Chapter 6 Audit Responsibilities and Objectives

Presentation Outline Financial Statement Responsibilities Categories of Fraud Auditor Responsibility for Detection of Illegal Acts Managing the Audit Process Phases of the Audit Process

I. Financial Statement Responsibilities Overall Objective of Financial Statement Audit Client Management Responsibilities Auditor Responsibilities Terminology

A. Overall Objective of Financial Statement Audit The expression of an opinion of the fairness with which they present fairly, in all respects, financial position, results of operations, and cash flows in conformity with GAAP.

B. Client Management Responsibilities Financial statements and internal control. Sarbanes-Oxley requires CEO and CFO of public companies to certify quarterly and annual financial statements submitted to the SEC. The Act also provides for criminal penalties for anyone who knowingly falsely certifies the statements.

C. Auditor Responsibilities Auditor must plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.

Professional Skepticism D. Terminology Material v. Immaterial Reasonable Assurance Error v. Fraud Professional Skepticism

1. Material v. Immaterial Misstatements are usually considered material if the combined uncorrected errors and fraud in the financial statements would influence a reasonable person using the statements. It would be extremely costly and probably impossible to hold the auditor accountable for immaterial errors and fraud.

2. Reasonable Assurance Auditors can not guarantee that there are no material misstatements because: Auditors use judgment based on samples. Errors in judgment can occur. Accounting presentations are based on complex estimates that involve uncertainty. Fraudulently prepared financial statements are difficult to detect, especially if there is collusion.

3. Error v. Fraud An error is an unintentional misstatement of the financial statements, whereas fraud is intentional. For fraud, there is a distinction between misappropriation of assets and fraudulent financial reporting.

4. Professional Skepticism Audit should be designed to provide reasonable assurance of detecting both material errors and fraud in the financial statements. Although an auditor should not assume that management is dishonest, the possibility of dishonesty must also be considered.

II. Categories of Fraud Fraudulent Financial Reporting Misappropriation of Assets

A. Fraudulent Financial Reporting Fraudulent financial reporting is often committed by management. Harms users of the financial statements by providing incorrect information. Survey results indicate that some of the most common techniques to misstate financial statements are: Recording revenues prematurely Recording fictitious revenue Overstatement of assets such as receivables, inventory, etc.

B. Misappropriation of Assets Often perpetrated by employees and sometimes management. Harms investors because assets are no longer available. Misappropriations often result in fraudulent financial reporting to hide the theft.

III. Auditor Responsibility for Detection of Illegal Acts SAS 54 defines illegal acts as violations of laws or government regulations other than fraud. Direct-Effect Illegal Acts Indirect-Effect Illegal Acts Evidence Accumulation When There is Suspicion of Illegal Acts Auditor Actions for Known Illegal Acts

A. Direct Effect Illegal Acts Certain illegal acts directly affect specific account balances. For example, violation of federal tax laws. Auditor responsibility for direct-effect illegal acts is the same as for errors and fraud.

B. Indirect-Effect Illegal Acts Indirect-effect illegal acts do not affect financial statements directly, but result in potential fines. Auditing standards clearly state that auditors provide no assurance that such illegal acts will be detected.

C. Evidence Accumulation When There is Suspicion of Illegal Acts Auditor should inquire of management at a level above those likely to be involved. Auditor should consult with the client’s legal counsel who is knowledgeable about the potential illegal act. Auditor should consider accumulating additional evidence to determine whether there actually is an illegal act.

D. Auditor Actions for Known Illegal Acts Consider the effects on the financial statements. Consider the effect on management representations. Communicate with the audit committee. Report the matter to the SEC after consultation with the auditor’s legal counsel.

IV. Managing the Audit Process The Cycle Approach The Testing of Client Assertions

A. The Cycle Approach A common way to divide an audit is to keep closely related types of transactions and account balances in the same segment. The following segments exist in many businesses: Sales and collection Acquisition and payment Payroll and personnel Inventory and warehousing Capital acquisition and repayment

B. The Testing of Client Assertions Management assertions are implied or expressed representations by client management about classes of transactions and related accounts in the financial statements. 1. Presentation and disclosure 2. Existence or occurrence There are five assertion categories per SAS No. 31, Evidential Matter 3. Rights and obligations 4. Completeness 5. Valuation or allocation

1. Presentation and Disclosure Management Represents Auditor Tests Financial statement components are properly combined or separated, described and disclosed. Auditor tests whether financial statements are presented in accordance with GAAP.

2. Existence or Occurrence Management Represents Auditor Tests Existence is concerned with whether assets, obligations, and equities included in the balance sheet actually existed on the balance sheet date. Auditor tests for overstatement of items Transactions recorded occurred during the accounting period.

3. Rights and Obligations Management Represents Auditor Tests Client organization possesses ownership rights to recorded assets. Auditor tests asset ownership and liability claims. Client records show liabilities owed as of the balance sheet date. Particularly applicable to small businesses that commingle business and personal records.

4. Completeness Management Represents Auditor Tests All transactions and accounts that should be presented in the financial statements are included. Auditor tests for understatement of items

5. Valuation or Allocation Management Represents Auditor Tests All asset, liability, equity, revenue, and expense accounts have been included in the financial statements at appropriate amounts. Auditor tests whether account balances are valued and allocated in accordance with GAAP.

V. The Phases of the Audit Process Phase I – Plan and Design an Audit Approach Phase II – Tests of Controls and Substantive Tests of Transactions Phase III – Analytical Procedures and Test of Details of Balances Phase IV - Complete the Audit and Issue an Audit Report

A. Phase I – Plan and Design an Audit Approach Two key aspects are imperative in the planning process: Obtain knowledge the client’s business strategies and processes and assess risks. This is used to help assess the risk of misstatement in the financial statements. Understand internal control and assess control risk. Strong internal controls may justify less accumulation of evidence.

B. Phase II – Tests of Controls and Substantive Tests of Transactions Control risk is the risk that internal controls will fail to catch inappropriate information reporting. To justify reducing the planned assessed control risk when internal controls are strong, the auditor must test compliance with controls. Depending on the assessed level of control risk, the auditor will then perform substantive testing of transactions to verify the monetary amounts of transactions.

C. Phase III – Analytical Procedures and Tests of Details of Balances Analytical procedures use comparisons and relationships to assess whether account balances or other data appear reasonable. Tests of details of balances involve specific procedures to test for the monetary misstatement of balances in the financial statements. Most of this evidence comes from a source outside of the client.

D. Phase IV – Complete the Audit and Issue a Report After completion of the audit work, it is necessary to combine the information obtained and decide if the financial statements are fairly stated. Appropriate report is then written.

Summary 1. Client and auditor responsibilities Fraudulent financial reporting vs. misappropriation of assets. 3. Testing client assertions 4. Phases of the audit process