Audit Responsibilities and Objectives. Objective of Conducting an Audit of Financial Statements The...

Audit Responsibilitiesand Objectives

Objective of Conducting an Audit of Financial Statements

• The objective of the ordinary audit of financial statements is the expression of an opinion of the fairness with which they present fairly, in all respects, financial position, result of operations, and its cash flows in conformity with GAAP.

Steps to Develop Audit Objectives

• Distinguish management’s responsibility for the financial statements and internal control from the auditor’s responsibility for verifying the financial statements and effectiveness of internal control.

Management’s Responsibilities• Management is responsible for the financial statements

and for internal control.

• The Sarbanes-Oxley Act increases management’s responsibility for the financial statements.

• It requires the CEO and the CFO of public companies to certify the quarterly and annual financial statements submitted to the SEC.

Management’s Responsibilities• The Sarbanes-Oxley Act provides for criminal penalties

for anyone who knowingly falsely certifies the statements.

auditor’s responsibility• The auditor is responsible of planning and performing the

audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.

• The auditor is able to obtain reasonable BUT not absolute assurance that material misstatements are detected.

• The auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that misstatements (caused by errors or fraud) that are not material to the financial statements are detected.

Material versus immaterial misstatements

• Misstatements are considered material if the combined uncorrected errors and fraud in the financial statements would likely have changed or influenced the decision of reasonable person.

• It would be extremely costly (and impossible) for auditors to have responsibility for finding all immaterial errors and fraud.

• Auditors are responsible for obtaining reasonable assurance.

Reasonable assurance• Assurance is a measure of the level of certainty that the

auditor has obtained at the completion of the audit.• Reasonable assurance is a high, but not absolute, level of

assurance that the financial statements are free of material misstatements.

• The auditor is responsible for reasonable assurance for the following reasons :

1.Testing samples.

2.Estimations.

3.Fraud is extremely difficult to detect.

Errors versus fraud• Errors: are unintentional misstatements.• Fraud: are intentional misstatements.

1. Misappropriation of Assets (Employee Fraud).

Harms stockholders and creditors because assets are no longer available.

2. Fraudulent Financial Reporting.(management Fraud).

Harms users by providing them incorrect financial statement information for their decision making.

Professional skepticism• The audit must be planned and performed with an attitude

of professional skepticism.• Auditor should not assume that management is dishonest,

BUT the possibility of dishonesty must be considered.

Auditor’s Responsibilities for Discovering Illegal Acts

• Illegal acts : violation of laws or government regulations other than fraud.

1.Violation of tax laws.

2.Violation of environmental protection laws.

Direct-effect illegal acts

• Have a direct financial effect on specific account balances in the financial statements.

• EX: violation of tax laws affects income tax expenses and income tax payable.

Indirect-effect illegal acts• Affect financial statements only indirectly.• EX: violation of environmental protection laws, financial

statements are only affected if there is a fine or sanctions.

Actions when the auditor knows of an illegal act

1. Consider the effect on the financial statements, including the adequacy of disclosures.

2. Effect on the relationship with management (if management knew of the illegal act).

3. Communicate with audit committee to make sure they know of the illegal act.

4. If client refuses of fails to take appropriate action, the auditor may withdrew from the engagement.

5. If client is publicly held the auditor must report to the SEC.

Financial Statements Cycles• Audits are performed by dividing the financial statements

into smaller segments or components.• Keeping closely related types (or classes) of transactions

and account balances in the same segment.• After the audit of each segment is completed, including

interrelationships with other segments, the results are combined. A conclusion can be reached about the financial statements taken as a whole.

Setting audit objectives

1. Transaction related audit objectives.

2. Balance related audit objectives.

3. Presentation and Disclosure audit objectives.

Managements Assertions • Are implied or expressed representations by management

about classes of transactions and the related accounts and disclosures in the financial statements.

• Assertions are classified into three categories :

1.Assertions about classes of transactions and events for the period under audit.

2.Assertions about account balances at period end.

3.Assertions about presentation and disclosure.

Assertions about classes of transactions and events

• Occurrence: transactions included in the financial statements Actually occurred during the accounting period.Ex: recorded sales.

• Is concerned with the possibility of including transactions that should not been included

• Relates to account overstatement.• Completeness: all transactions that should be included in

the financial statements are in fact included. Ex: all sales are recorded.

• Opposite from occurrence.• Is concerned with the possibility of omitting transactions.• Relates to account understatement.

• Accuracy: whether transactions have been recorded at correct amounts.

• Classification: whether transactions are recorded in the appropriate accounts.

• Cutoff: whether transactions are recorded in the proper accounting period.

Assertions about account balances• Existence: whether assets, liabilities, and equity included

in the balance sheet actually existed on the balance sheet date.

• Is concerned with the possibility of including amounts that should not been included.

• Relates to account overstatement.• Completeness: whether all accounts and amounts that

should be presented in the financial statements are in fact included.

• Is concerned with the possibility of omitting items.• Relates to account understatement.

• Valuation and Allocation: whether assets, liabilities and owners interests have been included in the financial statements at appropriate amounts, including any valuation adjustments to reflect assets amounts at net realizable value.

• Rights and obligations: whether assets are the rights of the entity and whether liabilities are the obligations of the entity.

Assertions about presentation and disclosure

• Occurrence and rights and obligations: whether disclosed events have occurred and are the rights and obligations of the entity.

• Completeness: whether all required disclosures have been included in the financial statements. EX: all material related party transactions have been disclosed.

• Accuracy and valuation: whether financial information is disclosed fairly and at appropriate amounts.

• Classification and Understandability: whether amounts are appropriately classified in the financial statements and in the footnotes. EX: classification of inventory.

Management Assertions forEach Category of Assertions

Assertions About Classes of Transactions and Events

Assertions About Account Balances

Assertions About Presentation and Disclosure

Occurrence Existence Occurrence and rightsand obligations

Completeness Completeness Completeness

Accuracy Valuation andallocation

Accuracy andvaluation

Classification Classification andunderstandability

Cutoff

Rights andobligations

General Transactions-related Audit Objectives

• Occurrence: Recorded transactions exist.• Deals with potential overstatement.• Completeness: Existing transactions are recorded.• Deals with potential Understatement.• Accuracy: A-Recorded transactions are stated at the

correct amounts.• B-posting and summarization : Transactions are included

in the master files and are correctly summarized.• Classification: Transactions are properly classified.• Timing: Transactions are recorded on the correct dates.

Management AssertionsAbout Classes ofTransactions and Events

General Transaction-related AuditObjectives

Specific Sales Transaction-related Audit Objectives

Occurrence Occurrence Recorded sales are forshipments made tononfictitious customers

Completeness Completeness Existing salestransactions are recorded

Accuracy Accuracy Recorded sales are forthe amount of goodsshipped and are correctlybilled and recorded

Transaction Related Audit Objectives Transaction Related Audit Objectives

Accuracy Posting andsummarization

Sales transactions areproperly included in themaster file and arecorrectly summarized

Classification Classification Sales transactions areproperly classified

Cutoff Timing Sales transactions arerecorded on the correctdates.

General Transaction-related AuditObjectives

Management AssertionsAbout Classes ofTransactions and Events

Specific Sales Transaction-related Audit Objectives

Transaction Related Audit Objectives Transaction Related Audit Objectives

Balance-related Audit Objectives

• Existence: amounts included Exist. Inclusion of an A/R from a customer in the trial balance when there is no receivable violates this objective.

• Counterpart to the management assertion of existence.• Deals with overstatement.• Completeness: Existing amounts are included. Failure to

include an A/R from a customer in the trial balance.• Counterpart to the management assertion of

completeness.• Deals with understatement.

• Accuracy: • A) Amounts included are stated at the correct amounts:

the amounts should be included at the correct amount.• B) Classification: Amounts are properly classified. EX:

classifying assets . • C) Cutoff: Transactions are recorded in the proper period.• D) Detail tie-in: Account balances agree with master file

amounts, and with the general ledger.

• Realizable value: Assets are included at estimated realizable value.(reduce historical cost or fair market value is required).

• Rights and obligations: Assets must be owned and liabilities must belong to the entity.

Management AssertionsAbout Account Balances

General Balance-related AuditObjectives

Specific Balance-related AuditObjectives Applied to Inventory

Existence Existence All recorded inventory existsat the balance sheet date

Completeness Completeness All existing inventory hasbeen counted and includedin the inventory summary

Balance Related Audit ObjectivesBalance Related Audit Objectives(Applied to Inventory)



Valuation andallocation

Accuracy • Inventory quantities on the client’s perpetual records agree with items physically on hand• Prices used to value inventories are materially correct• Extensions of price times quantity are correct and details are correctly added


(Applied to Inventory)

Balance Related Audit ObjectivesBalance Related Audit Objectives




Classification

Cutoff

Inventory items are properly classified as to raw materials, work in process, and finished goodsPurchase cutoff at year end is properSales cutoff at year end is proper






Detail tie-in

Realizablevalue

Total of inventory items agrees with general ledgerInventories have been written down where net realizable value is impaired


Rights and obligations Rights andobligations

The company has title to all inventory items listedInventories are not pledged as collateral


ManagementAssertions AboutPresentation andDisclosure

Specific Presentation andDisclosure-related Audit ObjectivesApplied to Notes Payable

Occurrenceand rights andobligations

Occurrenceand rights andobligations

Notes payable as described in thefootnotes exist and areobligations of the company

Completeness Completeness All required disclosures relatedto notes payable are included inthe financial statement footnotes

GeneralPresentation-and Disclosure-related AuditObjectives

Presentation and Disclosure Audit objectivesPresentation and Disclosure Audit objectives(Applied to Notes Payable)

ManagementAssertions AboutPresentation andDisclosure

Specific Presentation andDisclosure-related Audit ObjectivesApplied to Notes Payable



Footnote disclosures related tonotes payable are accurate.

Classificationandunderstandability

Classificationandunderstandability

Notes payable are appropriatelyclassified as to short-term andlong-term obligations andrelated financial statementdisclosures are understandable

GeneralPresentation-and Disclosure-related AuditObjectives

Presentation and Disclosure Audit objectivesPresentation and Disclosure Audit objectives(Applied to Notes Payable)

How Audit Objectives Are Met• The auditor must obtain sufficient appropriate audit

evidence to support all management assertions in the financial statements.

• The auditor must decide the appropriate audit objectives and evidence to accumulate to meet those objectives on every audit.

• To do this auditors follow an audit process.

• Audit process: methodology for organizing an audit to ensure that the evidence gathered is both sufficient and appropriate and that all required audit objectives are both specified and met.

Four Phases of a Financial Statement Audit

Phase IPlan and designan audit approach

Phase II

Perform tests ofcontrols andsubstantive testsof transactions

Phase III

Perform analyticalprocedures andtests of detailsof balances

Phase IVComplete theaudit and issuean audit report

Phase IPlan and design an audit approach

• There are two considerations affecting the approach the auditor selects to accumulate evidence:

1.Sufficient appropriate evidence must be accumulated.

2.The cost of accumulating the evidence should be minimized.

• Planning and designing au audit approach can be broken down into several parts :

1.Obtain an understanding of the entity and its Environment.

2.Understand internal control and assess control risk.

3.Assess Risk of material misstatement.

Phase IIPerform tests of controls and substantive tests of transactions

• By performing TESTS of CONTROLS the auditor can justify reducing planned assessed control risk when controls are believed to be effective.

• SUBSTANTIVE Test of Transactions : evaluate the clients recording of transactions.

Phase IIIPerform analytical procedures andtests of details of balances

• Analytical procedures : use comparisons and relationships. EX : examine the sales journal and compare results to prior periods.

• Tests of Details : specific procedures intended to test for monetary misstatements in the balances in the financial statements. EX: direct written communication with client’s customers to decide on the accuracy of A/R.

Phase IVComplete the audit and issue an audit report

• Reach and overall conclusion as to whether the financial statements are free of material misstatements.

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