Ownership

							        9.401 Auditing

            Chapter 5
Audit Responsibilities and Objectives
Auditor’s Responsibility…..
 To accumulate evidence to determine if the
  f/s are fairly stated in accordance with
  GAAP in all material respects,
 and to issue an appropriate report
Managements’s
Responsibility…..
 Adopting sound accounting policies
 Maintaining adequate internal control
 Generating financial statements. Still mgmt
  responsibility even if:
    Auditor provided bookkeeping services

    Auditor prepared f/s

    Auditor offered suggestions
Auditor vs. Management
   When auditor and management disagree on
    a material issue:
      If management capitulates, issue clean
       opinion
      Auditor can’t force management to alter
       financial statements
      If management refuses, auditor must
       qualify opinion
Auditors and Errors
   Errors
     =unintentional misstatements of f/s
        • Mistake in gathering or processing data

        • Incorrect estimate from oversight or
           misinterpretation of facts
        • Mistake in application of GAAP relating to
           amount, classification, presentation or
           disclosure
   Auditors seek reasonable, not absolute, assurance
    that f/s contain no material errors….
Why not provide absolute
assurance?
 Can’t because:
    Use of sampling

    Auditors use judgment, which is fallible

    F/S contain estimates

    Audit evidence is persuasive, not
     conclusive
    Internal control has limitations

 Won’t because prohibitive costs exceed
  benefits
Auditors and Fraud
 Employee Fraud
  =usually theft of assets from company
 Management Fraud
  =intentional misstatement of f/s, usually to
    deceive stakeholders
Auditors and Fraud
   Auditors have less responsibility towards
    fraud because:
      Object of concealment

      Can be hard to find if:

         Employees are colluding

         Management is overriding internal
          controls
Auditors and Fraud
   Auditors must be alert to factors increasing
    consider the risk of misstatements:
      means and opportunity

         (eg. Weak internal controls, areas of judgment
          or complexity, dominant mgmt, decentralized
          org)
      motive

         (eg. High expectations, financial problems,
          bonuses, IPO’s)
      mgmt character and engagement

         (eg. Aggressive, dishonest, evasive)

         New client, assets subject to misappropriation
Auditors and Fraud
   If risk of fraud is high:
      Be critical of accounting policies

      Use more experienced personnel

      Close supervision

      Do more work, more effective procedures,

       and closer to year end (=nature, timing
       and extent)
      Consider withdrawing from engagement
Throughout Audit
   Exercise professional scepticism
     Assume good faith of management

     Be aware that management could be
      dishonest
     Be alert to red flags which call

      management good faith into question
Red Flag Examples:
 Handwritten records usually computerized
 Evasive, uncooperative management
 Unrealistic time deadlines set by mgmt
 Limitation in scope imposed by mgmt
 Conflicting or unsatisfactory evidence
 Unsupported or unusual transactions,
  particularly close to year end
 Fewer confirmation responses than expected
  or significant differences found
What to do when red flags
appear:
 Perform additional work to confirm or dispel
  suspicions.
 If suspicions are confirmed:
    Talk to appropriate level of mgmt

    Talk to audit committee

    Consider effect on rest of audit

    Consider effect on evidence already

     gathered
    Consider if you should resign from audit-

     consult a lawyer
 Auditors and Illegal Acts
 Auditors are less likely to find illegal acts
  than errors:
    May not be directly related to audit

    Auditor may be unaware of laws

    Detecting violations may be outside of

     auditor’s expertise, question of law
    May be concealed

 The more the illegal act has a “direct effect”
  on f/s, the greater the auditor’s responsibility
Auditors and Illegal Acts
 Auditors should at minimum:
    Identify laws whose violation affects f/s

    Ask management about policies designed
     to prevent illegal acts
    Obtain written representation from mgmt

 If auditor DOES discover an illegal act:
    Inform mgmt and audit committee

    Consider effect on f/s and audit report

    Consider effect on audit evidence, mgmt
     good faith
 How to perform an audit
 Financial statements are made up of
   Account Balances, which are made up of
   Transactions
 The financial statements contain implied
  management assertions. Auditing these
  assertions leads to objectives which can be
  balance related (when auditing account
  balances) or transaction related (when
  auditing transactions)
               Management Assertions
   Existence or Occurrence
       Assets, liabilities and equities exist and that
                                                      Existence
        a transaction occurred that pertains to the
        entity
   Completeness
       There are no unrecorded assets, liabilitiesCompleteness
        or transactions
   Ownership or Rights and Obligations
       Assets of the company is owned by entity       Ownership
        at given date, liabilities represent
        obligations
           Management Assertions

                                                 Valuation
 Valuation or Measurement
    Assets or liabilities recorded at appropriate
     carrying value; transactions recorded in proper
     amount and allocated to proper period Presentation
 Presentation and Disclosure
    An item is disclosed in accordance with GAAP
      Assertions and Objectives
Mgmt Assertion   Balance Objective   Transaction Objective

Existence        Existence           Occurrence
                                     (=existence+ownership)
Completeness     Completeness        Completeness
Valuation/       Valuation/          Accuracy
Measurement      Measurement
                 Cutoff              Timing

Ownership        Ownership
Presentation/    Presentation/
Disclosure       Disclosure
                                     Classification
                 Detail tie in       Posting
Which assertions are violated?
1)   According to the company books, there are 25
     delivery vans but your physical count reveals that
     they only have 20.
2)   The company forgot to record on their financial
     statements that they will likely have to pay a
     settlement of two million dollars in connection
     with a civil lawsuit.
3)   The company has several accounts receivable
     from customers who have declared bankruptcy.
4)   The company does not show the breakdown
     between current and non-current assets and
     liabilities on the financial statements.
Which assertions are violated?
5)   A non-profit organization often receives sizable
     cash donations but only issues receipts if the
     donor requests them. It is possible that some
     cash is pocketed by the employees.
6)   The company calculates amortization on their
     machinery using an estimated useful life of 60
     years, which seems unreasonably long given the
     probability of technological obsolescence.
7)   The company failed to include in their financial
     statements an inventory shipment received
     immediately before year end.
8)   The inventory of a second hand clothing store is
     recorded on their financial statements, when it is
     actually inventory on consignment.
Which assertions are addressed by these procedures?
1)   You send out confirmations to accounts
     receivable customers recorded in the company
     books.
2)   You check to see that the inventory you counted
     in the warehouse is recorded in the company
     books.
3)   You recalculate the amortization of prepaid
     insurance.
4)   You request that the company’s major suppliers
     send you a copy of your client’s statement of
     account that you will check with your
     company’s records.
Which assertions are addressed by these procedures?
5)   You compare the ratio of the allowance for
     doubtful accounts to accounts receivable with the
     ratio of prior years.
6)   You check sales invoices after the year end to see
     if the inventory selling price was higher than its
     original cost.
7)   For each investment, you check if the amount of
     dividend revenue earned from portfolio
     investments corresponds with dividends declared
     according to the “Dividend Record Guide”.
8)   You check to see if the level of sales returns
     recorded after the year end seems to be normal.
Phases of Audit
 Planning
    Obtain knowledge of business

    Understand internal control and assess risk

 Tests of Controls
 Analytical procedures and substantive tests
  of balances
 Complete audit and issue report