures
performed
• Extent to which the procedures were performed with
due professional care
• High level of detection risk
• Audit firm is willing to take higher risk of not detecting
a material misstatement
• Audit risk is also high

7-39

39

DETECTION RISK AND AUDIT RISK

• Low level of detection risk

• Audit firm is not willing to take as much of a risk of not
detecting material misstatement
• Audit risk is also low
• Audit risk usually set at between 1% and 5%
• Detection risk ranges from 1% to 100%

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EXHIBIT 7.4 - RISKS AND THEIR

EFFECTS ON AUDIT WORK

7-41

41

EXHIBIT 7.4 - RISKS AND THEIR

EFFECTS ON AUDIT WORK

7-42

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HIGH RISK OF MATERIAL

MISSTATEMENT
• Assuming an account with many complex
transactions and weak internal controls
• Inherent risk and control risk assessed at their
maximum
• Audit risk set at a low level
• Audit risk model
Audit Risk = Inherent Risk × Control Risk × Detection Risk
0.01 = 1.00 × 1.00 × Detection Risk
Detection Risk = 0.01 / (1.0 × 1.0) = 1%

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43

LOW RISK OF MATERIAL

MISSTATEMENT
• Assuming an account with simple transactions and
well-trained personnel with no incentive to misstate
financial statements
• Inherent risk and control risk assessed at 50% and 20%
respectively
• Audit risk set at 5%
Audit Risk = Inherent Risk × Control Risk × Detection
Risk
0.05 = 0.50 × 0.20 × Detection Risk
Detection Risk = 0.05 / (0.50 × 0.20) = 50%

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AUDITING IN PRACTICE - AN EXPANDED

VERSION OF AUDIT RISK MODEL

7-45

45

LEARNING OBJECTIVE 7

RESPOND TO THE ASSESSED RISKS OF MATERIAL

MISSTATEMENT AND PLAN THE PROCEDURES TO
BE PERFORMED ON AN AUDIT ENGAGEMENT

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PLANNING AUDIT PROCEDURES TO RESPOND TO

THE ASSESSED RISKS OF MATERIAL MISSTATEMENT

• Auditor should design:

• Controls reliance audit
• Substantive audit
• When considering risk responses, auditor should:
• Evaluate reasons for assessed risk of material
misstatement
• Estimate likelihood of material misstatement due to
inherent risks of client

7-47

47

PLANNING AUDIT PROCEDURES TO RESPOND TO

THE ASSESSED RISKS OF MATERIAL MISSTATEMENT

• Consider the role of internal controls, and determine

whether control risk is relatively high or low
• Obtain more relevant and reliable evidence with
increase in assessment of risk of material misstatement

7-48

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EXHIBIT 7.5 - EFFECT OF RISK

ASSESSMENT ON RISK RESPONSE

7-49

49

NATURE OF RISK RESPONSE

• Types of audit procedures applied given the nature

of account balance and relevant assertions regarding
that account balance
• Procedures
• Assembling audit team with more experienced auditors
• Including on audit team outside specialists
• Increasing emphasis on professional skepticism

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TIMING OF RISK RESPONSE

• When audit procedures are conducted and whether

they are conducted at announced or predictable
times
• When risk of material misstatement is heightened
• Audit procedures conducted closer to year end on an
unannounced basis
• Some element of unpredictability included in timing

7-51

51

TIMING OF RISK RESPONSE

• Introducing unpredictability
• Performance of some audit procedures on low risk
accounts, disclosures, and assertions
• Change in timing of audit procedures from year to year
• Selection of items for testing that are lower than prior-
year materiality
• Performance of audit procedures on a surprise or
unannounced basis
• Varying location or procedures year to year

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TIMING OF RISK RESPONSE

• Procedures that can be completed only at or after

period end
• Comparison of financial statements to accounting
records
• Evaluation of adjusting journal entries made by
management in preparing financial statements
• Conduct procedures to respond to risks that
management may have engaged in improper
transactions at period end

7-53

53

EXTENT OF RISK RESPONSE

• Amount of evidence that is necessary given client’s

assessed risks, materiality, and level of acceptable
audit risk
• When risk of material misstatement is heightened,
auditor increases extent of audit procedures and
demands more evidence

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AUDITING IN PRACTICE - THE CITY OF DIXON, ILLINOIS

SUES ITS AUDITOR RELATED TO RITA CRUNDWELL
EMBEZZLEMENT
• The lawsuit alleges:
• Professional negligence
• Negligent misrepresentation
• Certain deficiencies in audit procedure
• Severe consequences to all parties involved
• When auditors fail to assess and appropriately respond
to risk of material misstatement

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LECTURE 7
AUDIT REPORTS ON FINANCIAL
STATEMENTS

LEARNING OBJECTIVES

1. Identify and describe the principles underlying audit

reporting on financial statements
2. Describe the information that is included in a
standard unqualified audit report on financial
statements and list the requirements for issuing a
standard unqualified report on financial statements
3. Describe financial statement audits requiring an
unqualified report with explanatory language and
identify the appropriate audit report modifications

15-2

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LEARNING OBJECTIVES

4. Describe financial statement audits requiring a

qualified report and identify the appropriate audit
report modifications
5. Describe financial statement audits requiring an
adverse report and identify the appropriate audit
report modifications
6. Describe financial statement audits requiring a
disclaimer of opinion and identify the
communication the auditor is required to provide

15-3

LEARNING OBJECTIVES

7. Assess various reporting situations requiring other

than a standard unqualified report and determine
the appropriate audit report that should be issued
8. Describe the information that is included in a
standard unqualified audit report on internal
control over financial reporting and identify the
appropriate audit report modifications for
situations requiring other than an unqualified
report on internal control over financial reporting

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LEARNING OBJECTIVES

9. Apply the frameworks for professional decision

making and ethical decision making to issues
involving audit reporting situations

15-5

THE AUDIT OPINION FORMULATION

PROCESS

15-6

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LEARNING OBJECTIVE 1

IDENTIFY AND DESCRIBE THE PRINCIPLES

UNDERLYING AUDIT REPORTING ON FINANCIAL
STATEMENTS

PRINCIPLES UNDERLYING AUDIT

REPORTING
• The American Institute of Certified Public
Accountant’s (AICPA) first and seventh principles
governing an audit conducted in accordance with
generally accepted auditing standards (GAAS)
describe the principles underlying audit reporting
• These principles require auditors to either:
• Express an unqualified opinion on the entire set of
financial statements and related footnotes, or
• State the reasons that such an opinion cannot be
expressed
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PRINCIPLES UNDERLYING AUDIT

REPORTING
• If there is a material deviation from generally
accepted accounting principles (GAAP):
• Auditor should explicitly state the nature of the
deviation and the dollar effects so that a user can
appropriately modify the financial statements

15-9

LEARNING OBJECTIVE 2

DESCRIBE THE INFORMATION THAT IS INCLUDED IN A

STANDARD UNQUALIFIED AUDIT REPORT ON FINANCIAL
STATEMENTS AND LIST THE REQUIREMENTS FOR ISSUING A
STANDARD UNQUALIFIED REPORT ON FINANCIAL STATEMENTS

10

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STANDARD UNQUALIFIED AUDIT

REPORTS - U.S. PUBLIC COMPANIES
• Designed to promote clear communication between
auditor and financial statement user by delineating:
• Introductory paragraph
• Scope paragraph
• Opinion paragraph

15-11

11

STANDARD UNQUALIFIED AUDIT

REPORTS - U.S. PUBLIC COMPANIES
• If a combined report on the financial statements and
internal controls, two additional paragraphs are
included
• Definition paragraph - Defines what is meant by
internal control over financial reporting
• Inherent limitations paragraph - Discusses why internal
control may not prevent or detect misstatements

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OTHER IMPORTANT COMPONENTS OF

AN AUDIT REPORT
Title
•Includes the word ‘independent’

Addressee
•Board of directors or shareholders of the organization for public companies
•Varies depending on the circumstances of the engagement

Audit report date

•No earlier than the date on which the auditor has obtained sufficient
appropriate evidence to support the opinion

Signature of audit firm

City/state from which the auditor’s report has been issued

15-13

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EXHIBIT 15.2 - SEC REPORTING

REQUIREMENTS

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REQUIREMENTS FOR A STANDARD UNQUALIFIED AUDIT

REPORT ON THE FINANCIAL STATEMENTS FOR U.S.
PUBLIC COMPANIES
• There should be no material violations of GAAP
• Disclosures should be adequate
• Auditor should be able to perform all of the necessary
procedures
• There should be no change in accounting principles
that had a material effect on the financial statements
• The auditor should not have significant doubt about
the client remaining a going concern
• The auditor should be independent

15-15

15

MODIFICATION OF THE STANDARD

UNQUALIFIED REPORT
• When the conditions are not present, auditor should
modify the standard unqualified report
• Options include:
• Issue an unqualified opinion with explanatory language
• Qualify the audit opinion
• Issue an adverse opinion
• Issue a disclaimer

15-16

16

8
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STANDARD UNQUALIFIED AUDIT REPORTS -

U.S. NONPUBLIC COMPANIES
• Introductory paragraph - What was audited
• Management’s responsibility paragraph -
Responsibilities of client management
• Scope paragraph - Responsibilities of the auditor and
the nature of the audit process
• Opinion paragraph - Auditor’s opinion on the
fairness of the financial statements
• For some engagements, financial statements might
be audited in accordance with multiple auditing
standards
15-17

17

NON-U.S. COMPANIES

• Auditors refer to ISA 700 for guidance

• Consistent with the AICPA’s AU-C 700 with a few
terminology differences
• True and fair view - Used in ISA 700; is not used in the
United States auditing standards
• Present fairly, in all material respects - GAAS
continues to require the use of the term

15-18

18

9
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LEARNING OBJECTIVE 3

DESCRIBE FINANCIAL STATEMENT AUDITS

REQUIRING AN UNQUALIFIED REPORT WITH
EXPLANATORY LANGUAGE AND IDENTIFY THE
APPROPRIATE AUDIT REPORT MODIFICATIONS

19

UNQUALIFIED AUDIT REPORTS WITH

EXPLANATORY LANGUAGE
• Used to explain:
• Justified departure from GAAP
• Inconsistent application of GAAP
• Substantial doubt about client being a going concern
• Emphasis of some matter, such as unusually important
subsequent events, risks, or uncertainties associated
with contingencies or significant estimates
• Reference to other auditors

15-20

20

10
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EXPLANATORY LANGUAGE - JUSTIFIED

DEPARTURE FROM GAAP
• Rule 203 of the AICPA Code of Professional Conduct
permits auditor to issue an unqualified opinion when
there has been a material departure from GAAP
• Only if the client can demonstrate, and auditor agrees,
that due to unusual circumstances, the financial
statements would have been misleading had GAAP
been followed

15-21

21

EXPLANATORY LANGUAGE - JUSTIFIED

DEPARTURE FROM GAAP
• Auditor should add:
• An informational paragraph either before or after the
opinion paragraph to describe the departure from
GAAP
• Its approximate effects
• Reasons for which compliance with GAAP would result
in misleading statements

15-22

22

11
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EXHIBIT 15.3 - EXAMPLE OF POSSIBLE AUDIT REPORT

LANGUAGE DESCRIBING A JUSTIFIED DEPARTURE FROM
GAAP

15-23

23

EXPLANATORY LANGUAGE -
INCONSISTENT APPLICATION OF GAAP
• Change in accounting principles
• From one GAAP to another - FIFO to LIFO
• From non-GAAP to GAAP - Cash basis to accrual basis
• Both changes would require auditor to add an
explanatory paragraph to the audit report

15-24

24

12
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EXPLANATORY LANGUAGE -
INCONSISTENT APPLICATION OF GAAP
• Changes in accounting estimates and accounting for
new transactions are not considered changes in
accounting principles
• Change in estimate affected by an accounting
principle requires an explanatory language in the
audit report
• AS 6 requires an additional paragraph for the
correction of an error not involving an accounting
principle for public companies

15-25

25

EXPLANATORY LANGUAGE -
INCONSISTENT APPLICATION OF GAAP
• The explanatory paragraph serves as a flag directing the
user’s attention to the relevant footnote disclosure if
client has:
• Changed an accounting principle
• Reasonable justification for the change
• Followed GAAP in accounting for and disclosing this
change

15-26

26

13
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EXPLANATORY LANGUAGE - SUBSTANTIAL DOUBT

ABOUT THE CLIENT BEING A GOING CONCERN

• Explanatory paragraph should be clearly worded to

indicate:
• Auditor’s substantial doubt about client’s continuing
as a going concern
• Reference to management’s footnote(s) explaining the
problems and plans to overcome the problem
• Auditor may not feel comfortable expressing any
opinion for some going-concern situations in which
client is experiencing severe financial distress
• Would issue a disclaimer
15-27

27

EXPLANATORY LANGUAGE - EMPHASIS

OF A MATTER
• Significant transactions with related entities
• Important subsequent events, such as a board-of-
director decision to divest a major segment of the
business
• Important risks or uncertainties associated with
contingencies or significant estimates

15-28

28

14
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EMPHASIS-OF-MATTER PARAGRAPHS AND OTHER-MATTER

PARAGRAPHS IN INDEPENDENT AUDITOR’S REPORT FOR
U.S. NONPUBLIC COMPANIES

• Paragraph included:
• In the auditor’s report that is required by GAAS, or
• At the auditor’s discretion, and that refers to a matter
appropriately presented or disclosed in the financial
statements
• This paragraph should be included immediately after the
opinion paragraph in the auditor’s report
• Use the heading ‘Emphasis of Matter’ or other
appropriate heading

15-29

29

EMPHASIS-OF-MATTER PARAGRAPHS AND OTHER-MATTER

PARAGRAPHS IN INDEPENDENT AUDITOR’S REPORT FOR
U.S. NONPUBLIC COMPANIES

• A clear reference to:

• The matter being emphasized should be included
• Where relevant disclosures that fully describe the
matter can be found in the financial statements should
be included
• Auditor should indicate that auditor’s opinion is not
modified with respect to the matter being
emphasized

15-30

30

15
 8/8/2024

EXPLANATORY LANGUAGE -
REFERENCE TO OTHER AUDITORS
• The principal auditor (group engagement partner)
needs to decide whether to mention the other
auditor in the overall audit report
• Care must be taken when relying on other auditors’
reports
• Principal auditor should have participated in the audit
at a sufficient level
• Regardless of reference being made in auditor’s report
to the report of another auditor, principal auditor is
responsible for the overall opinion
15-31

31

EXPLANATORY LANGUAGE -
REFERENCE TO OTHER AUDITORS
• If the principal audit firm chooses to mention the
other firm in the audit report
• Wording of the standard report is modified
• No additional paragraph is needed
• Change appears in:
• Introductory paragraph to indicate the shared
responsibility for the overall opinion
• Scope and opinion paragraphs modified to reference
the other auditor

15-32

32

16
 8/8/2024

EXPLANATORY LANGUAGE -
REFERENCE TO OTHER AUDITORS
• For nonpublic clients:
• Extensive change would appear in the auditor’s
responsibility section
• Opinion paragraph would include a reference to the
other auditor
• If the other auditor’s report is qualified:
• Principal auditor must consider whether the subject of
the qualification is of such nature and significance in
relation to the overall financial statements that it
would affect the overall opinion
15-33

33

EXHIBIT 15.6 - REPORTING REQUIREMENTS WHEN PART

OF AN AUDIT IS PERFORMED BY OTHER INDEPENDENT
AUDITORS

15-34

34

17
 8/8/2024

EXHIBIT 15.6 - REPORTING REQUIREMENTS WHEN PART

OF AN AUDIT IS PERFORMED BY OTHER INDEPENDENT
AUDITORS (CONT.)

15-35

35

EXHIBIT 15.6 - REPORTING REQUIREMENTS WHEN PART

OF AN AUDIT IS PERFORMED BY OTHER INDEPENDENT
AUDITORS (CONT.)

15-36

36

18
 8/8/2024

AUDITING IN PRACTICE - PROBLEMS WHEN SERVING AS

A PRINCIPAL AUDITOR: INSIGHTS FROM THE PCAOB

• Many registered public accounting firms located in the

United States issue audit reports on financial statements
filed by issuers that have substantially all of their
operations outside of the U.S
• Although it is not inappropriate, the Board’s inspection
process suggests that some firms may not be conducting
audits in accordance with PCAOB standards

15-37

37

QUALIFIED REPORTS, ADVERSE

REPORTS, AND DISCLAIMERS
• When the auditor alters the wording of the standard
unqualified report in a manner that affects the type
of opinion expressed, the report cannot be issued as
an unqualified opinion
• Auditor will provide a modified opinion which
includes:
• A qualified opinion
• An adverse opinion, or
• A disclaimer of opinion

15-38

38

19
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AUDITING IN PRACTICE - LANGUAGE IN MODIFIED

REPORTS FOR U.S. NONPUBLIC COMPANIES

• When an opinion on the financial statements is

modified, auditor should include a basis for
modification paragraph in the auditor’s report
• It should provide a description of the matter giving rise
to the modification
• Auditor should place this paragraph immediately
before the opinion paragraph and use a heading as
appropriate:
• Basis for Qualified Opinion
• Basis for Adverse Opinion
• Basis for Disclaimer of Opinion 15-39

39

LEARNING OBJECTIVE 4

DESCRIBE FINANCIAL STATEMENT AUDITS REQUIRING A

QUALIFIED REPORT AND IDENTIFY THE APPROPRIATE
AUDIT REPORT MODIFICATIONS

40

20
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QUALIFIED AUDIT REPORTS

• Situations in which an auditor will issue a qualified

report
• A material unjustified departure from GAAP that is not
pervasive
• Inadequate disclosure that is not pervasive
• A scope limitation such that the possible effects on the
financial statements of undetected misstatements, if
any, could be material but not pervasive

15-41

41

QUALIFIED REPORT - MATERIAL UNJUSTIFIED

DEPARTURE FROM GAAP THAT IS NOT PERVASIVE

• Qualified opinion will be expressed if a client has a

departure from GAAP that can be isolated to one
item
• Pervasive GAAP departures, affecting more than one
item, would result in an adverse opinion
• Pervasive: Describes the effects or the possible effects
on the financial statements of misstatements that are
undetected due to an inability to obtain sufficient
appropriate audit evidence

15-42

42

21
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QUALIFIED REPORT - INADEQUATE

DISCLOSURE
• If client refuses to make appropriate disclosures,
auditor should:
• Express a qualified or adverse opinion, depending on
pervasiveness of omitted disclosures
• Provide the omitted information in the audit report, if
practicable
• Explanatory paragraph - Should describe the nature
of the omitted disclosures
• Opinion paragraph - Should be modified to describe
nature of qualification
15-43

43

EXHIBIT 15.7 - OPINION QUALIFICATION

BECAUSE OF INADEQUATE DISCLOSURE

15-44

44

22
 8/8/2024

QUALIFIED REPORT - SCOPE

LIMITATION
• Restrictions on scope of audit, whether imposed by client
or by circumstances beyond the auditor’s or client’s
control, may require auditor to qualify an opinion
• In some situations circumstances may be such that a
disclaimer would be more appropriate
• Circumstances that may limit the audit scope
• Timing of the fieldwork
• Inability to gather sufficient appropriate evidence
• Inadequacy in the accounting records

15-45

45

LEARNING OBJECTIVE 5

DESCRIBE FINANCIAL STATEMENT AUDITS REQUIRING AN

ADVERSE REPORT AND IDENTIFY THE APPROPRIATE
AUDIT REPORT MODIFICATIONS

46

23
 8/8/2024

ADVERSE AUDIT REPORTS

• Adverse report is appropriate when financial

statements contain:
• Pervasive and material unjustified departure from
GAAP
• Lack of important disclosures that is pervasive
• When a significant number of items in the financial
statements violate GAAP

15-47

47

EXHIBIT 15.9 - EXAMPLE OF POSSIBLE AUDIT REPORT

LANGUAGE DESCRIBING A JUSTIFIED DEPARTURE FROM
GAAP

15-48

48

24
 8/8/2024

ADVERSE REPORT - LACK OF IMPORTANT

DISCLOSURES THAT IS PERVASIVE
• Auditor can issue an adverse opinion if:
• Client’s financial statements have omitted disclosures,
such that
• Financial statements taken as a whole are not presented
fairly in conformity with GAAP

15-49

49

LEARNING OBJECTIVE 6

DESCRIBE FINANCIAL STATEMENT AUDITS REQUIRING A

DISCLAIMER OF OPINION AND IDENTIFY THE
COMMUNICATION THE AUDITOR IS REQUIRED TO
PROVIDE

50

25
 8/8/2024

AUDIT REPORTS WITH A DISCLAIMER

OF OPINION
• An auditor issues a disclaimer of opinion report
when:
• Scope limitation exists
• Substantial doubt exists about the client being a going
concern
• There is lack of independence

15-51

51

DISCLAIMER - SCOPE LIMITATION

• Scope limitations caused by circumstances are such

that it is not possible to form an opinion
• Introductory paragraph’s wording modified for a
scope limitation
• Scope paragraph is omitted
• Additional paragraph is inserted to describe the scope
limitation(s)
• Last paragraph states that no opinion can be expressed

15-52

52

26
 8/8/2024

DISCLAIMER - SCOPE LIMITATION FOR

NON-U.S. COMPANIES
• ISA 705 requires auditor to withdraw from audit
when auditor is unable to obtain sufficient
appropriate audit evidence because of a
management-imposed limitation, and
• Auditor concludes that possible effects on financial
statements of undetected misstatements could be
both material and pervasive

15-53

53

DISCLAIMER - SCOPE LIMITATION FOR

NON-U.S. COMPANIES

ISA 705 U.S. Standards

Auditors required to consider

Auditors required to withdraw
withdrawal from the
from audit
engagement

If auditor concludes that possible Auditor should consider whether

effects of undetected to withdraw or disclaim an
misstatements could be both opinion on the financial
material and pervasive statements

15-54

54

27
 8/8/2024

DISCLAIMER - SUBSTANTIAL DOUBT ABOUT

THE CLIENT BEING A GOING CONCERN
• Auditor may issue a disclaimer of opinion if there is a
substantial doubt about the client continuing as a
going concern
• In such cases, auditor would believe that an
additional paragraph to an unqualified opinion is not
appropriate

15-55

55

DISCLAIMER - AUDITOR LACKING

INDEPENDENCE
• When auditors lack independence with respect to a
client:
• They cannot perform an audit in accordance with
professional auditing standards
• They are precluded from expressing an opinion on the
financial statements
• In such cases, a one-paragraph disclaimer should be
issued stating the lack of independence
• Auditor omits the reasons for lack of independence

15-56

56

28
 8/8/2024

DISCLAIMER - AUDITOR LACKING

INDEPENDENCE
• Report would have no title or salutation
• Such a situation should rarely occur
• It could happen when it is discovered late in the audit
that one of the auditors on the engagement had a
financial interest in the client

15-57

57

LEARNING OBJECTIVE 7

ASSESS VARIOUS REPORTING SITUATIONS REQUIRING

OTHER THAN A STANDARD UNQUALIFIED REPORT AND
DETERMINE THE APPROPRIATE AUDIT REPORT THAT
SHOULD BE ISSUED

58

29
 8/8/2024

COMPARISONS OF MODIFICATIONS TO THE

STANDARD UNQUALIFIED AUDIT REPORT
• Deciding on the type of opinion is important
• This is particularly true of the decisions based on:
• Materiality level and pervasiveness of GAAP violations
• Significance of scope limitations
• Likelihood of the entity being a going concern
• Issuing an inappropriate opinion can lead to legal
problems
• Report decision often involves consultation

15-59

59

EXHIBIT 15.11 - SUMMARY OF AUDIT REPORT

MODIFICATIONS FOR U.S. PUBLIC COMPANIES

15-60

60

30
 8/8/2024

LECTURE 8
AUDITING THE REVENUE CYCLE

LEARNING OBJECTIVES

1. Identify the significant accounts, disclosures, and

relevant assertions in the revenue cycle
2. Identify and assess inherent risks of material
misstatement in the revenue cycle
3. Identify and assess fraud risks of material
misstatement in the revenue cycle
4. Identify and assess control risks of material
misstatement in the revenue cycle

9-2

1
 8/8/2024

LEARNING OBJECTIVES

5. Describe how to use preliminary analytical

procedures to identify possible material
misstatements for revenue cycle accounts,
disclosures, and assertions
6. Determine appropriate responses to identified risks
of material misstatement for revenue cycle
accounts, disclosures, and assertions
7. Determine appropriate tests of controls and
consider the results of tests of controls for revenue
cycle accounts, disclosures, and assertions
9-3

LEARNING OBJECTIVES

8. Determine and apply sufficient appropriate

substantive audit procedures for testing revenue
cycle accounts, disclosures, and assertions
9. Apply the frameworks for professional decision
making and ethical decision making to issues
involving the audit of revenue cycle accounts,
disclosures, and assertions

9-4

2
 8/8/2024

THE AUDIT OPINION FORMULATION

PROCESS

9-5

LEARNING OBJECTIVE 1

IDENTIFY THE SIGNIFICANT ACCOUNTS,

DISCLOSURES, AND RELEVANT ASSERTIONS IN
THE REVENUE CYCLE

3
 8/8/2024

REVENUE CYCLE

• Process of:
• Receiving a customer’s order
• Approving credit for a sale
• Determining whether goods are available for shipment
• Shipping the goods
• Billing the customers
• Collecting cash
• Recognizing effect of this process on other related
accounts

9-7

REVENUE CYCLE

• Significant accounts include revenue and accounts

receivable
• Evidence is obtained for each financial statement
assertions
• Relevance of assertions varies with accounts and
clients
• More relevant assertions:
• Have risk of material misstatement
• Require higher-quality audit evidence

9-8

4
 8/8/2024

EXHIBIT 9.1 - REVENUE CYCLE ACCOUNTS:

AFFECTED BY SALES TRANSACTIONS

9-9

EXHIBIT 9.1 - REVENUE CYCLE ACCOUNTS:

AFFECTED BY SALES TRANSACTIONS

9-10

10

5
 8/8/2024

9-11

11

LEARNING OBJECTIVE 2

IDENTIFY AND ASSESS INHERENT RISKS OF

MATERIAL MISSTATEMENT IN THE REVENUE
CYCLE

12

6
 8/8/2024

PERFORMING RISK ASSESSMENT

PROCEDURES IN THE REVENUE CYCLE
• Requires information about:
• Inherent risks at the:
• Financial statement level
• Account and assertion levels
• Fraud risks
• Feedback from audit team’s brainstorming session
• Strengths and weaknesses in internal control
• Results from preliminary analytical procedures

9-13

13

REVENUES: IDENTIFYING INHERENT

RISKS
• Timing of revenue recognition - Important inherent
risk related to revenue transactions
• Following information is required to audit revenue
cycle
• Organization’s principal business
• Earnings process and nature of obligations that extend
beyond normal shipment of goods
• Impact of unusual terms, and when title passes to
customer

9-14

14

7
 8/8/2024

REVENUES: IDENTIFYING INHERENT

RISKS
• Right of customer to return a product, as well as
returns history
• Contracts that are combinations of leases and sales
• Proper treatment of sales transactions made with
recourse or that have an abnormal or unpredictable
amount of returns

9-15

15

CRITERIA FOR REVENUE RECOGNITION

• Refer to guidance provided by:

• International Accounting Standards Board (IASB)
• Securities and Exchange Commission (SEC)
• Financial Accounting Standards Board (FASB)
• American Institute of Certified Public Accountants
(AICPA)

9-16

16

8
 8/8/2024

CRITERIA DETERMINED BY SEC FOR

REVENUE RECOGNITION
• Persuasive evidence of an arrangement should exist
• Delivery should have occurred, or services should
have been rendered
• The seller’s price to the buyer should be fixed or
determinable
• Collectibility should be reasonably assured

9-17

17

CRITERIA DETERMINED BY SEC FOR

REVENUE RECOGNITION
• It does not consider delivery to have occurred until
customer:
• Takes title of ownership
• Assumes risks and rewards of ownership
• Auditors need to determine:
• When a client should recognize revenue
• How to audit revenue

9-18

18

9
 8/8/2024

ACCOUNTS RECEIVABLE: IDENTIFYING

INHERENT RISKS
Receivables pledged as collateral against specific loans with
restricted use

Receivables incorrectly classified as current when likelihood of

collection during next year is low

Collection of a receivable contingent on specific events that

cannot currently be estimated

Payment not required until purchaser sells product to its end

customers

Accounts receivable aged incorrectly, and potentially

uncollectible amounts not recognized

Orders accepted from customers with poor credit, but

allowance for doubtful accounts not increased accordingly

9-19

19

LEARNING OBJECTIVE 3

IDENTIFY AND ASSESS FRAUD RISKS OF

MATERIAL MISSTATEMENT IN THE REVENUE
CYCLE

20

10
 8/8/2024

FRAUD SCHEMES UNCOVERED BY THE

SEC AND PCAOB
Recognition of revenue on shipments that never occurred

Hidden side letters giving customers an irrevocable right to

return the product

Recording consignment sales as final sales

Creation of fictitious invoices

Shipment of more product than customer ordered

Early recognition of sales that occurred after end of fiscal period

9-21

21

FRAUD SCHEMES UNCOVERED BY THE

SEC AND PCAOB
Shipment of unfinished product

Shipment of product before customers wanted or agreed to

delivery

Recording shipments to company’s own warehouse as sales

Recording reshipment as a sale of new goods before issuing

credit for the returned sale

Incorrect aging of accounts receivable

Recording purchase orders as completed sales

9-22

22

11
 8/8/2024

LAPPING

• Technique used to cover up embezzlement of cash

• Stealing cash collection from a customer and crediting
him from another customer's payment
• This process continues and at least one customer’s
account is always overstated
• Occurs when duties are inadequately segregated

9-23

23

AUDITOR’S ROLE IN IDENTIFYING

FRAUD RISK FACTORS
• Assessing motivation to enhance revenue because of
either internal or external pressures
• Reviewing financial statements through preliminary
analytical procedures
• Recognizing that not all of the fraud will be instigated
by management
• Becoming aware of representations made by
management to analysts
• Potential effect of those expectations on stock prices

9-24

24

12
 8/8/2024

AUDITOR’S ROLE IN IDENTIFYING

FRAUD RISK FACTORS
• Determining whether company’s performance is
significantly different from rest of the industry or
economy
• Determining whether company’s accounting is being
investigated by organizations such as the SEC
• Considering management compensation schemes
• Determining whether accounting functions are
centralized
• If not, assessing if decentralization is appropriate

9-25

25

AUDITOR’S ROLE IN IDENTIFYING

FRAUD RISK FACTORS
• Assessing whether company engages in complex
sales arrangements
• Assessing whether company has a history of
aggressive accounting interpretations
• Determining that an uninterrupted history of growth
in earnings per share or revenue might provide
incentives to continue to show that growth
• Determining if client has numerous manual journal
entries affecting revenue process

9-26

26

13
 8/8/2024

LEARNING OBJECTIVE 4

IDENTIFY AND ASSESS CONTROL RISKS OF

MATERIAL MISSTATEMENT IN THE REVENUE
CYCLE

27

IDENTIFYING CONTROL RISKS

• Requires understanding of internal controls for

integrated audits and financial statement only audits
• Such understanding is gained by means of:
• Walkthrough of the process
• Inquiry
• Observation
• Review of client’s documentation

9-28

28

14
 8/8/2024

IDENTIFYING CONTROL RISKS

• At account and assertion levels auditor considers:

• Entity-wide controls
• Commitment to financial accounting competencies
• Independence of the board of directors
• Transaction controls

9-29

29

CONTROLS RELATED TO
EXISTENCE/OCCURRENCE
• Providing reasonable assurance that sale and
accounts receivable are recorded only when:
• Shipment has occurred
• Primary revenue producing activity has been
performed
• Mitigating risk that unearned revenues are recorded
• Distributing monthly statements to customers
• Unusual transactions require a high level of
management review

9-30

30

15
 8/8/2024

CONTROLS RELATED TO
COMPLETENESS
• Using prenumbered shipping documents and sales
invoices and its subsequent accounting
• Immediate online entry into computer system and
assignment of unique identification number
• Reconciliation of shipping records with billing records
• Supervisory review
• Reconciliation of inventory with sales

9-31

31

CONTROLS RELATED TO VALUATION

• Sales made from authorized price lists

• Valuation issues arise with:
• Unusual or uncertain sales terms
• Returns and allowances
• Policies and procedures for identifying and recording
returned goods
• Spelling out contractual return provisions in sales
contract
• Approving acceptance of returns

9-32

32

16
 8/8/2024

CONTROLS RELATED TO VALUATION

• Recording goods returned on prenumbered documents
accounted
• Identifying whether to:
• Give credit
• Rework the goods according to warranty provisions
• Determining potential obsolescence or defects in
goods
• Assuring proper classification of goods
• Developing and implementing a sales returns reserve
methodology
9-33

33

PROCEDURES USED IN CONTROLLING

A COMPANY’S CREDIT RISK
• Formal credit policy
• Automated for most transactions
• Requires special approval for large and/or unusual
transactions
• Continuous monitoring of receivables for evidence of
increased risk
• Adequate segregation of duties in credit department

9-34

34

17
 8/8/2024

DOCUMENTING CONTROLS

• Required for:
• Integrated audits
• Financial statement only audits

9-35

35

EXHIBIT 9.5 – partial Control Risk Assessment

Questionnaire: Sales and Receivables

9.5.png

9-36

36

18
 8/8/2024

9-37

37

EXHIBIT 9.6 - PARTIALLY COMPLETED

CONTROLS MATRIX FOR CONTRACT REVENUE

9-38

38

19
 8/8/2024

LEARNING OBJECTIVE 5

DESCRIBE HOW TO USE PRELIMINARY ANALYTICAL

PROCEDURES TO IDENTIFY POSSIBLE MATERIAL
MISSTATEMENTS FOR REVENUE CYCLE ACCOUNTS,
DISCLOSURES, AND ASSERTIONS

39

PERFORMING PRELIMINARY
ANALYTICAL PROCEDURES
• Help identify areas of potential misstatements
• Require developing expectations for account
balances, ratios, and trends
• Possible expected relationships in revenue cycle
include the following
• Absence of unusual year-end sales activity
• Accounts receivable growth is consistent with revenue
growth

9-40

40

20
 8/8/2024

PERFORMING PRELIMINARY
ANALYTICAL PROCEDURES
• Revenue growth, receivables growth, and gross margin
are consistent with activity in industry
• No unusual concentration of sales made to customers
• Accounts receivable turnover is not significantly
different from prior year
• Ratio of allowance for doubtful accounts to total
receivables or to credit sales is similar to the prior year

9-41

41

PERFORMING PRELIMINARY
ANALYTICAL PROCEDURES
• Auditor compares unaudited financial statements
with both past results and industry trends
• Following relationships might suggest a heightened
risk of fraud
• Revenue increases even though there is strong
competition
• Revenue increases are not consistent with industry or
economy
• Gross margins are higher than average, or there is an
unexpected change in gross margins
9-42

42

21
 8/8/2024

PERFORMING PRELIMINARY
ANALYTICAL PROCEDURES
• Large increases in revenue occur near end of the
quarter or year
• Revenue has grown and net income has increased, but
there is negative cash flow from operations

9-43

43

TREND ANALYSIS

• Considering ratios or accounts over time

• Include the following
• Monthly sales analysis compared with past years and
budgets
• Identification of spikes in sales at end of quarters or
end of the year
• Trends in discounts allowed to customers that exceed
both past experience and industry average

9-44

44

22
 8/8/2024

EXHIBIT 9.7 - USING RATIOS IN PRELIMINARY

ANALYTICAL PROCEDURES IN THE REVENUE CYCLE

9-45

45

COMPARING CLIENT’S RATIOS WITH

AUDITOR’S EXPECTATIONS
• Consider business reasons for changes
• Explore possible reasons for changes in ratios
• Check for potential explanation for the changes
• Look for corroborating evidence for potential
explanation

9-46

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LEARNING OBJECTIVE 6

DETERMINE APPROPRIATE RESPONSES TO IDENTIFIED

RISKS OF MATERIAL MISSTATEMENT FOR REVENUE CYCLE
ACCOUNTS, DISCLOSURES, AND ASSERTIONS

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RESPONDING TO IDENTIFIED RISKS OF

MATERIAL MISSTATEMENT
• Develop an audit approach that contains substantive
procedures and tests of controls
• Sufficiency and appropriateness of selected procedures
will vary for each relevant assertion
• Customize audit program based on assessment of risk
of material misstatement

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EXHIBIT 9.8 - PANEL A: SUFFICIENCY OF

EVIDENCE FOR COMPLETENESS OF REVENUE

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EXHIBIT 9.8 - PANEL B: APPROACHES TO OBTAINING

AUDIT EVIDENCE FOR COMPLETENESS OF REVENUE

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LEARNING OBJECTIVE 7

DETERMINE APPROPRIATE TESTS OF CONTROLS AND

CONSIDER THE RESULTS OF TESTS OF CONTROLS FOR
REVENUE CYCLE ACCOUNTS, DISCLOSURES, AND
ASSERTIONS

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TESTS OF TRANSACTION CONTROLS

• Inquiry of personnel performing the control

• Observation of control being performed
• Inspection of documentation confirming that control
has been performed
• Reperformance of control by the individual testing
the control

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APPROACHES TO TESTING
RECONCILIATION CONTROL
• Involve one or more of the following
• Inquiry
• Observation
• Inspection
• Reperformance

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TESTS OF CONTROLS
Selecting samples of transactions and obtaining supporting
documents

Reviewing monitoring controls

Testing computer access controls

Using generalized audit software (GAS) to match documents

and look for gaps

Reviewing customer complaints

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TESTS OF CONTROLS

Reviewing documents such as reconciliations and management

reports noting timely action taken

Reviewing sales contracts

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ANALYZING THE RESULTS OF TESTS OF

CONTROLS
• Helps determine additional appropriate procedures
• If control deficiencies are identified:
• Assess to determine their severity
• Modify the preliminary control risk assessment
• Document the implications of control deficiencies

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ANALYZING THE RESULTS OF TESTS OF

CONTROLS
• If no control deficiencies are identified:
• Determine that preliminary assessment of control risk
as low is still appropriate
• Determine the extent that controls can provide
evidence on correctness of account balances
• Determine planned substantive audit procedures

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LEARNING OBJECTIVE 8

DETERMINE AND APPLY SUFFICIENT APPROPRIATE

SUBSTANTIVE AUDIT PROCEDURES FOR TESTING REVENUE
CYCLE ACCOUNTS, DISCLOSURES, AND ASSERTIONS

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OBTAINING SUBSTANTIVE EVIDENCE IN

THE REVENUE CYCLE
• Substantive tests are performed to provide evidence
that:
• Sales transactions do exist and are properly valued
• Accounts receivable exist
• Balance in allowance account is reasonable
• Fraudulent transactions are not included in financial
statements

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EXHIBIT 9.10 - MANAGEMENT ASSERTIONS AND

SUBSTANTIVE PROCEDURES IN REVENUE CYCLE

9.10.png

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REVENUE - SUBSTANTIVE ANALYTICAL

PROCEDURES
• Perform reasonableness test or regression analysis
• If expectations
• Differ significantly - Follow up with sufficient
appropriate tests of details
• Do not differ significantly - Reduce tests of details

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REGRESSION ANALYSIS

• Performed as a time-series analysis

• Cross-sectional analysis - Designed to compare
results across a number of locations
• Allows auditor to identify any unusual store
performance

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REVENUE - SUBSTANTIVE TESTS OF

DETAILS
• Primarily involve inspection of relevant client
documentation
• Focused on existence and valuation assertions

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REVENUE - EXISTENCE AND

VALUATION ASSERTIONS
• Most relevant for revenue accounts
• Compare quantities billed and shipped with
customer orders
• Verify clerical accuracy of sales invoices to provide
assurance on valuation
• Useful technique - Computerized audit process

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REVENUE - COMPLETENESS ASSERTION

• Assures completeness in:

• Prenumbered shipping
• Billing documents
• Audit software can be used to:
• Look for gaps in recorded sales invoice numbers
• Verify that missing numbers are appropriate and do
not represent unrecorded sales

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REVENUE - CUTOFF ISSUES

• Additional audit attention given to sales transactions

recorded before and after year end
• Whether a recorded revenue transaction actually
occurred before end of accounting period
• Whether transactions recorded in subsequent year
actually relate to year being audited

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REVENUE - CUTOFF ISSUES

• Following items examined to determine whether

proper cutoff of sales and sales returns has been
achieved

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ACCOUNTS RECEIVABLE - SUBSTANTIVE

PROCEDURES BASED ON AGED TRIAL BALANCE

• Starting point for accounts receivable substantive

procedures is either of the following:
• Obtaining a detailed aged accounts receivable trial
balance from client
• Manually preparing a trial balance
• Using GAS to develop aging information

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ACCOUNTS RECEIVABLE - SUBSTANTIVE

PROCEDURES BASED ON AGED TRIAL BALANCE

• Aged trial balance used by auditor to:

• Agree the detail to balance in control account
• Select customer balances for confirmation
• Identify amounts due from:
• Officers, employees, or other related parties
• Nontrade receivables that need to be separately
disclosed
• Help determine reasonableness of allowance for
doubtful accounts by identifying past-due balances

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ACCOUNTS RECEIVABLE - SUBSTANTIVE

TESTS OF DETAILS - CONFIRMATIONS
• Used to ask client’s customers to confirm existence
and amount they owe to client
• Not necessarily assuring correct valuation
• Auditing standards require use of confirmations
unless one of the following conditions exists:
• Accounts receivable are not material
• Use of confirmations would be ineffective
• Auditor’s assessment of risk of material
misstatement is low and with sufficient assessment
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POSITIVE CONFIRMATIONS

• Requesting customers to respond directly to auditor

if they agree or disagree with indicated balance
• Auditors should inquire about:
• Possibility of bill-and-hold transactions
• Extended payment terms or nonstandard installment
receivables
• Unusual volume of sales to distributors/retailers

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POSITIVE CONFIRMATIONS

• Side letter
• Agreement containing contract terms not part of
formal contract
• Increase in audit risk because they enable key contract
terms to be hidden from auditor

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NEGATIVE CONFIRMATIONS

• Requesting customers to respond directly to auditor

only if they disagree with indicated balance
• Less expensive to administer
• Used if following conditions exist:
• Large number of relatively small customer balances
• Assessed level of risk of material misstatement for
receivables and related revenue transactions is low
• Auditor believes that customers are likely to give
proper attention to requests

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THE CONFIRMATION PROCESS

• Prepared using GAS

• Customers requested to return confirmations directly
to auditor’s office
• Undeliverable confirmations raise auditor’s
suspicion regarding existence of recorded receivable

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SAMPLE SELECTION AND SAMPLING

UNIT
• Sample selection - Confirm the large balances and
randomly select some of the smaller balances
• Include in the sample accounts that:
• Have credit balances
• Are significant and past due
• Have unusual customer names that are unfamiliar to the
auditor
• Sampling unit - Customer’s entire account balance
or one or more of the unpaid invoices that make up
that balance
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UNDELIVERABLE CONFIRMATIONS

• Determine customer’s existence if:

• Confirmations are returned as undeliverable -
Determine the reason
• Wrong address used - Obtain correct address and send
another request

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FOLLOW-UP TO NONRESPONSES FOR

POSITIVE CONFIRMATIONS
• Required for confirmations that are not returned
within a reasonable time after being mailed
• Alternative procedures:
• Procedures used to obtain evidence about existence
and valuation of accounts receivable when a positive
confirmation is not returned
• Such procedures include:
• Subsequent collection of the balance after year end
• Examination of supporting documents

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FOLLOW-UP PROCEDURES FOR EXCEPTIONS

NOTED ON POSITIVE CONFIRMATIONS
• Exceptions: Differences between a customer’s
records and client’s records reported on positive or
negative confirmations
• Investigated to determine difference being:
• Customer error
• Item in dispute
• Client misstatement
• Timing differences: Confirmation exceptions caused by
transactions that are in process at confirmation date
• These are not misstatements

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FOLLOW-UP FOR NEGATIVE

CONFIRMATIONS
• Customer may not respond even though balance is
wrong because:
• Letter was lost, misplaced, or sent to wrong address
• Customer did not understand the request
• Request was simply ignored and thrown away
• Reasons for negative confirmations being returned
• Customer did not understand the request

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FOLLOW-UP FOR NEGATIVE

CONFIRMATIONS
• Customer confirms an incorrect amount because
payments or shipments are in transit
• Amount recorded by the client is in error
• Follow-up work performed to determine whether
confirmed amount represents a misstatement
• If errors are detected, use expanded procedures to:
• Find underlying cause of errors
• Estimate amount of misstatement in account balance

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ADDITIONAL PROCEDURES WHEN ACCOUNTS

ARE CONFIRMED AT AN INTERIM DATE
• Gathering additional evidence during roll-forward
period if receivables confirmed at an interim date
• Roll-forward procedures include:
• Comparing customer balances at interim confirmation
date with year-end balances and confirming their
increase
• Checking whether monthly sales, collections, sales
discounts, and sales returns and allowances during the
roll-forward period appear out of line compared with
those of prior periods
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ADDITIONAL PROCEDURES WHEN ACCOUNTS

ARE CONFIRMED AT AN INTERIM DATE
• Reconciling receivable subsidiary records to general
ledger at confirmation date and year end
• For returns and allowances at year end, testing the
cutoff of:
• Sales
• Cash collections
• Credit memos
• Scanning journals to identify receivables postings
from unusual sources and investigate unusual items

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ADDITIONAL PROCEDURES WHEN ACCOUNTS

ARE CONFIRMED AT AN INTERIM DATE
• Computing number of days’ sales in receivables at
confirmation date and year end, compared to prior
periods
• Computing gross profit percentage during roll-
forward period

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ACCOUNTS RECEIVABLE - SUBSTANTIVE

PROCEDURES FOR ALLOWANCE ACCOUNT
• Determining reasonableness of client’s estimate of
allowance for doubtful accounts is a difficult task
• Client’s estimate must reflect:
• Economic status of client’s customers
• Current economic conditions
• An informed expectation about potential default on
payment

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APPROACHES USED TO OBTAIN EVIDENCE ABOUT

REASONABLENESS OF CLIENT’S ESTIMATE

• Inquire of management about collectibility of large

and long overdue customer balances
• Develop an independent model
• Review credit reports from outside credit bureaus
• Review customer correspondence files
• Review customer’s latest financial statements
• For unusually large or past due accounts
• Inquire about client’s procedures for deciding when
to write off an account
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ACCOUNTS RECEIVABLE - OTHER SUBSTANTIVE

PROCEDURES ACCOUNTS RECEIVABLE: RIGHTS AND
OBLIGATIONS
• Some companies sell receivables to financial
institutions but may retain responsibility for
collecting them
• Receivables sold with recourse, discounted, or
pledged as collateral on loans should be disclosed in
notes to financial statements

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SUBSTANTIVE AUDIT PROCEDURES REVEALING

RECEIVABLES OWNERSHIP AND RELATED DISCLOSURE
ISSUES
• Reviewing all arrangements and obtaining
confirmations from banks about contingent liabilities
• Inquiring about activities related to receivables
• Scanning cash receipts journal for relatively large
inflows of cash posted from unusual sources
• Obtaining bank confirmations, including information
on obligations to bank and loan collateral
• Reviewing board of directors’ minutes, generally
containing approval for these items
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ACCOUNTS RECEIVABLE -
PRESENTATION AND DISCLOSURE
• Trade accounts receivable should be presented
separately from other receivables
• Audit procedures directed toward identifying related-
party transactions include the following
• Reviewing SEC filings
• Reviewing accounts receivable trial balance
• Inquiring of management and audit committee about
receivables from related parties

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ACCOUNTS RECEIVABLE -
PRESENTATION AND DISCLOSURE
• Material debit balances in accounts payable for
amounts due from vendors should be reclassified as
accounts receivable
• Material credit balances in accounts receivable
should be reclassified as accounts payable
• Receivables not due within normal operating cycle or
one year should be listed as noncurrent assets

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AUDIT PROCEDURES TO IDENTIFY

MISCLASSIFIED RECEIVABLES
• Making inquiries of management
• Reviewing aged trial balance for large or old
outstanding balances
• Reading board of directors’ minutes
• Scanning subsidiary ledger to identify unusually large
receivable balances

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POTENTIAL FRAUD RISK FACTORS IN

REVENUE CYCLE
• Excessive credit memos or other credit adjustments
to accounts receivable after end of fiscal year
• Customer complaints and discrepancies in accounts
receivable confirmations
• Unusual entries to accounts receivable subsidiary
ledger or sales journal
• Missing or altered source documents or inability of
client to produce original documents in a reasonable
period of time

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POTENTIAL FRAUD RISK FACTORS IN

REVENUE CYCLE
• Lack of cash flow from operating activities when
income from operating activities has been reported
• Unusual reconciling differences between accounts
receivable subsidiary ledger and control account
• Sales to customers in last month of fiscal period at
terms more favorable than previous months
• Predated or postdated transactions
• Large or unusual adjustments to sales accounts just
prior to or just after fiscal year end
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FRAUD-RELATED AUDIT PROCEDURES USED

TO RESPOND TO FRAUD RISK FACTORS

Performing a thorough review of original source documents

Analyzing and reviewing accounts receivable adjustments for

period subsequent to balance sheet date

Analyzing all large or unusual sales made near year end and
vouching to original source documents

Confirming terms of transaction directly with customer

Comparing number of weeks of inventory in distribution

channels with prior periods for unusual changes

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FRAUD-RELATED AUDIT PROCEDURES USED

TO RESPOND TO FRAUD RISK FACTORS

Scanning general ledger, accounts receivable subsidiary ledger,

and sales journal for unusual activity

Performing analytical reviews of credit memo and writing-off

activity by comparing to prior periods

Analyzing recoveries of written-off accounts

Inquiring of company’s non-accounting personnel for any

unusual terms or conditions in connection with sales

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DOCUMENTATION REQUIREMENTS FOR

ACCOUNTS RECEIVABLE
• Tests of adequacy of allowance for doubtful accounts
• Details on inquires made regarding whether
receivables are sold, pledged, or assigned
• Cutoff tests
• Evidence of roll-forward procedures if confirmations
were sent at an interim date

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DOCUMENTATION RELATED TO THE

REVENUE SUBSTANTIVE PROCEDURES
• Substantive analytical procedures performed
• Unusual sales transactions
• Information indicating an understanding of client’s
revenue recognition policies
• Identification of specific items tests
• Relevant information on tests of details

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