Audit Responsibilities and Objectives Chapter 6 Audit Responsibilities and Objectives 1

Learning Objectives Explain the objective of conducting an audit of financial statements and an audit of internal controls. Distinguish management’s responsibility for the financial statements and internal control from the auditor’s responsibility for verifying the financial statements and effectiveness if internal control.

Learning Objectives Explain the auditor’s responsibility for discovering material misstatements due to fraud or error, and the need to maintain professional skepticism when conducting the audit. Classify transactions and account balances into financial statement cycles and identify benefits of a cycle approach to segmenting the audit.

Learning Objectives Describe why the auditor obtains a combination of assurance by auditing classes of transactions and ending balances in accounts, including presentation and disclosure. Distinguish among the three categories of management assertions about financial information. List the six general transaction-related audit objectives to management assertions for classes of transactions.

Learning Objectives Link the eight general balance-related audit objectives to management assertions for account balances. Link the four presentation and disclosure-related audit objectives to management assertions for presentation and disclosure. Explain the relationship between audit objectives and the accumulation of audit evidence.

Explain the objective of conducting an audit of financial statements and an audit of internal controls.

Objective of Conducting an Audit of Financial Statements The purpose of an audit is to provide financial statement users with an opinion by the auditor on whether the financial statements are presented fairly, in all material respects, in accordance with applicable financial accounting framework.

Steps to Develop Audit Objectives

2 Distinguish management’s responsibility for the financial statements and internal control from the auditor’s responsibility for verifying the financial statements and effectiveness of internal control.

Management’s Responsibilities Financial statements and internal controls. Sarbanes-Oxley increases management’s responsibility for the financial statements. CEO and CFO must certify quarterly and annual financial statements submitted to the SEC.

Management’s Responsibilities

Management’s Responsibilities The Sarbanes-Oxley Act provides for criminal penalties for anyone who knowingly falsely certifies the statements.

3 Explain the auditor’s responsibility for discovering material misstatements due to fraud or error, and the need to maintain professional skepticism when conducting the audit.

Objectives of the Auditor Obtain reasonable assurance Financial statements Free from material misstatements Opine Financial statements Applicable reporting framework Obtain reasonable assurance about whether the financial statements as a whole are free from material misstatements. Express an opinion whether the financial statements are prepared in all material respects in accordance with an applicable financial reporting framework. Report on the financial statements, and communicate as required by auditing standards, in accordance with the auditor’s findings. Report Financial statements Communicate per audit standards

Auditor’s Responsibilities Material misstatements Reasonable Assurance Ask students why auditors can only provide reasonable instead of absolute assurance on the financial statements. Professional Skepticism Errors vs. Fraud Fraudulent reporting vs. theft of assets

Auditor’s Responsibility to Consider Laws and Regulations Type Responsibility Direct-Effect Same for errors and fraud Regarding indirect-effect illegal acts, auditing standards state that the auditor lacks legal expertise and the frequent indirect relationship between illegal acts and the financial statements makes it impractical for auditors to assume responsibility for discovering those illegal acts. Indirect-Effect No Assurance

Auditor’s Responsibility to Consider Laws and Regulations Auditor suspects Inquire of management Consult client’s counsel or specialist Consider accumulating evidence Auditor knows Consider effects on financial statements Consider effect on relationship with management Communicate with audit committee or equivalent Several actions are necessary to determine whether the suspected illegal act actually exists: Inquire of management at a level above those likely to be involved in the potential illegal act Consult with the clients legal counsel or other specialist who is knowledgeable about the potential illegal act Consider accumulating additional evidence to determine whether there actually is an illegal act

4 Classify transactions and account balances into financial statement cycles and identify benefits of a cycle approach to segmenting the audit.

Financial Statement Cycles Audits are performed by dividing the financial statements into smaller segments or components.

Transaction Flow Example

Relationships Among Transaction Cycles General cash Capital acquisition and repayment cycle Sales and collection cycle Acquisition and payment cycle Payroll and personnel cycle Inventory and warehousing cycle

5 Describe why the auditor obtains a combination of assurance by auditing classes of transactions and ending balances in accounts, including presentation and disclosure.

Balance and Transactions Affecting Balances Example If the auditor could be completely sure that each of the four classes of transactions is correctly stated, the auditor could also be sure that the ending balance is correctly stated. Several audit objectives must be met before the auditor can conclude that the transactions are properly recorded. These are called transaction related objectives. Several objective must be met for each account balance. These are called balance-related objectives. A third category of audit objectives relates to presentation and disclosure of information in the financial statements.

6 Distinguish among the three categories of management assertions about financial information.

Management Assertions Assertions about classes of transactions and events for the period under audit 2. Assertions about account balances at period end The definition of auditing in chapter 1 states that auditing is a comparison of information to established criteria (assertions established according to accounting standards). Auditors must therefore understand the assertions to do adequate audits. 3. Assertions about presentation and disclosure

Management Assertions for Each Category of Assertions Transactions and Events Account Balances Presentation and Disclosure Occurrence Existence Occurrence and rights and obligations Completeness Completeness Completeness Accuracy Valuation and allocation Accuracy and valuation Classification The occurrence assertion concerns whether the recorded transactions included in the financial statements actually occurred during the period. Completeness addresses whether all transactions that should be included in the financial statements are in fact included. The accuracy assertion addresses whether transactions have been recorded at correct amounts. The classification assertion addresses whether transactions are recorded in the appropriate accounts. The cutoff assertion addresses whether transactions are recorded in the proper accounting period. Classification and understandability Cutoff Rights and obligations

PCAOB Assertions Existence or Occurrence Completeness Valuation or allocation Rights and obligations Presentation and disclosure Similar to AICPA auditing standards as the first three assertions are applicable to balances and transactions. Presentation is treated as a single assertion.

7 Link the six general transaction-related audit objectives to management assertions for classes of transactions.

General Transaction-related Audit Objectives Occurrence Recorded transactions exist Completeness Existing transactions are recorded Recorded transactions are stated at the correct amounts Accuracy

General Transaction-related Audit Objectives Transactions are included in the master files and are correctly summarized. Posting and summarization Classification Transactions are properly classified. Timing Transactions are recorded on the correct dates.

(Applied to Sales Transactions) Hillsburg Hardware Co. (Applied to Sales Transactions)

8 Link the eight general balance-related audit objectives to management assertions for account balances.

General Balance-related Audit Objectives Existence Amounts included exist Completeness Existing amounts are included Accuracy Amounts included are stated at the correct amounts

General Balance-related Audit Objectives Classification Amounts are properly classified Cutoff Transactions are recorded in the proper period Detail tie-in Account balances agree with master file amounts, and with the general ledger

General Balance-related Audit Objectives Realizable value Assets are included at estimated realizable value Rights and obligations Assets must be owned

(Applied to Inventory) Hillsburg Hardware Co.. (Applied to Inventory)

9 Link the four presentation- and disclosure-related audit objectives to management assertions for presentation and disclosure.

(Applied to Notes Payable) Hillsburg Hardware Co. (Applied to Notes Payable)

10 Explain the relationship between audit objectives and the accumulation of audit evidence.

How Audit Objectives Are Met The auditor must obtain sufficient appropriate audit evidence to support all management assertions in the financial statements. An audit process has four specific phases

Four Phases of a Financial Statement Audit Phase 1 includes obtaining an understanding of the entity and its environment, an understanding of internal control and assessing control risk, and assessing the risk of material misstatement.

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