Audit Week one Course Administration - PowerPoint Presentation

Slide1

Audit

Week oneSlide2

Course Administration

Professor Thomas Davis

Email:

tomas.davis@hotmail.com

Student course leader

Textbook

:

Auditing

and Assurance Services

,

Arens

/Elder/

Beaseley

, 12

th

editionSlide3

Course Assessment

30% midterm exam (5 Oct-22 Oct)

20% project

(week 11 case study)

50% final exam (30 Nov-17 Dec)Slide4

Course Outline

Introduction (week 1)

Audit overview (week 2)

Financial statement cycles/audit objectives (week 3)

Audit evidence (week

4

)

Audit planning (week 5)

Materiality (week 6)

Audit

plan/audit program/review

for midterm exam (week 7)Slide5

Course Outline

Sales

cycle: controls and transactions testing (week 8)

Case study (

week

9

)

Sales cycle: analytical procedures/balances testing (week 10)

Case study (week 11)

Payroll and acquisition cycles (week 12)

Inventory and capital cycles/audit completion (week 13)

Review for final exam (week 14)Slide6

Audit

Week twoSlide7

Readings

GAAS standards:

http

://

www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-00150.pdf

Audit

reports

http://

en.wikipedia.org/wiki/Auditor's_report

Legal liability

http

://

en.wikipedia.org/wiki/Legal_liability_of_certified_public_accountantsSlide8

Audit vs. Accounting

Accounting:

preparing

financial statements

Auditing:

verifying

financial statementsSlide9

The CPA Profession

The “Big Four”

Deloitte, EY, PwC, KPMG

Staff levels: Staff, Senior, Manager, Partner

CPA certification

Education

Exam

ExperienceSlide10

Generally Accepted Auditing Standards (GAAS)

General standards

Training and proficiency

Independence

Professional care

Standards of field work

Planning and supervision

Understanding of entity

Sufficient evidence

Standards of reporting

Evaluation of GAAP

Explanation of departures from GAAP

Adequate disclosure

Financial statement opinionSlide11

Audit Reports – Standard Unqualified Opinion

All four financial statements included

All three GAAS general standards followed

All three field work standards met

Presentation in accordance with GAAP

No explanation/modification

requiredSlide12

Other Audit

Reports

Unqualified opinion with explanation/modification

Qualified opinion – “except for”

Scope limitation – client or circumstances

Not in accordance with GAAP but fairly stated

Adverse opinion – financials not fairly stated per GAAP

Disclaimer – lack of information or lack of independenceSlide13

Materiality and Misstatements

Immaterial – unlikely to affect decision of user: unqualified opinion

Material but financial statements are fair (one item/isolated situation): qualified opinion

Material – fairness of financial statements is in question: disclaimer or adverse opinionSlide14

Ethics

Independence

Integrity and objectivity

Confidential client information

Contingent fees

Audit and consulting… conflict of interestSlide15

Legal Liability

Business failure vs. audit failure

Audit failure vs. audit risk

Negligence vs. fraud

Third parties vs. clients

Civil (securities law) vs. criminal (federal law) liability

“Joint and several” vs. “separate and proportionate” liabilitySlide16

Audit

week threeSlide17

Readings

Accounting cycles

http

://tgg-accounting.com/blog/2012/01/financial-statement-cycles

/

Audit objectives (not all objectives are covered here; we will discuss others during the class)

http

://

smallbusiness.chron.com/audit-procedures-objectives-58836.htmlSlide18

Auditor Responsibilities

Material vs. immaterial misstatements

Reasonable assurance

Errors vs. fraud

Professional skepticism – question

everything

!Slide19

Financial Statement Cycles

Sales and collection cycle

Acquisition and payment cycle (general assets and expenses)

Payroll and personnel cycle

Inventory and warehousing cycle (inventory and COGS)

Capital acquisition and repayment cycle (debt and equity transactions)Slide20

Financial Statement Cycles

Identify the transaction cycle for each account

Identify the main journal entries for each cycleSlide21

Objectives

Transaction-related

Balance-related

Presentation and disclosure-relatedSlide22

Transaction-Related Objectives

Occurrence – did it really happen?

Completeness – is anything missing?

Accuracy – is the information accurate?

Posting and summarization – are the transactions included in the journal and ledger?

Classification – is the transaction in the correct account?

Timing – is the transaction in the right period?Slide23

Balance-Related

Objectives

Existence – does this account really exist?

Completeness – is anything missing?

Accuracy – is the information accurate?

Classification – is the account correctly classified?

Cutoff – are the year-end transactions recorded in the right period?

Detail tie-in – does the balance

match the ledger

?

Realizable value – does the account reflect accurate value?

Rights and obligations – does account represent true ownership/liability?Slide24

Disclosure-Related Objectives

Occurrence and rights

and obligations

– did it really happen, and did it create true ownership/liability?

Completeness – is anything missing?

Valuation and allocation – do all accounts reflect the appropriate amounts?

Classification and understandability – is the classification correct and is the meaning clear?Slide25

Four Phases of an Audit

Plan the audit

Testing of controls and transactions

Analytical procedures and testing of balances

Audit reportSlide26

Audit

week

fourSlide27

Readings

Chapter 7 from textbookSlide28

Audit Evidence Decisions

Which procedures?

What sample size? (quantity)

Which items to select for testing? (quality)

When?Slide29

Persuasiveness of Evidence

Appropriate

Relevant: right test for the right audit objective

Reliable: external information > internal information

Sufficient

Sample size: higher risk = larger sample

Item quality: large amounts and random amountsSlide30

Types of Evidence

Physical examination – auditor inspects physical assets

Confirmation – response from third party

Documentation – internal and external documents

Analytical procedures – comparisons and relationships

Inquiries of the client – client responses; may be biased

Recalculation – checking client calculations

Reperformance

– checking non-calculation procedures

Observation –

watch/listen/touch/smellSlide31

Audit Documentation

Sample documents from audit files (attachment)

Activity – notes receivable

audit work (attachment)Slide32

Audit

week fiveSlide33

Readings

Chapter 8 from textbookSlide34

Audit Planning

Initial audit planning –

staffing

/

specialists

Client business and

industry

(

next

slide)

Client business

risk

B

ased

on

understanding

business/

industry

(

step

2)

High business

risk

= high

risk

of

material

misstatement

Analytical

proceduresSlide35

Client Business

and

Industry

Industry

Industry

economic

environment

and

risk

Industry

accounting

requirements

Business

operations

Management and

governance

–

philosophy

and

ethics

Objectives and

strategies

–

financial

and

legal

compliance

Measurement

and performance – conservative or

aggressive

?Slide36

Analytical Procedures

Industry data

Prior period data

Client-calculated expected results (budgets)

Auditor-calculated

expected results

Expected results using nonfinancial data (units, rates)Slide37

Client/Industry Comparison

Client is stable…. in an improving industry environment…

What happened?Slide38

Common Size Financial StatementsSlide39

Auditor-Calculated Expected ResultsSlide40

Non-Financial Data

This percentage difference is significant… we need to find out….

What happened?Slide41

Financial Ratios

Current ratio = current assets / current liabilities

Days receivables = 365 / (net sales/average receivables)

Inventory turnover

= cost

of goods sold/average inventory

Debt to equity = debt / equity

Gross profit margin = gross profit / net sales

Operating margin

=

operating income

/ net

sales

Profit margin

=

net income

/ net

sales

Expense item as % of total expenses = expense / total expenses

Return on assets = income before taxes / average assetsSlide42

Audit

Week sixSlide43

Readings

Chapter 9 from textbook, “Materiality and Risk”Slide44

Materiality

Set

preliminary

judgement

about

materiality

Allocate

amounts

to segments

Estimate

segment

misstatement

Estimate

combined

misstatement

Compare

combined

estimate

with

preliminary

judgementSlide45

Materiality Judgment

Guidelines (

vary

from

audit to audit):

6%

earnings

from

operations

3% of total

assets

Use the

smaller

result

to

calculate

materiality

Below

the

amount

: no issues

Above

the

amount

:

material

misstatment

;

adjustment

requiredSlide46

Materiality Judgment and Allocation

Earnings

from

operations

= $7,370,000

Total

assets

= $61,367,000

Materiality

calculation

:

Earnings

x 6% = $442,000

Assets

x 3% = $1,841,000

The

smaller

result

= $442,000Slide47

Additional Auditor Guidelines

Maximum

misstatement

for one

account

= 60%

60% * $442,000 = $265,000

To

prevent

high allocation to one

account

Maximum total of all

misstatments

= 200%

200% * $442,000 = $884,000

T

o

allow

for

overestimates

and over/

under

offsets

These

guidelines

vary

among

audit

firms

.Slide48

Materiality Judgment Allocation ExampleSlide49

Estimate and

Evaluate

Misstatement

Projection =

misstatements

/

sample

size %

Sampling

error

=

risk

of non-

representative

sample

Calculate

total

estimated

misstatement

Compare total to

preliminary

judgmentSlide50

Estimate and

Evaluate

:

ReceivablesSlide51

Estimate and

Evaluate

:

Receivables

Estimated

misstatement

exceeds

tolerable

misstatement

…

What

do

we

do?Slide52

Receivables

Misstatement

Options

If

we

increase

our

sample

size,

we

can

decrease

the

sampling

error

% and

recalculate

the total

estimated

misstatement

(

see

next

slide); if

we

still

exceed

materiality

,

we

adjust

.

Adjusting

entry:

Sales $xx

Accounts

receivable

$xx

The

adjustment

amount

will

be

negotiated

between

the client and the

auditor

.Slide53

Receivables:

Revised

Sampling

If

we expand the sample

size (from slide 10),

we can

decrease the sample error %

, and evaluate the new

result. In this case, because the amount of misstatement in the revised sample still exceeds the materiality threshold, we will propose the adjusting entry.Slide54

In Class Activity: Payables

AnalysisSlide55

Audit Risk

Model

PDR =

AAR

IR * CR

PDR =

planned

detection

risk

(

risk

of

undiscovered

misstatement

)

auditor

risk

;

lower

risk

=

more

evidence

AAR = acceptable audit

risk

(

risk

of an incorrect audit opinion);

auditor

risk

;

lowe

r

risk

=

more

evidence

IR =

inherent

risk

(

account-specific

risk

);

client

risk

;

lower

risk

=

less

evidence

CR = control

risk

(

risk

of ineffective

control system

);

client

risk

;

lower

risk

=

less

evidenceSlide56

Audit

Week eightSlide57

Readings

Chapter 14, “Audit of the Sales and Collection Cycle” and Chapter 15, “Audit Sampling for Tests

of Controls” from textbookSlide58

Sales and Collection Cycle Accounts

Sales

Cash

Accounts receivable

Sales discounts

Sales returns and allowances

Allowance for uncollectible accounts

Bad debts expenseSlide59

Sales and Collection Cycle Documents

Customer order

Sales order

Bill of lading (shipping document)

Sales invoice

Additional documentation: cash receipts, sales returns

,

bad

debt

provision, write-offsSlide60

Sales and Collection Cycle Controls

Separation

of

duties

Authorization (credit/shipping/pricing)

Documentation

Prenumbered

documents (to prevent missing/duplicate documents)

M

onthly statements

I

nternal

verificationSlide61

Tests of Controls and Transactions

First, I consider my six

transaction objectives

:

occurrence, completeness, accuracy, posting, classification, timing.

Then, I design tests relating to these objectives based

on information I have from client (procedures manual, client discussions,

observation); these tests are the

audit program

. Slide62

Types of Evidence for Controls and Transactions

Controls

Documentation

Inquiry

Reperformance

Observation

Transactions

Documentation

Inquiry

Recalculation

ReperformanceSlide63

Audit Program for Controls/Transactions

This is a sample of the audit program on page 464:Slide64

Four Audit Evidence Decisions

We have decided our

procedures

(Ch. 14)

Audit evidence

decisions (

Ch.

15):

What

sample size

? (quantity)

Which items

to select for testing? (quality)

When

? (timing)Slide65

Sampling for Controls and Transactions

We sample and test for controls based on

attributes

, not

dollar amounts

.

Our assessment is based on number of errors.

Dollar amount does not matter.

Chapter 15 covers sampling procedures; we will not study this information, rather I will provide you with sampling instructions.Slide66

Perform the Audit Procedures

We set an estimated population exception rate based on our understanding of client controls.

We set a tolerable exception rate (generally from 3%-10%) based on what we consider acceptable.

We determine a sample size based on relationship between the estimated and tolerable amounts (big difference = smaller sample).

We perform our testing based on the audit program

.Slide67

What Do We Do with the Results?

I compare my sample exception rate to my tolerable exception rate.

If TER>SER

, I can rely on this control

procedure.

If TER<SER, I

either 1) increase testing or 2) revise control risk

(I

don’t rely on this

control)

This evaluation of controls and transactions is the basis for the design of my audit program for balances (

Chs

. 16-17).Slide68

Case Study Documentation Package

Auditor documents

Audit program

Attributes defined

Sampling sheet

Sales invoice sequence

Company accounting documents

Sales journal

A/R ledger

Company operations documents

Customer order

Sales order

Bill of lading

Sales invoiceSlide69

Audit

Week tenSlide70

Readings

Chapter 16, “Completing the Tests in the Sales and Collection Cycle” and Chapter 17, “Audit Sampling for Tests

of

Details of Balances”

from textbookSlide71

Sales and Collection Cycle Accounts

Sales

Cash

Accounts receivable

Sales discounts

Sales returns and allowances

Allowance for uncollectible accounts

Bad debts expenseSlide72

Analytical ProceduresSlide73

Analytical Procedures – Potential Misstatement

These results indicate a potential misstatement relating to the objective of “realizable value” which will affect our balance testing for this objective.Slide74

Tests of Balances

First, we consider the eight

balance objectives

:

existence, completeness, accuracy, classification, cutoff, detail tie-in, realizable value, rights/obligations.

Then, we design tests relating to these objectives based on:

The tolerable misstatement calculated in

phase I

T

he controls/transaction testing completed in

phase II

Analytical procedures just completed (this,

along with tests of

balances, is

phase III

)Slide75

Types of Evidence for Balances

Physical examination

Confirmation

Documentation

Client inquiry

Recalculation

ReperformanceSlide76

Test of Balances for Accounts Receivable

Aged trial balance (classification

,

tie-in, realizable value)

Confirmation (existence, accuracy)

Sales cutoff (cutoff)

Obtain last bill of lading number for year

Test recorded sales to confirm no subsequent BOLs

Document review/client inquiry (rights)

Pledging/factoring

Assignment/saleSlide77

Aged Trial Balance

List of all receivable balances

Customer name

Amount outstanding

Age of receivables balance

Audit procedures

Tie account balance to general ledger

Review customer names for any related parties

Analysis of allowance for uncollectible accountsSlide78

Aged Trial BalanceSlide79

Analysis of Analysis for Uncollectible AccountsSlide80

Analysis of Analysis for Uncollectible Accounts

I will include this difference in the “Summary of Possible Misstatements” schedule in the audit file.

Bad debts expense xx

Allowance for doubtful accounts xx

Since the calculation is greater than the trial balance amount, this is an

OVER

statement

. If the difference exceeds materiality, I will make the following adjusting entry for the excess amount: Slide81

Confirmation of Accounts Receivable

Types of confirmation

Positive confirmation

Negative confirmation

Analysis of differences and potential accounting issues

Payment made – cash receipts cutoff error,

t

heft?

Goods not received – shipping cutoff error?

Goods returned – sales returns recording error?

Clerical errors – client miscalculation?

For non-response – audit subsequent receipt of cashSlide82

Audit Program for Tests of BalancesSlide83

Audit Program for Tests of BalancesSlide84

Four Audit Evidence Decisions

We have decided our

procedures

(Ch. 16)

Audit evidence

decisions (

Ch.

17):

What

sample size

? (quantity)

Which items

to select for testing? (quality)

When

? (timing; for testing of

balances

, most testing will be after year-end)Slide85

Sampling for Balances

We sample and test for balances based on

dollar amounts

.

Chapter 17 covers sampling procedures; we will not study this information, rather I will provide you with sampling instructions.Slide86

Perform the Audit Procedures

We set the tolerable misstatement during phase I.

We determine a sample size and sample items using sampling procedures and considering the results of our controls and transactions testing (strong controls = less balance testing).

We perform our testing based on the audit program

.Slide87

What Do We Do with the Results?

I analyze sample misstatements to calculate total projected misstatement.

I compare projected misstatement to tolerable misstatement

If projected misstatement < tolerable misstatement, account balance is presented fairly.

If projected

misstatement > tolerable

misstatement,

I

either 1)

perform additional testing

or 2)

propose adjusting entry.Slide88

Analysis of

Receivables

Confirmation –

Estimated

Misstatement

(

from

lecture 6)

Now

let’s

look at the

same

analysis

using

stratified

sampling

…Slide89

Analysis of Receivables Confirmation Using Stratified Sampling

Stratified sampling – test higher percentage of large amounts and smaller percentage of small

amounts.Slide90

Adjustments to Financial Statements

We are performing multiple tests to evaluate the sales cycle; once we complete our testing for this cycle, we will evaluate the need for adjusting entries.

The confirmations testing analysis on slide 19 is only one of these tests; other tests might indicate the need for a larger or smaller adjustment to accounts receivable.

Accounts receivables is only one account in the sales cycle; other tests might indicate the need to make adjustments to other accounts in the sales cycle.Slide91

Audit

Week twelveSlide92

Readings

Chapter 18, “Audit of the Payroll and Personnel Cycle”

Chapter 19, “Audit of the Acquisition and Payment Cycle”

Chapter 20, “Completing the Tests in the

Acquisition and Payment Cycle

”Slide93

Payroll Accounts

Cash

Accrued payroll

Direct labor

Tax withholdings

Accrued payroll tax expense

Payroll tax expenseSlide94

Payroll Controls/Transactions Testing

Verify payroll records - work and employees (occurrence)

Payroll is recorded in accounting system (completeness)

Hours and rates in payroll records are correct (accuracy)

Payroll master file ties to general ledger (posting)

Payroll is correctly classified (classification)

Payroll is recorded on correct date (timing)Slide95

Payroll Analytical ProceduresSlide96

Payroll Balance Testing

Accrued payroll expense is correct (accuracy); main test is recalculation.

Payroll transactions are in correct period (cutoff); main test is reviewing payroll payments after yearend.Slide97

Acquisition and Payments Accounts

Cash

Accounts payable

Inventory

Purchase returns, allowances, discounts

Property, plant, and equipment

Prepaid expenses

Operating expensesSlide98

Acquisitions Controls/Transactions Testing

Verify acquisitions records - goods/services received (occurrence)

Acquisitions are recorded in accounting system (completeness)

Acquisitions transactions are accurate (accuracy)

Acquisitions accounts tie to general ledger (posting)

Acquisitions are correctly classified (classification)

Acquisitions are recorded on correct date (timing)Slide99

Payments Controls/Transactions Testing

Verify payments are for legitimate goods/services (occurrence)

Payments are recorded in accounting system (completeness)

Payments are accurate (accuracy)

Cash and accounts payable tie to general ledger (posting)

Payments are correctly classified (classification)

Payments are recorded on correct date (timing)Slide100

Acquisitions and Payments Analytical ProceduresSlide101

Accounts Payable Balance Testing

All accounts payable are included in AP ledger (completeness); review subsequent cash disbursements and year-end receiving reports

Payables are correctly classified (classification)

Acquisition transactions are in correct period (cutoff)Slide102

Other Acquisition/Payment Cycle Accounts

Property, plant, and equipment – examine documentation of current year acquisitions to confirm existence and classification.

Prepaid assets – examine documentation to confirm existence and cutoff.

Accrued liabilities – ensure that normal accruals (taxes and payroll) are included in financials and are correctly calculated.

Income and expense accounts – ensure that normal expenses are included in financials and are correctly calculated.Slide103

Audit

Week thirteenSlide104

Readings

Chapter 21-24 (Inventory, Capital, Cash, Audit completion) from

textbookSlide105

Inventory and Warehousing Accounts

Raw materials

Direct labor

Manufacturing overhead

Work in process

Finished goods

Cost of goods soldSlide106

Inventory Controls/Transactions Testing

Materials and overhead – tested in acquisitions cycle

Labor – tested in payroll cycle

Shipping of inventory – tested in sales cycleSlide107

Inventory Analytical ProceduresSlide108

Inventory Balance Testing - Observation

Verify inventory items are present (existence)

Verify all inventory is counted (completeness)

Verify counting and pricing is accurate (accuracy)

Verify inventory/COGS is recorded in correct period (cutoff)

Obsolete/damaged inventory value is correct (value)

Client has rights to counted inventory (rights)Slide109

Capital Acquisition and Repayment Cycle

Notes payable and interest expense

Capital stock and dividends

Infrequent transactions; often 100% tested (no sampling

)

Key audit considerations

Interest expense is accurate – recalculation

Debt balance is complete – bank confirmation

Capital issuance is not disguised debt

– board meeting minutes

Dividends are not disguised expenses – board meeting minutesSlide110

Audit of Cash Balances

Controls testing is generally completed in other cycles

Bank reconciliation

Bank confirmation

for year-end balance

Next month bank statement to confirm outstanding checks and deposits at year-endSlide111

Presentation and Disclosure Testing

Occurrence and rights and obligations

Completeness

Classification and understandability

Accuracy and valuationSlide112

Completing the Audit

Contingent liabilities – client inquiry, attorney inquiry letter

Subsequent events – from year end to audit report date

Management representation letter

Evaluate possible misstatements for adjustment (slide 11)

Audit documentation review

Issue the audit reportSlide113

Summary of Possible Misstatements