Chapter 05 - PowerPoint Presentation

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Chapter 05Audit Evidence andDocumentation

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Audit RiskThe possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstatedThis is the risk that the auditors will issue an unqualified opinion on financial statements that contain a material departure from GAAP.Auditors must obtain sufficient appropriate audit evidence to reduce audit risk to a low level in every audit.Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide3

Financial Statement AssertionsRelevant assertions are those that, without regard for controls, have a reasonable possibility of containing a material misstatement; typesAssertions about account balances (Accounts)Assertions about classes of transactions and events (Transactions)Assertions about presentation and disclosure (Disclosures)Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide4

Financial Statement Assertions: Auditing Standards Board and International Standards AccountsTransactionsDisclosures

Existence

Occurrence

Occurrence

Rights and obligations

Rights and obligations

Completeness

Completeness

Completeness

Valuation and allocation

AccuracyAccuracy and valuationCutoffClassificationClassification and understandability

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Combined Assertions

Used in this Text

Existence or Occurrence

—Assets

, liabilities, and equity interests exist and recorded transactions have occurred

Rights and Obligations

—The

company holds rights to the assets, and liability are the obligations of the company

Completeness

—All

assets, liabilities, equity interests, and transactions that should have been recorded have been recordedCutoff—Transactions and events have been recorded in the correct accounting periodValuation, Allocation and Accuracy—All transactions, assets, liabilities and equity interests are included in the financial statements at proper amountsPresentation and Disclosure—Accounts are described and classified in accordance with generally accepted accounting principles, and financial statement disclosures are complete, appropriate, and clearly expressedCopyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide6

Audit Risk

Risk of Material Risk Auditors Fail

Audit Risk = Misstatement to Detect Material

Misstatement

= Inherent Control Detection

Risk Risk Risk

Inherent Risk—Risk of a material misstatement occurring in an assertion assuming no related internal controls.Control Risk—Risk that a material misstatement in an assertion will not be prevented or detected on a timely basis by the company’s internal control.Detection Risk—Risk that the auditors’ procedures will lead them to conclude that a material misstatement does not exist in an assertion when in fact such misstatement does exist.Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide7

Audit Risk Formula

AR = IR * CR * DR

AR = Audit risk

IR = Inherent risk

CR = Control risk

DR = Detection risk

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Audit Risk Figure 5.2Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide9

Inherent RiskFactors that affect inherent risk:Nature of the client and its environmentNature of the particular financial statement elementBusiness characteristics indicative of high inherent risk:Inconsistent profitability of clientOperating results highly sensitive to economic factorsGoing concern problemsLarge known and likely misstatements detected in prior auditsSubstantial turnover, questionable reputation, or inadequate accounting skills of managementCopyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide10

Assertions with high inherent riskInvolve:Difficult to audit transactions or balancesComplex calculationsDifficult accounting issuesSignificant judgment by managementValuations that vary significantly based on economic factorsCopyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide11

Types of TransactionsRoutineRecurring financial statement activities recorded in the accounting records in the normal course of businessLower inherent riskNonroutineInvolve activities that occur only periodically such as the taking of physical inventoriesHigh inherent riskEstimation transactionsActivities that create accounting estimatesHigher inherent riskCopyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide12

Appropriateness of Audit Evidence

Auditor must obtain sufficient

appropriate

audit evidence.

To be appropriate audit evidence must be:

Relevant

Reliable

Principles—Audit evidence is ordinarily more reliable when it is

Obtained from knowledgeable independent sources outside the company rather than nonindependent sources

Generated internally through a system of effective controls rather than ineffective controls.

Obtained directly by the auditor rather than indirectly or by inferenceDocumentary in form rather than oralProvided by original documents rather than copiesCopyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide13

Overall Categories of Audit Procedures Risk assessment proceduresTo obtain an understanding of the client and its environment, including its internal control, to assess the risks of material misstatementFurther Audit ProceduresTests of controlsWhen appropriate, to test the operating effectiveness of controls in preventing material misstatementsSubstantive proceduresTo detect material misstatements at relevant assertion level. Substantive procedures include (a) analytical procedures, (b) tests of details of account balances, transactions and disclosuresCopyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide14

Types of Audit ProceduresInspection of records and documentsInquiry of knowledgeable persons within or outside the entityExternal confirmationInspection of tangible assetsObservation of processes or procedures being performed by othersRecalculation of mathematical accuracy.Reperformance of proceduresAnalytical proceduresCopyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide15

Audit Procedures and Examples Figure 5.3Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide16

Substantive ProceduresAnalytical proceduresTests of detailsTests of account balancesTests of classes of transactionsTests of disclosuresOne may change the scope of audit procedures by changing the (NTE, or re-ordered as NET): Nature (type and form)Timing (when performed)Extent (quantity of evidence obtained)Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide17

Nature and Timing of Procedures Holding the extent of procedures constant, one may increase the scope of procedures (make them more effective) by either changing theNature—obtain more reliable evidenceoften externally generated evidence.Timing—wait until year-end to obtain evidence from entire set of transactions as contrasted to performing interim testing, say two months prior to year-end and simply updating those procedures.Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide18

Extent of ProceduresHolding other factors such as the nature and timing of procedures constant:The greater the risk of material misstatement, the greater the needed extent of substantive proceduresThe main way to increase the extent of audit procedures is to examine more itemsSample sizes should reduce detection risk so as to restrict audit risk to a low levelCopyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide19

General on Analytical Procedures(1 of 3)Timing of analytical proceduresRisk assessment (sometimes referred to as planning analytical procedures)Substantive proceduresFinal reviewSteps involvedDevelop expectation of account (or ratio) balanceDetermine amount of difference that can be accepted without investigationCompare the company’s account (ratio) with the expectationInvestigate and evaluate significant differencesCopyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide20

General on Analytical Procedures (2 of 3)Developing an expectationPrior period informationAnticipated resultsRelationships among elements of financial information within a periodIndustry informationRelationships between financial information and relevant nonfinancial data.Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide21

General on Analytical Procedures (3 of 3) Types of ExpectationsTrend analysis—analyze changes in accounts of a company over timeRatio analysis — compare relationships between two or more financial statement accounts or comparisons of account balances to nonfinancial dataLiquidity (e.g., current ratio)Leverage (e.g., debt to equity)Profitability (e.g., gross profit percentage)Activity (e.g., inventory turnover)Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide22

Ratio Analysis Approaches to ratio analysisHorizontal analysisReview ratios over timeCross sectional analysisAnalyze ratios of similar firms at a point in timeVertical analysisAnalyze relationships within a period“Common size” statements preparedOther methodsRegression analysis, reasonableness testCopyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide23

Identifying Potential MisstatementsFigure 5.5Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide24

Basic Approaches to Auditing Accounting Estimates

Review and test management’s process for developing the estimate.

Independently develop an estimate to compare to management’s estimate.

Review subsequent events or transactions bearing on the estimate.

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Auditing Fair Values Inputs to use in applying valuation techniques (FAS 157)Level 1 – inputs of observable quoted prices in active markets for identical assets or liabilitiesEx. A closing stock price in WSJLevel 2 – inputs of observable quoted prices, generally for similar assets or liabilities in active markets Ex. Company discounts future cash flows on its not publicly traded debt securities at rate used by market for publicly traded debt securitiesLevel 3 – inputs that are unobservable for the assets or liabilityEx. A private company uses judgment to determine a proper rate to discount the future cash flows of its not publicly traded securitiesCopyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide26

Related Party TransactionsDisclosure requirements must be metPrimary challenge is identifying undisclosed related party transactionsDetermine related partiesInquiries of managementReview SEC filings, stockholder’s listings and conflict-of-interest statementsBe alert for transactions with related parties and any transactions with unusual termsCopyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide27

Functions of Audit Documentation

Primary functions:

Support the auditors’ compliance with auditing standards

Support the auditors’ opinion

Secondary functions:

Assist continuing and new audit team members in planning and performing the audit

Serves as a record of matters of continuing audit interest

Assists in supervision and review of the audit

Demonstrates the accountability of team members

Assists internal reviewers, external peer reviewers, PCAOB inspectors, and successor auditors in performing their roles

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Sufficiency of Audit DocumentationAudit documentation should be sufficient to:Enable an experienced auditor to understand the work performed and the significant conclusions reachedIdentify who performed and reviewed the workShow that the accounting agree or reconcile to the financial statementsAudit documentation should include all significant audit findings and the actions taken to address themCopyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide29

Types of Working PapersAudit administrative working papersWorking trial balanceLead schedulesAdjusting journal entries and reclassification entriesSupporting schedulesAnalysis of a ledger accountReconciliationsComputational working papersCorroborating documentsCopyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Slide30

Types of Working Files

Current files

Current year working papers

Index and cross-referencing

Permanent files

Items of continuing audit interest

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Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Organization of the Current Files Figure 5.7Slide32

Preparation of a Working Paper Figure 5.8Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.