Auditing

Lecture (4)
Audit Responsibilities and Objectives
(I) Financial Statement Responsibilities
(II) Categories of Fraud
(III) Auditor Responsibility for Detection of Illegal Acts
(IV) Managing the Audit Process
(V) Phases of the Audit Process

I. Financial Statement Responsibilities

(a) Overall Objective of Financial Statement Audit

(b) Client Management Responsibilities

(c) Auditor Responsibilities

(d) 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.
1|Page
Auditing

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.

D. Terminology
(1) Material v. Immaterial

(2) Reasonable Assurance

(3) Error v. Fraud

(4) 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 cannot guarantee that there are no material misstatements because:

(a) Auditors use judgment based on samples. Errors in judgment can occur.

(b) Accounting presentations are based on complex estimates that involve

uncertainty.

(c) Fraudulently prepared financial statements are difficult to detect, especially

if there is collusion.

2|Page
Auditing

(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

(a) Fraudulent Financial Reporting
(b) 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.

3|Page
Auditing

Lecture (5)
(V) Phases of the Audit Process
A. Phase I Plan and Design an Audit Approach

B. Phase II Tests of Controls and Substantive Tests of Transactions

C. Phase III Analytical Procedures and Test of Details of Balances

D. 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:

(1) 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.

(2) 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.

4|Page
Auditing

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.

III. Auditor Responsibility for Detection of Illegal

Acts
- SAS 54 defines illegal acts as violations of laws or government regulations
other than fraud.
A. Direct-Effect Illegal Acts
B. Indirect-Effect 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.

5|Page
Auditing

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.
Lecture (6)
IV. Managing the Audit Process
A. The Cycle Approach
B. 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:
o Sales and collection
o Acquisition and payment
o Payroll and personnel
o Inventory and warehousing
o 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
3. Rights and obligations
4. Completeness
5. Valuation or allocation

6|Page
 Auditing

Management Represents Auditor Tests

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

- Existence is concerned with Auditor tests for overstatement of

whether assets, obligations, and items
(2) Existence or equities included in the balance
Occurrence sheet actually existed on the
balance sheet date.

- Transactions recorded occurred

during the accounting period.

(3) Rights and - Client organization possesses Auditor tests asset ownership and
Obligations ownership rights to recorded liability claims.
assets.

- Client records show liabilities

owed as of the balance sheet
date.

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

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

7|Page
Auditing

8|Page