Electronic Presentations in Microsoft ® PowerPoint ® Prepared by Brad MacDonald SIAST © 2003...

Electronic Presentations in Microsoft® PowerPoint®

Prepared by

Brad MacDonald

SIAST

© 2003 McGraw-Hill Ryerson Limited

Copyright © 2003 McGraw-Hill Ryerson Limited

Chapter4

2

Audit Objectives, Procedures, Audit Objectives, Procedures, and Working Papersand Working Papers

Copyright © 2003 McGraw-Hill Ryerson Limited 3Chapter 4

Chapter 4 OverviewChapter 4 Overview

Pre-engagement

arrangements

Activities

Managementassertions &

audit objectives

Basic Concepts

Understand the client’s business

Obtain thefinancial

statements

Sufficientappropriate

evidence

Generalaudit

procedures

Audit workingpapers


Learning Objective 1Learning Objective 1

Describe the activities auditors undertake before beginning an audit.


Pre-engagement ArrangementsPre-engagement Arrangements

Auditors undertake two types of activities before beginning an audit:

– Risk management: • Auditors try to reduce the risk (probability of

something going wrong) by carefully managing the engagement.

– Quality management: • Auditors manage audit in accordance with quality

control standards.



Client selection and retention:– An important element of an accounting firm’s quality

control policies and procedures is a system for deciding

• (a) to accept a new client, and • (b) whether to resign from audit engagements.

– Accounting firms are not obligated to accept undesirable clients, nor retain existing audit clients.


Client Acceptance and Client Acceptance and Retention PoliciesRetention Policies

Client acceptance and retention procedures should include:

– Obtain and review financial information about prospective client.

– Enquire of bankers, legal counsel, other.– Communication with predecessor auditor.– Consider unusual risks.– Evaluate independence.– Consider needs for special skills.


Communication Between Predecessor Communication Between Predecessor and Successor Auditorsand Successor Auditors

When companies change auditors, the former auditor is the predecessor auditor, and the new auditor is the successor auditor.

– Rules of professional conduct require the successor auditor to contact the predecessor auditor.

• Ask if there are issues that should be considered in accepting the client.

• Obtain information from the predecessor auditor for planning the audit.

– Predecessor auditor is required by the rules of conduct to respond to the communication.


Communication Between Predecessor Communication Between Predecessor and Successor Auditorsand Successor Auditors

Successor auditor should ask the client to consent to discussions with the predecessor auditor.

– Consent is not required, the communication must take place.

– Consent allows the predecessor auditor to relay more information.

• Predecessor auditor still has a duty to maintain confidentiality.

• Audit files belong to the auditor, not the client.– Auditor should be wary of any client who refuses

consent.


Engagement LettersEngagement Letters

When a new audit client is accepted an engagement letter should be obtained.

– The engagement letter forms the contract for the audit.• Engagement letters are highly

recommended to reduce the risk of misunderstandings.

– A new engagement letter should be obtained every year of a continuing audit.



Staff assignment:– When the new client is obtained, accounting firms

assign a full-service team to the new client. • Engagement partner• Audit manager• One or more senior audit staff members• Staff assistants• Specialists• A tax partner, a consulting services partner and a

second audit partner– For a small firm or client, audit team may be just one

or two people.



Time budget:– The partner or manager propose a plan for the timing

of the work (interim and year-end).– Time reports are recorded by budget categories for

• evaluation of the efficiency of audit team members

• billing the client

• planning of the next audit

– Time budget allows the audit firm to spread its workload between interim and year-end periods.

• Interim – before the statement date• Year-end – at or after the statement date


Example Time BudgetExample Time Budget

Audit Time Budget (hours)Interim Year-End

Knowledge of the business 15Internal audit familiarization 10Assessment of control risk 30 10Audit program planning 25Related parties investigation 5 15Client conferences 10 18Cash 10 15Accounts receivable 15 5Inventory 35 20Accounts payable 5 35Representation letters 20Financial statement review 25Report preparation 12Total 160 175



Identify the procedures and sources of information that auditors can use to obtain knowledge of a client’s business and industry.


Understanding the Client’s Understanding the Client’s BusinessBusiness

Auditing standards require a sufficient understanding of the business to plan and perform audit work.

– Objectives:• Effective audit: identify and address all significant

risks of material misstatement• Efficient audit: provides sufficient appropriate audit

evidence in an economical manner• Enhance accuracy of auditor’s evaluation• Provide better ancillary services to client


Strategic Systems Approaches Strategic Systems Approaches to Auditingto Auditing

A recent trend in audit practice, referred to as “strategic systems approach” (SSA), is to base more of the audit on knowledge of the business.

– Used by two of the Big four firms, but has not yet filtered down to smaller firms.

– SSA is a top-down approach.• Starts with corporate strategy to determine effects

on financial statements (Ch. 13).– Traditional audits use a bottom-up approach.

• Gather evidence on individual transactions and aggregate to financial statement level.


Understanding the Understanding the Client’s BusinessClient’s Business

Methods and sources of information:– For continuing audits, information is available in the

permanent files.– Enquiry and interview with client management and

personnel to • obtain information for computer based audit work• determine needs of users of the statements

– Observation and tour of company’s physical facilities – Study and review of published materials, guides and

reference materials on the industry and the client.


Understanding the Understanding the Client’s BusinessClient’s Business

Other aspects of understanding the business:

– First-time audits require more work.– Audit efficiency can be realized by working in

tandem with the internal auditors.– Analysis of client financial statements and

ratios contribute a significant understanding of the business.

– Understanding enables the auditor to determine the need for specialists.



Name the principal accounts in each cycle in accounting and business processes.


Management’s Financial Management’s Financial StatementsStatements

There are two important points to remember about client financial statements:

• Management is responsible for preparing them, and they contain management’s assertions about economic actions and events.

• The financial statement numbers are produced by the company's accounting system and summarized by the trial balance.


Management’s Financial Management’s Financial StatementsStatements

To simplify the audit plan, auditors typically group the accounts into several cycles.

– This text contains four cycles: (1) revenues and collection (2) acquisition and expenditure (3) production and conversion (4) finance and investment

– The purpose of using cycles is to group together related accounts by transactions that normally affect them all.


Trial Trial BalanceBalance

Revenue and collection cycleAcquistion and expenditure cycle

Production and conversion cycleFinancing and investment cycle

Debit CreditX X Cash 484 X Accounts receivable 400 X Allowance for doubtful accounts 30 X Sales 8,500 X Sales returns 400 X Bad debt expense 50

X X Inventory 1,940 X Capital assets 4,000 X Accum. Amortization 1,800 X Accounts payable 600 X Accrued expenses 10 X General expenses 1,955

X Cost of goods sold 5,265 X Amortization expense 300

X Bank loans 750 X Long term notes 400 X Accrued interest 40 X Share capital 2,000 X Retained earnings 900 X Dividends declared - X Interest expense 40 X Income tax expense 196

Accounts are organized by

cycle

Should list comparative

period



Describe and define the five principal management assertions in financial statements, and explain their role for establishing audit objectives.


Management Assertions Management Assertions and Audit Objectivesand Audit Objectives

Existence or occurrence:– Establish with evidence that assets, liabilities

and equities actually exist and that revenue and expense transactions actually occurred as of a proper date.

– Cut-off: No transactions from the next period are recorded at the statement date.



Completeness:– Establish with evidence that all transactions

and accounts that should be presented in the financial reports are included.

– Cut-off: All transactions from the period are recorded in the period.



Rights and obligations:– Establish with evidence that amounts

reported as assets of the company represent property rights and the amounts reported as liabilities represent obligations.

Valuation or allocation:– Determine whether proper values have been

assigned to assets, liabilities, equities, revenues, and expenses.



Presentation and disclosure:– Determine whether the accounting principles

are properly selected and applied and whether disclosures are adequate.



A compliance assertion:– Management asserts compliance with laws

and regulations.– Not normally listed as a separate

management assertion.

Importance of assertions– Financial statement assertions are the focal

points for audit procedures.


AssertionsAssertions

7 assertions listed in CICA Handbook

Existence

Occurrence -> transactions

Completeness

Ownership

Valuation

Measurement

Statement presentation

5 textbook categories of assertions

Existence or occurrence Completeness

Rights & obligations

Valuation or allocation

Presentation & disclosure



Explain audit evidence in terms of its appropriateness and relative strength of persuasiveness.


Appropriateness of EvidenceAppropriateness of Evidence

To be considered appropriate, evidence must be relevant and reliable.

– Relevant: audit evidence must relate to one of the management assertions.

– Reliability: of audit evidence depends on nature and source.• Reliability combined with relevance

determine the persuasiveness of evidence.• The following hierarchy of evidence can be

used to judge reliability.


Reliability of EvidenceReliability of Evidence

1. Auditors direct, personal knowledge:– Gained though observation and recalculation– This is the most reliable evidence.

2. External evidence:– Documentary evidence that is obtained

directly from independent sources.– Very reliable evidence



3. External-internal evidence:– Documentary evidence that originates outside the

client’s system, but that has been received and processed by the client:

– This is reliable evidence (although circumstances of internal control are important).

4. Internal evidence:– Evidence that is produced within the client’s system.– Low reliability, but used extensively under

satisfactory internal control conditions.– Plentiful and easy to obtain, less costly than other

evidence.



5. Spoken and written representations:– Evidence that comes from the client’s

officers, directors, management, and employees in response to enquiry.

– Generally considered the weakest form of evidence.• Representations should be corroborated

with other types of evidence.


Sufficiency of EvidenceSufficiency of Evidence

Sufficiency of evidence is a question of how much appropriate evidence is enough.

– No official standard, the auditor must use professional judgement.• Test of sufficiency is whether you can

persuade someone else that you have collected enough evidence to support your conclusion.



List and describe six general types of audit techniques for gathering evidence.


General Audit ProceduresGeneral Audit Procedures

The third examination standard identifies six techniques for gathering evidence:

– computation– observation– confirmation– enquiry– inspection– analysis



Computation:– Performing independent calculations or

recalculating the client’s calculations.• Computation produces highly reliable

mathematical evidence.• Computation addresses existence and

valuation for calculated amounts.



Observation: – Looking at the application of policy or

procedures by others.• Reliable evidence as to performance at the

time of observation.• Produces a general awareness of events.



Confirmation:– Consists of (written) enquiry to verify

accounting records.• Confirmation with independent parties is

used widely for a variety of transactions and balances.

• Confirmation can produce evidence regarding existence, ownership, valuation and cut-off.



Confirmation procedures:– Confirmations should be printed on the

client’s letterhead, signed by a client officer.– Auditor needs to ensure that the address on

the confirmation is legitimate.– The recipient should be able to provide the

information.– The auditor must mail the confirmations.– Responses must be returned directly to the

auditor.



Forms of confirmations:– Positive confirmations: request a reply in all

cases.• Follow-up is required for all exceptions

reported, and for all unreturned confirmations.

– Negative confirmations: request a reply only where information is incorrect.• Only exceptions need to be followed up.



Enquiry:– Involves the collection of oral evidence from

the client and independent third parties.• Evidence from enquiry requires

corroboration.• Evidence from enquiry is important in

understanding the client’s business.• SSA audits put increasing stress on

enquiry.



Inspection:– Looking at records, documents, or assets

having physical substance.• Reliable evidence for existence, supports

valuation.• Documents can be prepared by

independent outside parties as either formal authoritative or ordinary documents.

• Documents can also be prepared by the entity under audit.


Particular Inspection TechniquesParticular Inspection Techniques

Vouching:– Information is selected from an account or

other summary of information and the auditor goes back through the control system to find the source documentation.• Vouching supports existence.

Source documents

Account / other

summary

Vouch



Tracing:– Auditor selects source documents and

proceeds forward through the control system to the final recording of the transaction.• Tracing supports completeness

Source documents

Account / other

summary

Vouch

Trace



Scanning:– An eyes-open approach of looking for

anything unusual.• Does not produce direct evidence, but can

raise questions.• Computers can be used to scan electronic

data files.• Scanning can be used to reduce sampling

risk by scanning the items not selected.



Analysis:– Evaluation of financial items in determining other

audit programs and performing analytic procedures that compare recorded amounts to expectations.

• Analysis is the “other” category in the list of audit techniques.

• Analytical procedures are both important and effective.

• Analysis is used in planning, execution, and completion of the audit.


Analytic ProceduresAnalytic Procedures

Some typical analytic procedures:– Compare current year to prior year.– Compare current year to budget.– Evaluate current year balances against other

current year balances.– Compare financial ratios to industry

standards.– Study relationship of balances and non-

financial information.



Discuss the effectiveness of various audit procedures.


Effectiveness of Effectiveness of Audit ProceduresAudit Procedures

Audits are designed to provide reasonable assurance of detecting misstatements that are material to the financial statements.

– Soft procedures (enquiry and analysis) account for 45% to 50% of discovered errors.• Note: these procedures are applied first.

– Detail procedures are also effective.• Misstatements uncovered by soft

procedures will be quantified by detail procedures.



Review an audit working paper for proper form and content.


Audit Working PapersAudit Working Papers

Working papers are the auditors’ record of compliance with GAAS.

– Working papers should contain support for the decisions made in the course of the audit.

– The auditor is the owner of the working papers.• Confidentiality requires client consent

before the file is opened to third parties.– There are three categories of working papers,

generally stored in two files.


Audit Working PapersAudit Working Papers

Permanent file:– Permanent file papers: information of

continuing interest.

Current file:– Audit administrative papers: documentation

of early planning.– Audit evidence papers: evidence obtained

and decisions made.


Working Paper Arrangement Working Paper Arrangement and Indexingand Indexing

Working papers (W/P) are grouped in order according to financial statement captions.

– Each page in the file must have:• Index: A page number that allows a W/P

to be removed and replaced properly.• Cross-referencing: Connects information

between pages in the W/P file.• Heading: Includes the entity under audit,

period being audited, and a descriptive title.


Working Paper Arrangement Working Paper Arrangement and Indexingand Indexing

W/P are grouped in order according to financial statement captions.

– Each page in the file must have:• Initials: from the auditor and the reviewer. • Dates: of the preparation and review.• Tick marks: to indicate the work

performed.• Tick marks should be appropriately described.


Audit W/P SoftwareAudit W/P Software

Specialized W/P software is becoming very popular. Advantages include:

– increase in productivity by automating tasks– integration with client database (extraction of

trial balance or transactions)– facilitation of analysis, links to other

databases, and websites


Framework for Strategic Framework for Strategic Analysis (Appendix 4A)Analysis (Appendix 4A)

PEST analysis:– Political factors

• Stability, tax policy, spending, international– Economic factors

• Inflation, employment, interest rates, GNP– Social and cultural factors

• Demographics, education, lifestyle, income– Technological factors

• New developments, speed of technology transfer, rate of obsolescence


Porter’s Five Forces ModelPorter’s Five Forces Model(Appendix 4A)(Appendix 4A)

Firm

Industry competitors

Intensity of rivalry

New EntrantsThreat of new entrants

Suppliers

Bargaining power of suppliers

Substitutes

Threat of substitutes

Buyers

Bargaining power of buyers

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