Fluent Essays

Auditing help 1 Auditing- A Practical Approach Chapter 7: UNDERSTANDING AND TESTING THE CLIENT’S SYSTEM OF INTERNAL CONTROLS Test of Controls FMGT 4310 Auditing 2 7-1 Chapter 7 Learning Objectives 1. Define internal control 2. State the seven generally accepted objectives of internal control activities 3. Understand and describe the elements of internal control at the entity level 4. Identify the different types of controls 5. Explain how to select and design tests of controls 6. Explain the different techniques used to document internal controls 7-2 Chapter 7 Learning Objectives 7. Understand how to interpret the results of testing of controls 8. Explain how to document tests of controls 9. Describe the importance of identifying strengths and weaknesses in a system of internal controls 10. Explain how to communicate internal control strengths and weaknesses to those charged with governance 7-3 2 What is “internal control”? … 7-4 Internal Control Internal control is the process designed, implemented, and maintained by those charged with governance, management, and other personnel to provide reasonable assurance about the achievement of the entity’s objectives with regard to reliability of financial reporting, effectiveness and efficiency of operations, and compliance with applicable laws and regulations (CAS 315) 7-5 Objectives of Internal Controls Is an entity’s internal control effective as it relates to recording of transactions and balances? … 7-6 3 Effective internal control meets the following objectives: 1. Real – no fictitious or duplicated transactions 2. Recorded – prevent or detect omission of transactions 3. Valued – correct amounts assigned to transactions 4. Classified – transactions charged to correct account 7-7 O (occurrence) C (completeness) A (accuracy) C (classification) Effective internal control meets the following objectives: 5. Summarized – transactions summarized and totalled correctly 6. Posted – accumulated totals in transaction file are correctly transferred to the general and subsidiary ledgers 7. Timely – transactions recorded in correct accounting period 7-8 A A C (cutoff) Auditors must: • Gain understanding of internal controls systems  objectives • Identify key controls • Identify control weaknesses 7-9 4 Inherent limitations: • Human error  control breakdown • Collusion • Management override 7-10 Entity-level Internal Controls 1. Control environment 2. Entity’s risk assessment process 3. Information systems 4. Control activities 5. Monitoring of controls 7-11 Entity-level Internal Controls Consider  Small entities • Difficult to implement formal controls • Fewer resources • Segregation of incompatible functions • Reliance on owner/manager 7-12 5 Types of Controls • Controls have two main objectives: 1. To prevent/detect misstatements 2. To support the automated parts of the business 7-13 Types of Controls • Controls are classified as: – Manual controls – Automated (or application) controls – IT general controls (ITGCs) – IT-dependent manual controls 7-14 Types of Controls 7-15Copyright John Wiley & Sons Canada, Ltd. 6 7-16 Prevent or Detect? Types of Controls • Preventative controls – Applied to AVOID errors – May not be any • physical evidence of performance, or • evidence of effectiveness of control 7-17 Types of Controls 7-18Copyright John Wiley & Sons Canada, Ltd. Examples of preventative controls  Credit check  Match to MASTER  Check to price list  Computer checking 7 Types of Controls • Detective controls – DISCOVER fraud/error that occurs – Usually applied outside normal flow of transactions 7-19 Types of Controls 7-20Copyright John Wiley & Sons Canada, Ltd. Examples of detective controls  Reconciliation  Computer checking  Periodic review  Periodic review Types of Controls • Manual controls – Do NOT rely on IT EXAMPLES? 7-21 8 Types of Controls • Automated controls rely on IT – IT General controls (ITGCs) – Application controls 7-22 Types of Controls • IT dependent manual controls – Manual + automated EXAMPLES? 7-23 Copyright John Wiley & Sons Canada, Ltd. 7-24 Test of Controls CR= low CR= moderate CR= high AR= 5\% 9 Test of Controls • Professional judgment required – Which controls to select for testing? • Effective/efficient audit evidence • Key controls  multiple WCGWs 7-25 Key ASSERTIONS Test of Controls If internal controls are NOT good, will auditors perform any control testing? NO- Auditors will test ONLY those controls that we intend to rely upon. 7-26 Test of Controls • How much testing is required? – Professional judgment • Control frequency • Degree of reliance • Persuasiveness of evidence • Significance of WCGWs • Other factors  Sampling? 7-27 10 Test of Controls • Testing must provide enough evidence that Control was effective throughout the period 7-28 Tests of Controls 7-29Copyright John Wiley & Sons Canada, Ltd. CR= low CR= moderate Test of Controls • Testing must provide enough evidence that Control was effective throughout the period When to test? 7-30 11 Documenting Internal Controls – Narratives – Flowcharts – Checklists/questionnaires 7-31 Copyright John Wiley & Sons Canada, Ltd. Example: Credit Sales Process Figure 7.5 7-32 Documenting Internal Controls Copyright John Wiley & Sons Canada, Ltd. 7-33 Documenting Internal Controls 12 Copyright John Wiley & Sons Canada, Ltd. 7-34 Documenting Internal Controls Testing Internal Controls Auditors will use various techniques – Enquiry – Observation – Inspection of physical evidence – Re-performance 7-35 CAIRORE Testing Internal Controls What will auditors be looking for? – Attribute • INSPECT signature of approval • OBSERVE  separation of duties 7-36 CAIRORE 13 Copyright John Wiley & Sons Canada, Ltd. 7-37 Test of Controls Control (compliance) testing? Substantive testing? Testing Internal Controls Is the internal control effective throughout the period of the audit? – If YES, we can continue with the audit plan 7-38 Testing Internal Controls Is the internal control effective throughout the period of the audit? – If NO, • Are there compensating controls? • Otherwise, must update assessment of CR 7-39 14 Copyright John Wiley & Sons Canada, Ltd. 7-40 Management Letters • After documentation, auditor must assess control system • Report to “those charged with governance” (CAS 260) • Auditor applies professional judgment • Includes management response 7-41 Copyright John Wiley & Sons Canada, Ltd. 7-42 Management Letter 1 Auditing- A Practical Approach Chapter 7: UNDERSTANDING AND TESTING THE CLIENT’S SYSTEM OF INTERNAL CONTROLS Test of Controls FMGT 4310 Auditing 2 7-1 Chapter 7 Learning Objectives 1. Define internal control 2. State the seven generally accepted objectives of internal control activities 3. Understand and describe the elements of internal control at the entity level 4. Identify the different types of controls 5. Explain how to select and design tests of controls 6. Explain the different techniques used to document internal controls 7-2 Chapter 7 Learning Objectives 7. Understand how to interpret the results of testing of controls 8. Explain how to document tests of controls 9. Describe the importance of identifying strengths and weaknesses in a system of internal controls 10. Explain how to communicate internal control strengths and weaknesses to those charged with governance 7-3 2 What is “internal control”? … 7-4 Internal Control Internal control is the process designed, implemented, and maintained by those charged with governance, management, and other personnel to provide reasonable assurance about the achievement of the entity’s objectives with regard to reliability of financial reporting, effectiveness and efficiency of operations, and compliance with applicable laws and regulations (CAS 315) 7-5 Objectives of Internal Controls Is an entity’s internal control effective as it relates to recording of transactions and balances? … 7-6 3 Effective internal control meets the following objectives: 1. Real – no fictitious or duplicated transactions 2. Recorded – prevent or detect omission of transactions 3. Valued – correct amounts assigned to transactions 4. Classified – transactions charged to correct account 7-7 O (occurrence) C (completeness) A (accuracy) C (classification) Effective internal control meets the following objectives: 5. Summarized – transactions summarized and totalled correctly 6. Posted – accumulated totals in transaction file are correctly transferred to the general and subsidiary ledgers 7. Timely – transactions recorded in correct accounting period 7-8 A A C (cutoff) Auditors must: • Gain understanding of internal controls systems  objectives • Identify key controls • Identify control weaknesses 7-9 4 Inherent limitations: • Human error  control breakdown • Collusion • Management override 7-10 Entity-level Internal Controls 1. Control environment 2. Entity’s risk assessment process 3. Information systems 4. Control activities 5. Monitoring of controls 7-11 Entity-level Internal Controls Consider  Small entities • Difficult to implement formal controls • Fewer resources • Segregation of incompatible functions • Reliance on owner/manager 7-12 5 Types of Controls • Controls have two main objectives: 1. To prevent/detect misstatements 2. To support the automated parts of the business 7-13 Types of Controls • Controls are classified as: – Manual controls – Automated (or application) controls – IT general controls (ITGCs) – IT-dependent manual controls 7-14 Types of Controls 7-15Copyright John Wiley & Sons Canada, Ltd. 6 7-16 Prevent or Detect? Types of Controls • Preventative controls – Applied to AVOID errors – May not be any • physical evidence of performance, or • evidence of effectiveness of control 7-17 Types of Controls 7-18Copyright John Wiley & Sons Canada, Ltd. Examples of preventative controls  Credit check  Match to MASTER  Check to price list  Computer checking 7 Types of Controls • Detective controls – DISCOVER fraud/error that occurs – Usually applied outside normal flow of transactions 7-19 Types of Controls 7-20Copyright John Wiley & Sons Canada, Ltd. Examples of detective controls  Reconciliation  Computer checking  Periodic review  Periodic review Types of Controls • Manual controls – Do NOT rely on IT EXAMPLES? 7-21 8 Types of Controls • Automated controls rely on IT – IT General controls (ITGCs) – Application controls 7-22 Types of Controls • IT dependent manual controls – Manual + automated EXAMPLES? 7-23 Copyright John Wiley & Sons Canada, Ltd. 7-24 Test of Controls CR= low CR= moderate CR= high AR= 5\% 9 Test of Controls • Professional judgment required – Which controls to select for testing? • Effective/efficient audit evidence • Key controls  multiple WCGWs 7-25 Key ASSERTIONS Test of Controls If internal controls are NOT good, will auditors perform any control testing? NO- Auditors will test ONLY those controls that we intend to rely upon. 7-26 Test of Controls • How much testing is required? – Professional judgment • Control frequency • Degree of reliance • Persuasiveness of evidence • Significance of WCGWs • Other factors  Sampling? 7-27 10 Test of Controls • Testing must provide enough evidence that Control was effective throughout the period 7-28 Tests of Controls 7-29Copyright John Wiley & Sons Canada, Ltd. CR= low CR= moderate Test of Controls • Testing must provide enough evidence that Control was effective throughout the period When to test? 7-30 11 Documenting Internal Controls – Narratives – Flowcharts – Checklists/questionnaires 7-31 Copyright John Wiley & Sons Canada, Ltd. Example: Credit Sales Process Figure 7.5 7-32 Documenting Internal Controls Copyright John Wiley & Sons Canada, Ltd. 7-33 Documenting Internal Controls 12 Copyright John Wiley & Sons Canada, Ltd. 7-34 Documenting Internal Controls Testing Internal Controls Auditors will use various techniques – Enquiry – Observation – Inspection of physical evidence – Re-performance 7-35 CAIRORE Testing Internal Controls What will auditors be looking for? – Attribute • INSPECT signature of approval • OBSERVE  separation of duties 7-36 CAIRORE 13 Copyright John Wiley & Sons Canada, Ltd. 7-37 Test of Controls Control (compliance) testing? Substantive testing? Testing Internal Controls Is the internal control effective throughout the period of the audit? – If YES, we can continue with the audit plan 7-38 Testing Internal Controls Is the internal control effective throughout the period of the audit? – If NO, • Are there compensating controls? • Otherwise, must update assessment of CR 7-39 14 Copyright John Wiley & Sons Canada, Ltd. 7-40 Management Letters • After documentation, auditor must assess control system • Report to “those charged with governance” (CAS 260) • Auditor applies professional judgment • Includes management response 7-41 Copyright John Wiley & Sons Canada, Ltd. 7-42 Management Letter Auditing- A Practical Approach Chapter 13: COMPLETING AND REPORTING ON THE AUDIT FMGT 4310 Auditing 2 Chapter 13 Learning Objectives 1. Explain the procedures performed as part of the engagement wrap-up 2. Understand the considerations when assessing the going concern assumption 3. Understand the purpose of and the procedures performed in the review for contingent liabilities and commitments 4. Compare the two types of (material) subsequent events to determine what effect they have on the financial statements (if any) 13-2 Chapter 13 Learning Objectives 5. Analyze misstatements and explain the difference between quantitative and qualitative considerations when evaluating misstatements 6. Evaluate conclusions obtained during the performance of the audit and explain how these conclusions link to the overall opinion 7. Describe the components of an audit report 8. Identify the types of modifications to an audit report 13-3 Chapter 13 Learning Objectives 9. Explain what reporting is required to management and those charged with governance 10. Understand the various types of other engagements that auditors may be asked to perform (Appendix 13) 13-4 • The auditor must gather sufficient, appropriate, audit evidence (SAAE- GAAS) to support the opinion. • Must consider problem areas that may have arisen during the course of the audit. 13-5 OBJECTIVE OF FIELD WORK Engagement Wrap-Up • Has there been any change in the assessment of RMM? • If there have been misstatements or control deviations – Explanation why? – Does this change RMM assessment? 13-6 Engagement Wrap-Up • Do we need to revise materiality? Consider: – Changes in client circumstances – New users (e.g. new lender) – Posting of audit adjustments  NI 13-7 Engagement Wrap-Up • Administrative issues Consider: – Clearing all outstanding review notes – Obtaining and reviewing working papers from other auditors – Finalizing working paper files 13-8 Final Analytical Procedures • Useful as a final review for material misstatements or financial problems not noted during other testing. • Final objective look at the financial statements. 13-9 Going Concern Assumption • What is the going concern assumption? 13-10 Evaluation of Going Concern Assumption • Management must prepare an assessment of going concern. • Auditor must consider the reasonableness of this assessment (CAS 570) 13-11 Evaluation of Going Concern Assumption • Results of analytical review and overall financial statement review will guide the auditor with respect to risks of business failure. • Further queries and follow-up will be used where liquidity problems surface. 13-12 Evaluation of Going Concern Assumption • Conditions which could cast doubt on the entity’s ability to continue as a going concern: – Serious deficiencies in working capital; – Inability to obtain financing sufficient for continued operations; – Inability to comply with the terms of existing loan agreements; – The possibility of an adverse outcome of one or more contingencies; – A plan to significantly curtail or liquidate operations. 13-13 Evaluation of Going Concern Assumption NOT a going concern? Clean opinion? Disclosure 13-14 Contingent liabilities • What are contingent liabilities? “Existing conditions” “Future liability” Contingent liabilities • What are the auditor’s responsibilities? (CAS 501) • Primary assertion(s)? Searching for contingent liabilities • What audit procedures are commonly performed in the search for contingent liabilities? • What evidence? • … specific procedures?  Inspect…? Searching for contingent liabilities – Inquire of management – Review/inspect minutes of shareholders’ and directors’ meetings – Read/inspect contracts, agreements, and related correspondence What will auditors be looking for? Importance of analyzing legal expense • A close analysis of the legal expense account is an important part of the search for unrecorded contingent liabilities or commitments Why? 13-19 Confirmation from client’s lawyer(s) • Important procedure • Contact all lawyers that are known to be working for the client Claims vs. Possible claims 13-20 Legal Inquiry Letter- Format • Formatted as an letter from the client • Management assessment of outstanding AND possible claims • Lawyer to reply to client, cc auditor • The information that lawyers can provide is limited due to their requirement to hold client information as confidential 13-21 Evaluating known contingent liabilities • What is the likelihood of the potential liability? • What is the amount of the potential liability? The evaluation of these two factors will determine the necessary disclosure and/or adjustment. Likely/probable? Measurable?  DISCLOSURE? Subsequent Events • What are subsequent events? • Why are auditors concerned with subsequent events? Adjustment vs. Disclosure 13-23 Subsequent Events Review Period 13-24 ----|----------------------------|----------------|------| Year Approved Audit Issued End by Mgmt Report |----- / /---------------------------|----------------| Subsequent events period • Where there is a subsequent event that has a direct effect on the financial statements – Is an adjustment required? IF it arises from conditions that existed at the balance sheet date.. YES 13-25 Subsequent Events Type 1 • Where there is a subsequent event that has no direct effect on the financial statements. i.e. Conditions that did not exist as of the balance sheet date but, is an adjustment required? NO- but if they are so significant they may require disclosure 13-26 Subsequent Events Type 2 Subsequent Events Evidence • Subsequent events audit evidence includes…? • May lead to the “dual dating” of the audit report. 13-27 • Consider differences due to • Wrong amount • Classification, or • Presentation/Disclosure • Misstatement due to fraud vs. error • Material? 13-28 Misstatements Adjustment required? 12-29 • Explanation of the audit process • Conclusions reached • Formal communication 13-30 Audit Report 1. Report Title 2. Addressee 3. Opinion Paragraph 4. Basis for Opinion 5. Key Audit Matters 6. Management Responsibility 7. Auditor Responsibility 8. Other Reporting responsibilities 9. Name of public accounting firm 10.Date of the auditor’s report 11.Auditor’s address 13-31 Audit Report “Clean”(CAS 700)  Optional unless required by law/regulation (CAS 701) Areas of high RMM Significant auditor judgement Effect of significant events Responsibilities of management going concern Material uncertainty related to going concern 13-32 Going Concern Inserted before Key Audit Matters Modifications? • Consider: • Emphasis of matter • Scope limitation • GAAP deviation 13-33 Audit Report Does not affect opinion Future actions/events 12-34 GAAP Scope Emphasis of Matter Auditor Communications The auditor must communicate with management and/or the audit committee with respect to: • Illegal acts • Material misstatements • Reportable internal control conditions (internal control deficiencies that could lead to material errors) 13-35 “..those charged with governance” (CAS 260) Auditor Communications The auditor must communicate with the audit committee with respect to: • Significant disagreements with management; • Serious difficulties encountered while performing the audit; and • Any matter that has a significant effect on the qualitative aspects of the accounting principles used in the financial statements. 13-36 Auditor Communications The auditor is also required to communicate at least annually with the audit committee: • Confirmation of the auditor’s independence. • Disclosure of all direct and indirect relationships between the auditor and the entity. • If the entity is publicly accountable, disclosure of the total fees charged for audit and non-audit services provided by the auditor to the entity during the last year. 13-37 Auditing- A Practical Approach Chapter 12: AUDITING CASH, and INVESTMENTS FMGT 4310 Auditing 2 12-1 Chapter 12 Learning Objectives 1. Identify the audit objectives applicable to cash 2. Discuss considerations relevant to determining the audit strategy for cash 3. Design and execute an audit program for cash balances 4. Describe special considerations when auditing cash balances, including lapping, petty cash funds, and imprest bank accounts 12-2 Chapter 12 Learning Objectives 5. Identify the audit objectives applicable to investments 6. Discuss considerations relevant to determining the audit strategy for investments 7. Design and execute an audit program for investments 8. Explain the special considerations applicable to the audit of investments in subsidiaries, associates and joint ventures 12-3 Audit Objectives Key Issues • Cash – EXISTS – Is OWNED – Properly Disclosed  E, R, P/D 12-4 Types of Cash Accounts • General cash account • Imprest payroll account • Branch bank account • Imprest petty cash fund • Cash equivalents (term deposits) 12-5 Types of cash accounts 12-6 Relationship between cash and transaction cycles • Is there such a thing as a “cash cycle”? No 12-7 Relationship between cash and transaction cycles • the General Cash account is considered significant in almost all audits, even when the ending balance is immaterial Why? 12-8 Relationship between cash and transaction cycles • Is it necessary to specifically audit cash transactions? No  Sales cycle  Purchases cycle 12-9 12-10 Payments and Receipts 12-11 12-12 Assess materiality and IR Methodology- Designing Test of Details Assess CR Design/perform Control tests Design/perform Analytics Design Tests of Detail: •Audit procedures •Sample size •Items to select •Timing Identify at risk assertions FOR EACH ASSERTION: 12-13 INHERENT Risk of misstatement or fraud • How does cash differ from other asset accounts? • Why is there generally more risk? 12-14 Audit of the general cash account 1. Assess controls over the related transaction cycles 2. Assess controls over the preparation of independent bank reconciliations 3. Test key controls to be relied upon 4. Analytical procedures may be reduced if the year end bank reconciliation is audited 100\% 5. Design and conduct audit procedures of year end cash balances General Cash Account Internal Controls • Controls over the transaction cycles: • Appropriate controls over the receipts of cash (sales and other receipts) and, • Appropriate controls over disbursements (payments to suppliers, employees and others) SALES CYCLE PURCHASES CYCLE Audit of other transaction cycles can discover errors associated with cash • Examples of such errors include: • Failure to bill a customer • Billing customer at an incorrect price • Duplicate payment of a vendor’s invoice • Payment for raw materials not received What transaction cycles do these errors relate to? General Cash Account Internal Controls • Controls over the balance: • Independent bank reconciliations • Timely completion • Bank statements should be forwarded unopened to the independent reconciler • Review of the completed reconciliation by a responsible person What is a bank reconciliation? 12-19 12-20 • Bank debit memo that should have been charged to a different customer. • A cheque written out for $100 more than the amount on the vendor’s invoice. • Cash recorded as a deposit in the GL bank account, but stolen before it is deposited in the bank. Which of the following errors will be uncovered by a bank reconciliation? 12-21 Auditing Strategy Substantively verify General Cash – Audit the bank reconciliation – Trace to subsequent bank statement – Agree the GL bank balance to the bank confirmation – Cash count 12-22 Auditing Strategy What will auditors do with the subsequent bank statement? 12-23 What is a bank Confirmation? 12-24 Client authorization Loans Deposits Copyright John Wiley & Sons Canada, Ltd. 12-25 Copyright John Wiley & Sons Canada, Ltd. 12-26 Bank confirmation Auditor controls the sending of the bank confirmation and has it directly returned to the auditor’s office Why? 12-27 Auditing Strategy How do we audit the bank reconciliation? 12-28 Cash count WCGW? Procedures? 12-29 Fraud-Oriented Procedures • Proof of cash • Tests for lapping • Tests for kiting 12-30 Audit of Payroll Cash Account Easy to perform if • an imprest account is used, and • the bank reconciliation is current 12-31 Petty Cash • Balance is frequently immaterial, however may be audited because of • Susceptibility to defalcation • Client expectations 12-32 Internal Controls Over Petty Cash • Responsibility of a single individual • Funds should be kept separate from other activities • Properly documented and authorized 12-33 Audit Objectives Key Issues • Investments – EXIST – OWNED – Properly Valued and Disclosed  E, R, V, P/D 12-34 Investments • Purpose? 1) Surplus funds 2) LT relationship 12-35 Investments • Stocks (equity)  dividends • Bonds (debt)  interest 12-36 12-37 12-38 Investments Internal Controls Control environment: • Authority Treasurer • Information systems • Internal audit Investments Internal Controls Clear policies for • purchase/sale approval • handling of $$ • accounting • physical security Auditing Strategy Low transaction volume Substantively verify Investments • verify opening balances • vouch sales/purchases • vouch income • count securities 12-41 Auditing Strategy Consolidation? 12-42Copyright John Wiley & Sons Canada, Ltd. Auditing- A Practical Approach Chapter 11: AUDITING INVENTORIES, and PROPERTY, PLANT and EQUIPMENT FMGT 4310 Auditing 2 Chapter 10 Learning Objectives 1. Identify the audit objectives applicable to inventories 2. Describe the functions and control procedures normally found for custody and maintenance of inventory records 3. Discuss considerations relevant to determining the audit strategy for inventories 4. Design a substantive audit program for inventories 10-2 Chapter 10 Learning Objectives 5. Identify the audit objectives applicable to properly, plant, and equipment 6. Discuss considerations relevant to determining the audit strategy for property, plant, and equipment 7. Design a substantive audit program for property, plant, and equipment 10-3 Property Plant and Equipment (PPE) • Expected lives > one year • Used in the business • Not acquired for resale 10-5 10-6 10-7 Fixed assets vs. Current asset accounts • How does the nature of fixed asset accounts (e.g. building) differ from other current assets (e.g. inventory)? • Consider: – Frequency of transactions – Size of transactions CR assessment? Other Audit considerations IR considerations: –Vulnerability to theft –Estimates for useful life –Depreciation methods Other Audit considerations • Emphasis is on auditing current period acquisitions • Why? Tracking Fixed Assets • How do large organizations track fixed assets? • How do smaller organizations track fixed assets? Other Audit considerations • Traced to the capital cost allowance section of the tax working papers • Amortization and accumulated amortization accounts are also verified • Other accounts that are verified in a similar manner include: patents, copyrights, catalogue costs Categories of audit tests conducted for fixed assets and related accounts • Verification of: – Current-year acquisitions – Current-year disposals – The ending balance in the asset account – Amortization expense – The ending balance in accumulated amortization Verification of current year acquisitions • WCGW? • Capitalization policy • Continuity schedule • Examination of supporting documentation • Important Assertions? Verification of current year disposals • WCGW? • The most important internal control? • The most important audit procedures? • Important Assertions? Verification of asset balances • Is it necessary to verify fixed assets acquired in prior years? • Important Assertions? • Impairment? Verification of amortization expense • Internal allocations vs. exchange transactions with outside parties • Primary audit objectives: – Consistent amortization policy (occurrence) – Accurate calculations (accuracy) Verification of accumulated amortization • Opening balances • Debits to account • Credits to account Analytical procedures for Fixed Assets Analytical procedure Potential misstatement detected Compare amortization expense divided by gross fixed asset cost with previous years Misstatement in amortization expense and accumulated amortization Compare accumulated amortization divided by gross fixed asset cost with previous years Misstatement in accumulated amortization Analytical procedures for Fixed Assets Analytical procedure Potential misstatement detected Compare monthly or annual repairs and maintenance, supplies expense, small tools expense, and similar accounts with previous years Expensing amounts that should be capital items Compare gross manufacturing cost divided by some measure of production with previous years Idle equipment or equipment that has been disposed of but not written off Inventory • Used in the business • Acquired for resale Audit Objectives Key Issues • Inventory – EXISTS – Is OWNED – Properly VALUED  E, R, V 10-22 10-23  Purchases  Sales 10-24 Business functions in the Inventory cycle • Process purchase orders • Receive new materials • Store materials • Process goods • Store finished goods • Ship finished goods 10-25Manufacturing entity Inventory Audit Transaction Cycle Acquire/record raw materials, labour Internally transfer assets and costs Ship goods, record revenue/costs Physically observe inventory Price and compile inventory Purchases, Payroll Inventory Sales receipts Inventory Inventory 10-26 Inventory Audit Transaction Cycle Acquire/record raw materials, labour Internally transfer assets and costs Ship goods, record revenue/costs Physically observe inventory Price and compile inventory Purchases, Payroll Inventory Sales receipts Inventory Inventory Cost accounting Physical controls 10-27 Business functions in the Inventory cycle Consider: • Perpetual vs. Periodic inventory systems • Cost accounting systems – E.G. Job costing, standard costing 10-28 Key Internal Controls in the Inventory cycle • Segregate CUSTODY and RECORDING  WCGW? 10-29 Key Internal Controls in the Inventory cycle • Receiving reports • WCGW? 10-30 Key Internal Controls in the Inventory cycle • Internal transfers  WCGW? 10-31 Inventory Audit Transaction Cycle Acquire/record raw materials, labour Internally transfer assets and costs Ship goods, record revenue/costs Physically observe inventory Price and compile inventory Purchases, Payroll Inventory Sales receipts Inventory Inventory 10-32 Key Internal Controls in the Inventory cycle • Shipping reports • WCGW? 10-33 Inventory Audit Transaction Cycle Acquire/record raw materials, labour Internally transfer assets and costs Ship goods, record revenue/costs Physically observe inventory Price and compile inventory Purchases, Payroll Inventory Sales receipts Inventory Inventory 10-34 Key Internal Controls in the Inventory cycle • Compare Physical Inventory to Inventory Records • WCGW? 10-35 Consider: • Assigning and communicating responsibility • Preparing the warehouse • Identifying the inventory • Counting Inventory Count Procedures 10-36 Inventory Audit- Transaction Cycle Acquire/record raw materials, labour Internally transfer assets and costs Ship goods, record revenue/costs Physically observe inventory Price and compile inventory Purchases, Payroll Inventory warehousing Sales receipts Inventory warehousing Inventory warehousing 10-37 Merchandise inventory, or Manufactured inventory Pricing and Compilation of Inventory 10-38 Units counted  $$ For Manufactured inventory: • Raw materials costing • FIFO, LIFO, weighted average • Direct labour • Overhead • WIP  Finished goods • Finished goods  COGS Pricing and Compilation of Inventory 10-39 Auditing Strategy – Usually a major item on the balance sheet – Inventory items could be at different locations – Very diverse items  how can it be counted? – Valuation  obsolescence – Valuation methods 10-40 Assess materiality and IR Methodology- Designing Test of Details Assess CR (for various cycles) Design/perform Control tests Design/perform Analytics Design Tests of Detail: •Audit procedures •Sample size •Items to select •Timing Identify at risk assertions FOR EACH ASSERTION: 10-41 10-42 Incompatible functions? 10-43 Inventory count Compilation Designing Tests of Controls for Cost Accounting Important General Controls: • Access control to cost accounting system software (passwords) • Controls over systems updating and development 10-44 Designing Tests of Controls for Cost Accounting Important Specific Controls: • Standard costing systems, variance analysis • Independent review, reporting 10-45 Designing Tests of Physical Controls Important Physical Controls: • Restricted access • Environmental controls- temperature, etc. • Controls over the allocation and use of inventory 10-46 Inventory Audit- Transaction Cycle Acquire/record raw materials, labour Internally transfer assets and costs Ship goods, record revenue/costs Physically observe inventory Price and compile inventory Purchases, Payroll Inventory warehousing Sales receipts Inventory warehousing Inventory warehousing 10-47 10-48 Substantive Procedures Copyright John Wiley & Sons Canada, Ltd. Auditing Strategy How to audit Existence of inventory? Rely on perpetual records? CR must be LOW 10-49 Auditing Strategy How to audit Existence of inventory? Observe count near YE, roll forward? CR must be LOW-MODERATE 10-50 Auditing Strategy How to audit Existence of inventory? Observe count at YE? Substantive approach 10-51 Consider: • Checking the count • Clearing the inventory • Recording • Cut-off • Recounts? Inventory Observation 10-52 Inventory Observation • It is essential that the auditor have a complete understanding of the client’s physical inventory procedures and controls before the inventory-taking begins.  Why? 10-53 Tests of Details for Physical Inventory Observation: Existence • Does the inventory counted as part of the inventory count actually exist? “Sheet  Floor” 10-54 Tests of Details for Physical Inventory Observation: Completeness • Has all inventory been counted, and included in the inventory balance? “Floor  Sheet” 10-55 Tests of Details for Physical Inventory Observation: Valuation & Allocation • Is there any damaged, non- saleable, or obsolete inventory? (i.e. “rust or dust”) • Has the counted inventory been classified correctly? (e.g. raw materials, work in progress, finished goods) 10-56 Tests of Details for Physical Inventory Observation: Rights and Obligations • How do we test that the company has a right (i.e. owns) to the inventory that is included in the count? inquiry, observation What evidence can we inspect? 10-57 Tests of Details for Physical Inventory Observation: (Purchases) Cut-off • Have the sales (inventory consumption) and purchases (inventory accumulation) recorded in the correct period?  Matching Principle 10-58 Tests of Details for Pricing and Compilation • Inventory listing agrees with physical counts, • additions/extensions are correct, (quantity x cost) and • agrees with General Ledger 10-59 1 Auditing- A Practical Approach Chapter 8: EXECUTION OF THE AUDIT – PERFORMING SUBSTANTIVE PROCEDURES FMGT 4310 Auditing 2 Chapter 8 Learning Objectives 1. Define substantive audit procedures 2. Understand the link between the audit risk model and the nature, timing, and extent of substantive procedures 3. Provide examples of different substantive audit procedures 4. Explain the different levels of audit evidence obtained when performing substantive procedures 5. Describe the documentation of the conclusions reached as a result of performing substantive procedures 8-2 What are “substantive procedures”? 8-3 2 Tests of details to detect Misstatements OVER, or UNDER 8-4 - inspection (physical examination) - confirmation - observation - enquiries of client - reperformance - recalculation - analytical procedures Types of evidence 8-5 CAIRORE Substantive Procedures • Can we complete an audit using ONLY substantive procedures? • Yes, but… 8-6 3 audit risk = x x inherent risk control risk planned detection risk Risks of Material Misstatement Substantive Procedures Audit Risk Model 8-8 Copyright John Wiley & Sons Canada, Ltd. Nature, extent of timing of substantive procedures is determined by: RMM- Risk of material misstatement –Level of assurance needed? –Persuasiveness of evidence available? –Complexity of client systems 8-9 Substantive Procedures 4 e.g., Warranty provision – risk that some claims are omitted is higher than risk of incorrect measurement of identified claims • Affects both extent and timing of tests – For warranty provision » More extensive tests of completeness assertion needed than valuation & allocation assertion » Completeness tests more likely near year end, valuation & allocation tests of identified claims could be done at interim date 8-10 Substantive Procedures Primary risk of OVERSTATEMENT or UNDERSTATEMENT? When to perform? what is CR assessment? –Typically at YE –If at interim – roll forward procedures 8-11 Substantive Procedures 8-12 Copyright John Wiley & Sons Canada, Ltd. Substantive Procedures P la n n e d 5 Auditors will use various techniques  INSPECTION of supporting documents 8-13 Substantive Procedures CAIRORE Direction of INSPECTION will determine what assertion is being tested – Vouching • Occurrence (Existence) – Tracing • Completeness 8-14 Substantive Procedures Direction of Tests for Sales 12- 15 C cradle to grave grave to cradle O Substantive Procedures 6 How much of the balance should be examined? Professional judgment • RMM • Evidence available • Sampling? 8-16 Substantive Procedures Why do auditors perform analytical procedures? • Audit planning • Substantive testing • Audit completion 8-17 Substantive Procedures What are analytical procedures? 8-18 • Absolute data comparisons (prior year, budgets etc.) • Ratio analysis (activity, liquidity, profitability, leverage) • Trend analysis (over several accounting periods) • Common-size financial statements • Break-even analysis • Pattern analysis and regression (most sophisticated) Substantive Procedures 7 Analytical procedures • e.g., Rent expense • Vouch twelve months of payments, or…? 8-19 Substantive Procedures Risk of OVERSTATEMENT or UNDERSTATEMENT? Use of computers- CAATS • examine client files • plan, perform evaluate May depend on CR 8-20 Substantive Procedures Analytical procedures • Primary (persuasive) • Corroborative • Minimal 8-21 Substantive Procedures 8 • Evidence from different types of substantive procedures varies in persuasiveness 1. Persuasive evidence • Is suitable as primary test of balance • Provides a reasonable estimate of balance, enabling auditor to conclude whether or not the account balance is free from material errors • No further procedures required Copyright John Wiley & Sons Canada, Ltd. Levels of Evidence 8-22 Copyright John Wiley & Sons Canada, Ltd.Table 8.2 8-23 2. Corroborative • Confirms audit findings from other procedures • Supports management representations or otherwise decreases the level of audit skepticism • Allows auditor to limit extent of other procedures in the area • Unexpected results would require auditor to expand other substantive audit procedures to provide explanation of result Copyright John Wiley & Sons Canada, Ltd. Levels of Evidence 8-24 9 Copyright John Wiley & Sons Canada, Ltd. 8-25 3. Minimal • Not persuasive or corroborative • e.g., simple comparison with previous year to help identify problems, not to reduce other testing – Usefulness of procedure to generate more persuasive evidence depends on circumstances such as complexity of client and extent of fluctuations in particular account balance Copyright John Wiley & Sons Canada, Ltd. Levels of Evidence 8-26 Copyright John Wiley & Sons Canada, Ltd. 8-27 10 Substantive Procedures Misstatements? – Errors (including fraud), vs – Judgmental misstatements – Isolated “one off” events, vs – Systematic breakdowns 8-28 Auditing- A Practical Approach Chapter 10: AUDITING PURCHASES, PAYABLES, AND PAYROLL FMGT 4310 Auditing 2 Chapter 10 Learning Objectives 1. Identify the audit objectives applicable to purchases, payables and payroll 2. Describe the functions and control procedures normally found in information systems for processing purchase, payment and purchase adjustment transactions 3. Describe the functions and control procedures normally found in information systems for payroll transactions 10-2 Chapter 10 Learning Objectives 4. Discuss considerations relevant to determining the audit strategy for purchases, payables, and payroll 5. Indicate the factors relevant to determining an acceptable level of detection risk for the audit of purchases, payables, and payroll 6. Design a substantive audit program for purchases, payables, and payroll 10-3 Audit Objectives Key Issues • Purchases are all recorded and not understated • Payables that are derived from the purchases are fully recorded as a liability  C (COMPLETENESS) 10-4 10-5 10-6 10-7 Business functions in the Purchases and Payments cycle What are the typical business functions? • “purchases” • “payables” • “payments” 10-8 Business functions in the Purchases and Payments cycle Key functions – requisitioning goods and services – preparing purchase orders – receiving the goods – storing goods received for inventory – checking and approving the supplier’s invoice – recording the liability 10-9 Business functions in the Purchases and Payments cycle Key functions  Purchase requisition 10-10 Who should prepare purchase requisitions?How many copies? Business functions in the Purchases and Payments cycle Key functions  Purchase order 10-11 Who should prepare purchase orders? How many copies? Business functions in the Purchases and Payments cycle Key functions  Receiving report 10-12 Who should prepare receiving reports? How many copies? Business functions in the Purchases and Payments cycle Key functions  Vendor Invoice 10-13 Who should receive invoices? Procedures? Business functions in the Purchases and Payments cycle Key functions  Recording AP – AP Master file – Supplier statements – Review/oversight (budgets?) – Incompatible functions? 10-14 Recording / Custody / Authorization / Reconciliation Business functions in the Purchases and Payments cycle Key functions  Paying AP – Regular cheque runs – Supporting documents 10-15 Who should sign cheques? Business functions in the Purchases and Payments cycle Key functions  Other control procedures – Independent review – Independent bank reconciliations 10-16 What is the Human Resources and Payroll cycle? 10-17 Business functions in the Human Resources and Payroll cycle • Personnel evaluation and hiring • Master file changes (semi-permanent information) • Timekeeping and payroll preparation • Payment of payroll • Employee withholdings and benefit remittances 10-18 Business functions in the Human Resources and Payroll cycle • Personnel evaluation and hiring – Résumé – Interview(s) – Offer/contract – Employee Master File – TD1 10-19 Who should process payroll? Business functions in the Human Resources and Payroll cycle • Master file changes (semi- permanent information) 10-20 What information? Authorization for changes? Business functions in the Human Resources and Payroll cycle • Timekeeping and payroll preparation 10-21 Authorization of hours? Termination? Business functions in the Human Resources and Payroll cycle • Payment of payroll 10-22  Imprest account Who should distribute cheques? Business functions in the Human Resources and Payroll cycle 10-23 Who should review? Business functions in the Human Resources and Payroll cycle • Employee withholdings and benefit remittances 10-24 Funds in trust Set materiality and Assess IR Methodology- Designing Test of Details Assess CR Design/perform Control tests Design Tests of Detail: •Audit procedures •Sample size •Items to select •Timing Purchases/Payments & HR/Payroll Cycles Assess Inherent risk • Pressures on management to: • Over or understate Purchases? • Over or understate AP? • Other inherent risk factors • Major expense • High volume of transactions • Employee theft/false payroll 10-26 Procurement fraud? Over or Under statement? Assess Control risk • Is CR LESS than maximum? • Must assess WCGW for each assertion 10-27 Purchases/Payments & HR/Payroll Cycles COCCA CERV 10-28 Purchases/Payments Cycle Procurement fraud? 10-29 Purchases/Payments Cycle 10-30 Purchases/Payments Cycle Procurement fraud? 10-31 HR/Payroll Cycle Overpayment O 10-32 HR/Payroll Cycle Control testing  Test of Operating Effectiveness Is the control effective for the entire period of audit? May also provide substantive evidence i.e. “Dual purpose” tests 10-33 Purchases/Payments & HR/Payroll Cycles 10-34 Purchases/Payments & HR/Payroll Cycles 10-35 Purchases/Payments & HR/Payroll Cycles 10-36 Purchases/Payments & HR/Payroll Cycles • Transactions that occur throughout the year. • Accounts payable  balance sheet. • Material balance? Substantive Testing 10-37 1.Initial Procedures – Trace opening AP balances – Review activity – Agree year end accounts payable to the GL trial balance Substantive Testing 10-38 1.Initial Procedures • AP listing as at balance sheet date – Check arithmetic – Agree to GL control account – Agree supplier balances to AP subledger Substantive Testing 10-39 2.Analytical Procedures – Review understanding of entity  expectations? – Year to year comparisons, ratio analysis – Are actual results consistent with expectations? Substantive Testing 10-40 Key ratios/analytics? 2.Analytical Procedures – Persuasive evidence for payroll expenses? Substantive Testing 10-41 Key calculations? 3.Tests of Details of Transactions - Vouch purchases to supporting transactions, OR - Trace supporting documents to purchases  sample? - Test purchases cut off Unmatched PO’s, receiving reports Substantive Testing 10-42 O C Co Accounts Payable 10-43 • How does the audit of AP differ from the audit of AR? –Overstatement vs. Understatement Existence vs. Completeness Accounts Payable 10-44 • Substantive testing –Reconciling supplier statements –Confirmations –Subsequent payments Which suppliers? • What is the approach for selecting AP items for confirmation? –Large account balances? –Small account balances? –Significant vendors Accounts Payable 10-45 • Search for unrecorded liabilities –Review subsequent payments –Discussions with management • Contingencies? Accounts Payable 10-46 4. Presentation & Disclosure – GAAP requirements – Management representation letter Substantive Testing 10-47 Auditing- A Practical Approach Chapter 7: UNDERSTANDING AND TESTING THE CLIENT’S SYSTEM OF INTERNAL CONTROLS Test of Controls FMGT 4310 Auditing 2 7-1 Chapter 7 Learning Objectives 1. Define internal control 2. State the seven generally accepted objectives of internal control activities 3. Understand and describe the elements of internal control at the entity level 4. Identify the different types of controls 5. Explain how to select and design tests of controls 6. Explain the different techniques used to document internal controls 7-2 Chapter 7 Learning Objectives 7. Understand how to interpret the results of testing of controls 8. Explain how to document tests of controls 9. Describe the importance of identifying strengths and weaknesses in a system of internal controls 10. Explain how to communicate internal control strengths and weaknesses to those charged with governance 7-3 What is “internal control”? … 7-4 Internal Control Internal control is the process designed, implemented, and maintained by those charged with governance, management, and other personnel to provide reasonable assurance about the achievement of the entity’s objectives with regard to reliability of financial reporting, effectiveness and efficiency of operations, and compliance with applicable laws and regulations (CAS 315) 7-5 Objectives of Internal Controls Is an entity’s internal control effective as it relates to recording of transactions and balances? … 7-6 Effective internal control meets the following objectives: 1. Real – no fictitious or duplicated transactions 2. Recorded – prevent or detect omission of transactions 3. Valued – correct amounts assigned to transactions 4. Classified – transactions charged to correct account 7-7 O (occurrence) C (completeness) A (accuracy) C (classification) Effective internal control meets the following objectives: 5. Summarized – transactions summarized and totalled correctly 6. Posted – accumulated totals in transaction file are correctly transferred to the general and subsidiary ledgers 7. Timely – transactions recorded in correct accounting period 7-8 A A C (cutoff) Auditors must: • Gain understanding of internal controls systems  objectives • Identify key controls • Identify control weaknesses 7-9 Inherent limitations: • Human error  control breakdown • Collusion • Management override 7-10 Entity-level Internal Controls 1. Control environment 2. Entity’s risk assessment process 3. Information systems 4. Control activities 5. Monitoring of controls 7-11 Entity-level Internal Controls Consider  Small entities • Difficult to implement formal controls • Fewer resources • Segregation of incompatible functions • Reliance on owner/manager 7-12 Types of Controls • Controls have two main objectives: 1. To prevent/detect misstatements 2. To support the automated parts of the business 7-13 Types of Controls • Controls are classified as: – Manual controls – Automated (or application) controls – IT general controls (ITGCs) – IT-dependent manual controls 7-14 Types of Controls 7-15Copyright John Wiley & Sons Canada, Ltd. 7-16 Prevent or Detect? Types of Controls • Preventative controls – Applied to AVOID errors – May not be any • physical evidence of performance, or • evidence of effectiveness of control 7-17 Types of Controls 7-18Copyright John Wiley & Sons Canada, Ltd. Examples of preventative controls  Credit check  Match to MASTER  Check to price list  Computer checking Types of Controls • Detective controls – DISCOVER fraud/error that occurs – Usually applied outside normal flow of transactions 7-19 Types of Controls 7-20Copyright John Wiley & Sons Canada, Ltd. Examples of detective controls  Reconciliation  Computer checking  Periodic review  Periodic review Types of Controls • Manual controls – Do NOT rely on IT EXAMPLES? 7-21 Types of Controls • Automated controls rely on IT – IT General controls (ITGCs) – Application controls 7-22 Types of Controls • IT dependent manual controls – Manual + automated EXAMPLES? 7-23 Copyright John Wiley & Sons Canada, Ltd. 7-24 Test of Controls CR= low CR= moderate CR= high AR= 5\% Test of Controls • Professional judgment required – Which controls to select for testing? • Effective/efficient audit evidence • Key controls  multiple WCGWs 7-25 Key ASSERTIONS Test of Controls If internal controls are NOT good, will auditors perform any control testing? NO- Auditors will test ONLY those controls that we intend to rely upon. 7-26 Test of Controls • How much testing is required? – Professional judgment • Control frequency • Degree of reliance • Persuasiveness of evidence • Significance of WCGWs • Other factors  Sampling? 7-27 Test of Controls • Testing must provide enough evidence that Control was effective throughout the period 7-28 Tests of Controls 7-29Copyright John Wiley & Sons Canada, Ltd. CR= low CR= moderate Test of Controls • Testing must provide enough evidence that Control was effective throughout the period When to test? 7-30 Documenting Internal Controls – Narratives – Flowcharts – Checklists/questionnaires 7-31 Copyright John Wiley & Sons Canada, Ltd. Example: Credit Sales Process Figure 7.5 7-32 Documenting Internal Controls Copyright John Wiley & Sons Canada, Ltd. 7-33 Documenting Internal Controls Copyright John Wiley & Sons Canada, Ltd. 7-34 Documenting Internal Controls Testing Internal Controls Auditors will use various techniques – Enquiry – Observation – Inspection of physical evidence – Re-performance 7-35 CAIRORE Testing Internal Controls What will auditors be looking for? – Attribute • INSPECT signature of approval • OBSERVE  separation of duties 7-36 CAIRORE Copyright John Wiley & Sons Canada, Ltd. 7-37 Test of Controls Control (compliance) testing? Substantive testing? Testing Internal Controls Is the internal control effective throughout the period of the audit? – If YES, we can continue with the audit plan 7-38 Testing Internal Controls Is the internal control effective throughout the period of the audit? – If NO, • Are there compensating controls? • Otherwise, must update assessment of CR 7-39 Copyright John Wiley & Sons Canada, Ltd. 7-40 Management Letters • After documentation, auditor must assess control system • Report to “those charged with governance” (CAS 260) • Auditor applies professional judgment • Includes management response 7-41 Copyright John Wiley & Sons Canada, Ltd. 7-42 Management Letter Auditing- A Practical Approach Chapter 6: SAMPLING AND OVERVIEW OF THE RISK RESPONSE PHASE OF THE AUDIT FMGT 4310 Auditing 2 Chapter 6 Learning Objectives 1. Explain how audit sampling is used in an audit 2. Understand the difference between sampling and non-sampling risk 3. Differentiate between statistical and non- statistical sampling 4. Describe sampling methods and the factors to be considered when choosing a sample 5. Determine the factors that influence the sample size when testing controls 6-2 Chapter 6 Learning Objectives 6. Determine the factors that influence the sample size when substantive testing and consider techniques used to perform substantive tests 7. Outline how to evaluate the results of tests conducted on a sample 8. Understand the difference between tests of controls and substantive tests 9. Explain the factors that impact the nature, timing, and extent of audit testing 6-3 What is “sampling” ? 6-4 Importance of Sampling to Auditors • The auditor doesn’t look at everything… just selected pieces. • In some circumstances, the auditor CANNOT look at everything. 6-5 Purpose of Sampling Why? 6-6 Reasonable assurance Cost vs. Benefit Auditors will take a sample when: • A decision must be made about the balance or class of transactions. • The nature and materiality of the balance or class of transactions does not demand a 100\% audit. • The time and cost to audit 100\% of the population would be too great. 6-7 Professional judgement Sampling is Used to Conduct: • “Walk through” tests (to understand internal controls) • Tests of controls • Tests of details 6-8 The objective is to select a sample that is representative of the population as a whole. i.e. representative sampling 6-9 Representative sampling Representative sampling If the sample turns out to be different than the population as a whole, then it is NOT representative Is this a problem? 6-10 Non-representativeness can occur due to: → Sampling risk → Non-sampling risk 6-11 Representative sampling Table 6.1 6-12Copyright John Wiley & Sons Canada, Ltd. Representative sampling → Sampling Risk Control Tests Increased AR Inefficient audit 6-13 Representative sampling → Sampling Risk Detail Tests Sampling risk could result in: • auditor concludes financial statements NOT misstated when there is one in the population • sample contains more misstatements than population, auditor concludes financial statement misstated Increased AR Inefficient audit 6-14 Representative sampling Non-sampling risk could result in: • Application of ineffective procedures • Reliance on poor evidence • Too little time testing high risk accounts or critical controls Statistical vs. Non-Statistical Representative sampling 6-15 Statistical sampling • Sampling that uses the laws of probability for selecting and evaluating the validity of a sample from a population for the purposes of reaching a conclusion about the population 6-16 Statistical sampling – sample items selected at random – statistical calculations are used to measure and express the results (e.g. standard deviation, confidence interval) → sample risk/error can be quantified using statistical calculations 6-17 Statistical sampling • Simple random sample selection • Systematic sample selection –Interval –Probability proportionate-to- size 6-18 Sample Population- Revenue account Materiality= $25,000 Sampling Unit? 6-19 Statistical sampling Advantages – Provides: • quantitative evaluation of the sample results. • a more defensible expression of the test results. • provides objective recommendations for management. 6-20 Statistical sampling Disadvantages- • generally more costly and time consuming to set up and run. • may require additional training costs for staff members to use statistics or specialized software. 6-21 Judgmental Sample Selection methods • Directed sample selection • Block sample selection • Haphazard sample selection 6-22 Judgmental Sampling Advantages • Allows the auditor to apply subjective judgment in determining the sample size and selection process. →can achieve results equal to statistical sampling with less cost • May be designed so that it is equally effective as statistical sampling while being less costly. 6-23 Judgmental Sampling Disadvantages • Cannot draw objectively valid statistical inferences from the sample results. • Cannot quantitatively measure and express sampling risk. →INCORRECTLY regarded by some as being less effective for audit purposes. 6-24 Summary Statistical vs. Judgemental Similarities • Both require a structured process involving planning, selection, conducting, evaluating • Both can be applied to a stratified population • Both require judgment Differences • Sampling risk can be quantified in statistical sampling using mathematical formulae • Cannot quantify sampling risk in judgmental sampling 6-25 Stratify the Population • The auditor may choose to stratify the population before selecting a sample. • i.e. the auditor splits the population into multiple smaller sets or layers, and each set has a similar characteristic. • After the population is stratified, the sample will be selected using either a probabilistic or non- probabilistic sampling method. 6-26 Sampling process For both statistical and judgmental methods, the four main stages are: 1. Planning the sample 2. Selecting the sample 3. Performing the tests 4. Evaluating the results 6-27 Planning 1. State the objectives of the test Test of detail: • Auditor wants to determine the maximum amount of monetary misstatement that could exist, based on the sample Test of control: • Are the identified internal controls that the auditor intends to rely upon effectively applied? 6-28 Test of control: • Some internal controls can be sampled • While others cannot be Test of detail: • Decision to sample for test of details depends on the nature of the population, risk, etc. • May choose to verify 100\% instead Planning 2. Decide IF Audit Sampling is appropriate 6-29 Planning 3. Define Attributes and Exception/Error Conditions Planning: Test of control (e.g. attribute sample) Test of detail (e.g. MUS sample) Define the item of interest Identify the characteristic or attribute of interest Individual dollars Define exceptions or errors Define the control deviation (an exception) Normally, any monetary difference (error) 6-30 Planning 3. Define Attributes and Exception/Error Conditions Planning: Test of control Sales (Occurrence) Test of detail AR (Existence) Define the item of interest Control- Credit approval before shipment Individual dollars Define exceptions or errors Sale released even though customer balance exceeds credit limit Confirmed AR amount different from amount in customer account 6-31 Planning 4. Define the Population • Population can be defined in a way to suit the audit tests • Most populations can be stratified, if needed. • Must draw sample from the entire sample population as defined 6-32 Planning 5. Define the Sampling Unit Tests of control: • Usually a physical unit, e.g. invoice, shipping document, purchase order Test of detail: • If MUS, would be the individual dollar • For judgmental sampling, it is likely the unit making up the balance, e.g. an unpaid invoice 6-33 Slide 19 Test of detail: • Materiality is used to determine the acceptable misstatement amount for the audit of each account These decisions require the use of professional judgment. Test of control: • TER is the exception rate the auditor will permit in the population and still be willing to use the assessed control risk • As TER increases, the sample size decreases Planning 6. Specify the Tolerable Error Rate (TER) or Materiality 6-34 • For judgmental sampling, professional judgment is used to calculate the sample size • For statistical sampling, mathematical formulae or software are used Planning Determine initial sample size 6-35 When determining size of sample for control testing, CAS 530 requires auditor to consider: –Amount of reliance on that control –TER for that control –Expected population error rate –Population size Sample Size 6-36 Factors that influence sample size Table 6.3 6-37 Risk drives the amount of work needed to be done Risk? When determining size of sample for substantive testing, CAS 530 requires auditor to consider: –RMM –Other substantive testing –Materiality –Expected population error rate –Population size Sample Size 6-38 Factors that influence sample size Table 6.4 6-39 Risk drives the amount of work needed to be done Risk? • Once the sample size has been determined, choose the items from the population using the sampling unit defined in Step #5 Sample Selection 7. Select the sample 6-40 • Stratification may result in a combination of sample methods to be used Sample Selection 8. Select the sample 6-41 Stratification Example: AR Confirmation sample includes: • Small number of High value accounts • Accounts due from related parties • Numerous low value accounts Sample Selection 8. Select the sample 6-42 • For test of controls, examine each item for the attribute defined in Step #3, recording all exceptions found – Test for: Are all sales properly approved for credit? Perform the Tests 9. Perform the audit procedures 6-43 • For test of details, apply the audit procedures to each item to determine whether the BALANCE is correct or contains any misstatement – Send and reconcile AR confirmations, conduct alternative procedures to verify AR account balance. Perform the Tests 9. Perform the audit procedures 6-44 • For test of controls sample error rate (SER) equals actual number of exceptions divided by actual sample size – But that is not necessarily equal to the actual population error rate – a potential range of likely error must be calculated Evaluate Results 10. Generalize from the sample to the population 6-45 • In practice, auditors tend to test controls when they expect NO exceptions • i.e. If the controls are effective, ANY exceptions are too many. If any exceptions are discovered, then it may be the case that no reliance on the controls is possible. →We are trying to answer the question: Can we rely on the internal controls for a particular account assertion? Evaluate Results 10. Generalize from the sample to the population 6-46 • When generalizing tests of details, auditors deal with $$ amounts rather than with exceptions • Misstatements found are projected from the sample results to the population →Are the accounts materially misstated? Sample $ error → Population $ error Evaluate Results 10. Generalize from the sample to the population 6-47 Test of controls: • Was there a breakdown in internal controls that caused the exceptions? (Does it affect control risk?) • Are there other compensating controls that can be tested/relied upon? • Should additional substantive testing be conducted because of these results? (i.e. you are unable to rely on controls) Evaluate Results 11. Analyze exceptions or misstatements 6-48 Test of detail: • Were the misstatements caused by serious control exceptions? – (Do we need to reassess control risk?) • Is additional substantive testing required? – (to better identify magnitude of the error) Evaluate Results 11. Analyze exceptions or misstatements 6-49 Test of controls: • If SER >TER, we will normally conclude that the control is NOT effective. Test of detail: • Compare materiality to total projected error. • If total projected error is greater than materiality, we can conclude that the account balance is NOT acceptable. Evaluate Results 12. Decide on the acceptability of the population 6-50 • What if the auditor decides the population is NOT acceptable? What next? Evaluate Results 12. Decide on the acceptability of the population 6-51 • What if the auditor decides the population is NOT acceptable? 1. Revise TER, materiality – not easily defensible Evaluate Results 12. Decide on the acceptability of the population 6-52 • What if the auditor decides the population is NOT acceptable? 2. Expand the sample size. –May decrease the sample error rate OR you could end up with the same result. Evaluate Results 12. Decide on the acceptability of the population 6-53 • What if the auditor decides the population is NOT acceptable? 3. For compliance testing • Conclude that the control is ineffective. For substantive testing • Conclude that the account is misstated. Evaluate Results 12. Decide on the acceptability of the population 6-54 • What if the auditor decides the population is NOT acceptable? 4. Revise assessed control risk. –Errors in account details could be caused by weaknesses in internal controls. –This will likely mean an increase in tests of detail. Evaluate Results 12. Decide on the acceptability of the population 6-55 6-56 Table 6.5 As an auditor what would you conclude if the materiality was set at $3,500? What if the materiality was $7,500? Evaluate Results 12. Decide on the acceptability of the population Adjustment? Auditing 1 Refresher Review- 1 Assurance Engagements • What is an “assurance engagement”? 21-2 Assurance Engagements • What is an “assurance engagement”? • pursuant to an accountability relationship between two or more parties, • a practitioner is engaged to issue a written communication expressing a conclusion concerning a subject matter for with the accountable party is responsible. 21-3 Three Parties in an Assurance  Engagement 21-4 Assurance Engagements • Assurance engagements can be very broad in  nature. • They include financial statement audits, review  engagements, certain types of management  consulting, and specialized reports. 21-5 What is AUDITING? Review- 6 What is AUDITING? Auditing is the accumulation and evaluation of evidence about information to determine and report on the degree of correspondence between the information and established criteria. Review- 7 Five Key Components of Auditing 1. Quantifiable information to be audited (related to entity) 2. Criteria: normally generally accepted accounting principles (ASPE/IFRS). 3. Evidence gathering and evaluation 4. Competent, independent person 5. Reporting Review- 8 What is the difference between auditing and  accounting? accountant? auditor? Review- 9 Can an auditor perform BOTH functions for  the same client? accountant? auditor? Review- 10 Fundamental Principles of Professional  Ethics • All professional accountants in Canada must abide  by a code of professional conduct based upon six  fundamental principles • These include: • Integrity • Objectivity • Professional competence • Due care • Confidentiality • Professional behaviour 11 Professional Standards Principles Rules of conduct Interpretations issued by provincial institutes (not technically enforceable) ideal standards of ethical con- duct (general standards- e.g. confidentiality) enforceable minimum standards Review- 12 RPC: Basic Principles Governing Conduct • Maintaining the good  reputation of the  profession • Perform services with  integrity, due care;  sustain professional  competence • Be and remain free of  influence (independence) • Duty of confidence  (confidentiality) • Develop practice based  upon professional  excellence (advertising to  be in good taste and  accurate) • Professional courtesy  should be maintained Review- 13 Rules of professional Conduct Association • Association is the term used to indicate a public  accountants involvement with financial information • Association typically occurs when: • Public accountant performs a service or consents  to the use of his/her name implying a services was  performed with the information • Third party indicate without consent of public  accountant that he/she is associated with  information • Third part assumes that the public accountant is  associated with the information Review- 14 Independence • Independence in auditing means taking an unbiased  viewpoint in the performance of audit tests, the  evaluation of the results, and the issuance of the  auditor’s reports. • Three important concepts: • Independence in fact • Independence in appearance • Threats to independence Review- 15 Auditor Independence Threats to independence • Self‐interest • Self‐review • Advocacy • Familiarity • Intimidation Review- 16 Legal Liability Business Failure vs. Audit Failure • Business failure: when a business  cannot repay its debts, perhaps due to  poor management, a shift in demand, or  economic factors • Audit failure: when the auditor issues an  incorrect audit opinion (e.g. an  unqualified opinion when it should be  qualified) Review- 17 Legal Liability Expectation Gap • There is an expectation gap when two  different groups expect different outcomes  in a particular situation. • Here, we use the term ‘expectation gap’ to  refer to the difference between what users  actually expect and what the audit report  actually provides. Review- 18 Several legal terms apply to auditor liability: • Contract→ failed to live up to their responsibilities agreeing to act as the auditor and explicit in engagement letter • fraud - a false assertion made knowingly or recklessly • tort action for negligence Review- 19 Several legal terms apply to auditor liability: To establish negligence, plaintiff must prove: - defendant intended plaintiff to act on the assertion - plaintiff did act on the assertion - plaintiff suffered a loss Review- 20 Auditor’s Defenses Against Negligence lack of duty absence of negligence contributory negligence absence of causal connection absence of misstatement no damages Review- 21 Quality Control • These standards clarify the minimum  policies and procedures that firms  should have in place. • CICA Handbook Section CSQC‐1  describes general standards of quality  control that are applied to firms  performing assurance engagements. Review- 22 Elements of Quality Control • Leadership and responsibilities within the firm • General ethical requirements • Independence • Client acceptance or continuance • General human resource policies • Professional development • Engagement performance procedures • Engagement QC review • Documentation Review- 23 Client Acceptance and Continuance • The first stage in any audit engagement  is client acceptance or continuance  decision • Step 1: Assess client integrity • Step 2: Assess audit firm’s ability to  meet ethical requirements, service client • Step 3: Prepare client engagement letter Review- 24 Objective of an Audit of Financial  Statements Per CAS 200: • Expression of an opinion • Are financial statements fairly presented? • Are financial statements in conformity with  GAAP (ASPE/IFRS)? • The audit is conducted by an independent  auditor. Review- 25 What are management’s responsibilities with  respect to financial reporting? - adopting sound accounting policies - maintaining adequate internal controls - ensuring fairness of financial statement presentation Review- 26 What are the auditors’ responsibilities? • expression of an opinion • reasonable assurance that material misstatements are absent • plan and perform the audit in accordance with GAAS Review- 27 Stages of an Audit The main stages of an audit are  1.planning,  2.performing  3.reporting Review- 28 Preliminary Risk Identification Review- 29 Preliminary Risk Identification Review- 30 Preliminary Risk Identification Review- 31 Preliminary Risk Identification Review- 32 There are two types of fraud: –Fraudulent financial reporting –Misappropriation of assets Review- 33 Conditions for Fraud Review- 34 The auditor needs  to maintain  ‘‘professional  skepticism ’’ What is the Auditor’s role in assessing Fraud Risk? Review- 35 Auditor Responsibilities when Fraud is  Suspected or Detected • Conduct audit procedures to confirm or dispel  suspicions. • Inform the appropriate level of management  (above the suspected level of fraud);  • Inform audit committee when senior management  fraud is suspected. Review- 36 Preliminary Risk Identification Review- 37 Preliminary Risk Identification Review- 38 Preliminary Risk Identification Review- 39 Preliminary Risk Identification Review- 40 What is the purpose of the audit  report? The audit report is an explanation of the audit process and conclusions reached. The report is the formal communica- tion between the auditor and the external users of the financial state- ments, primarily the shareholders. Review- 41 Standard Unqualified Independent  Auditor’s Report (CAS 700) • Report Title • Addressee • Introductory Statement • Management Responsibility • Auditor Responsibility • Opinion Paragraph • Basis for opinion • Name of public accounting firm • Date of the auditor’s report • Auditor’s address Review- 42 ← NEWish Key Enhancements‐ CAS 700 Enhanced auditor reporting of going concern  (CAS 700) Affirmative statement about • auditor’s independence • ethical responsibilities Auditor responsibilities, key features of an  audit → appendix Review- 43 New Audit Standard‐ CAS 701 KEY AUDIT MATTERS • Professional judgement → “most significant” in  the audit of financial statements of the current  period. REQUIRED for listed entities (otherwise optional) Review- 44 Conditions Requiring a Departure From An  Unqualified Report‐ Review- 45 Audit Assertions cont’d Assertions About Classes of Transactions Copyright John Wiley & Sons Canada, Ltd. 46 Occurrence Transactions and events that have been recorded have occurred and pertain to the  entity. Completeness All transactions and events that should have been recorded have been recorded. Accuracy Amounts and other data relating to recorded transactions and events have been  recorded appropriately. Cut‐off Transactions and events have been recorded in the correct accounting period. Classification Transactions and events have been recorded in the proper accounts Table 5.1 C-O-C-C-A + P Audit Assertions cont’d Assertions About Account Balances at Year End Copyright John Wiley & Sons Canada, Ltd. 47 Existence Assets, liabilities and equity interests exist. Rights and  obligations The entity holds or controls the rights to assets, and liabilities are  the obligations of the entity. Completeness All assets, liabilities and equity interests that should have been  recorded have been recorded. Valuation and  allocation Assets, liabilities and equity interests are included in the financial  report at appropriate amounts and any resulting valuation or  allocation adjustments are appropriately recorded. Table 5.2 C-E-R-V + P What is audit EVIDENCE? Review- 48 • Confirmation • Analytical procedures • Inspection (vouching/tracing documents) • Reperformance • Observation • Recalculation • Enquiries of client Types of evidence  Review- 49 CAIRORE Five Evidence Decisions 1. RISK: Which risks could result in a risk of  material misstatement at the assertion  level? 2. NATURE: Which audit procedures to use 3. EXTENT: What sample size to select for a  given procedure 4. SELECTION: Which particular items to  select from the population 5. TIMING: When to perform the procedures Review- 50 S-A-A-E Absolute vs. Reasonable Assurance requires requires absolute certainty convincing evidence high audit costs requires requires reasonable certainty persuasive evidence reasonable audit costs Review- 51 AR vs RMM ? Review- 52 set materiality, and assess acceptable audit risk and inherent risk What is acceptable audit risk? Acceptable audit risk is the risk that the auditor is willing to accept that an unqualified opinion will be issued for statements that are materially misstated. Review- 53 audit risk Audit Risk has 3 components which  combine to make the audit risk model: = x x inherent risk control risk planned detection risk Risks of Material Misstatement Review- 54 Overall Financial Statement Level Risk High level assessment of : • Pervasive risk • Risks that may potentially affect many account assertions Consider: • Entity’s control environment • Economic conditions Review- 55 Audit Risk • Audit risk is the risk that an auditor expresses an  inappropriate audit opinion when the financial  statements are materially misstated (CAS 200) • This means the auditor gives an opinion that the  financial statements are fairly presented when  they contain a significant error or fraud • Audit risk can never be zero • Audit risk is reduced during planning by  identifying the key risks and adjusting audit  effort accordingly 56 What is materiality? Note the reference to materiality in the audit report. Review- 57 Materiality • Materiality guides audit planning, testing, and  assessment of information in the financial  statements • Information is material if it impacts on the  decision‐making process of users of the  financial statements • Information could be considered material  because of its qualitative or quantitative characteristics Copyright John Wiley & Sons Canada, Ltd. 58 Audit Strategy • An audit strategy consists of a planned  approach to the conduct of audit testing,  taking into account assessed risks. • The strategy can be developed only after the  client risk profile has been developed and  risks assessed. Review- 59 After completing risk  assessment, there is a  decision to be made: Do we intend to rely upon  internal controls? Review- 60 Copyright John Wiley & Sons Canada, Ltd. Review- 61 Audit risk = f Inherent risk Control risk Detection risk High High Low Audit strategy No (or very limited)  tests of controls Increased reliance  on substantive tests  of transactions and  account balances Audit risk = f Inherent risk Control risk Detection risk Low Low High Audit strategy Increased reliance  on tests of controls Reduced reliance  on substantive tests  of transactions and  account balances Table 4.3 Table 4.4