Auditing Principles - CH5 - Audit Evidence and Documentation

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  1. Audit Risk Definition
    • The possibility that the auditors may unknowingly fail to appropriately modify
    • their opinion on financial statements that are materially misstated

    This is the risk that the auditors will issue an unqualified opinion on financial statements that contain a material departure from GAAP.
  2. Financial Statement Assertions
    Material Misstatement types
    without controls, great possibility for mistmnt:

    Account Balances (Accounts)

    Transaction/Events (Transactions)

    Presentation/Disclosure (Disclosures)
  3. Combined Assertions
    • Existence or Occurrence
    • Rights and Obligations
    • Completeness
    • Cutoff
    • Valuation
    • Presentation and Disclosure
  4. Audit Risk Formula
    AR = IR * CR * DR

    • or
    • AUDIT RISK =
    • Risk of material misstatement
    • x
    • Risk auditors fail to detect material mistatement
  5. Inherent Risk
    Risk of a material misstatement occurring in an assertion assuming no related internal controls

  6. Control Risk
    Risk that a material misstatement in an assertion will not be prevented or detected on a timely basis by the company’s internal control.
  7. Detection Risk
    Risk that the auditors’ procedures will lead them to conclude that a material misstatement does not exist in an assertion when in fact such misstatement does exist
  8. Where is Risk of Material Misstatement Found
    Inherent and Control Risks
  9. 0 to Fraud
    Revenues and Assets UP

    Expenses and Liabilities DOWN
  10. Inherent Risk Factors/Characteristics
    • Factors that affect inherent risk:
    • Nature of the client and its environment
    • Nature of the particular financial statement element

    • Involve:
    • Difficult to audit transactions or balances
    • Complex calculations
    • Difficult accounting issues
    • Significant judgment by management
    • Valuations that vary significantly based on economic factors
  11. Types of Transactions
    • *Routine
    • Recurring financial statement activities recorded in the accounting records in the normal course of business
    • Lower inherent risk

    • *Nonroutine
    • Involve activities that occur only periodically such as the taking of physical inventories
    • High inherent risk

    • *Estimation transactions
    • Activities that create accounting estimates
    • Higher inherent risk
  12. Appropriateness of Audit Evidence must

  13. Principles—Audit evidence is ordinarily more reliable when it is
    • Obtained from knowledgeable independent
    • sources outside the company rather than nonindependent sources

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

    • Obtained directly by the auditor rather
    • than indirectly or by inference

    Documentary in form rather than oral

    • Provided by original documents rather
    • than copies
  14. Types of Audit Procedures
    1.Inspection of records and documents

    2.Inquiry of knowledgeable persons within or outside the entity

    3.External confirmation

    4.Inspection of tangible assets

    5.Observation of processes or procedures being performed by others

    6.Recalculation of mathematical accuracy.

    7.Reperformance of procedures

    8.Analytical procedures
  15. Substantive Procedures
    • Analytical Proceudres
    • Tests of details:
    • •Tests of account balances
    • •Tests of classes of transactions
    • •Tests of disclosures
  16. One may change the scope of audit procedures by changing the

    • Nature (Type and Form)
    • Extent (Quantity of evidence obtained)
    • Timing (When performed)
  17. Analytical Procedures
    • lDevelop expectation of account (or ratio)
    • balance

    • lDetermine amount of difference that can
    • be accepted without investigation

    • lCompare the company’s account (ratio)
    • with the expectation

    • lInvestigate and evaluate significant
    • differences
  18. Developing an expectation
    lPrior period information

    lAnticipated results

    • lRelationships among elements of financial
    • information within a period

    lIndustry information

    • lRelationships between financial
    • information and relevant nonfinancial data.
  19. Types of Expectations
    lTrend analysis—analyze changes in accounts of a company over time

    • lRatio analysis – compare relationships between two or more financial statement
    • accounts or comparisons of account balances to nonfinancial data

    •Liquidity (e.g., current ratio)

    •Leverage (e.g., debt to equity)

    •Profitability (e.g., gross profit percentage)

    •Activity (e.g., inventory turnover)
  20. Approaches to ratio analysis
    • lHorizontal analysis
    • •Review ratios over time

    • lCross sectional analysis
    • •Analyze ratios of similar firms at a
    • point in time

    • lVertical analysis
    • •Analyze relationships within a period
    • •“Common size” statements prepared

    • lOther methods
    • •Regression analysis, reasonableness test
  21. Basic Approaches to Auditing Accounting Estimates
    ØReview and test management’s process for developing the estimate.

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

    ØReview subsequent events or transactions bearing on the estimate.
  22. Auditing Fair Values
    • lLevel 1 – inputs of observable quoted prices in active markets for identical assets or liabilities
    • •Ex. A closing stock price in WSJ

    • lLevel 2 – inputs of observable quoted prices, generally for similar assets or liabilities in active markets
    • •Ex. Company discounts future cash flows on its not publicly traded debt securities at rate used by market for publicly traded debt securities

    • lLevel 3 – inputs that are unobservable for the assets or liability
    • •Ex. A private company uses judgment to determine a proper rate to discount the future
    • cash flows of its not publicly traded securities
  23. Related Party Transactions
    ØDisclosure requirements must be met

    ØPrimary challenge is identifying undisclosed related party transactions

    • lDetermine related parties
    • •Inquiries of management
    • •Review SEC filings, stockholder’s
    • listings and conflict-of-interest statements

    lBe alert for transactions with related parties and any transactions with unusual terms
  24. Functions of Audit Documentation
    ØPrimary functions:

    • •Support the auditors’ compliance with auditing standards
    • •Support the auditors’ opinion

    • ØSecondary functions:
    • •Assist continuing and new audit team members in planning and performing the audit
    • •Serves as a record of matters of continuing audit interest
    • •Assists in supervision and review of the audit
    • •Demonstrates the accountability of team members
    • •Assists internal reviewers, external peer reviewers, PCAOB inspectors, and successor
    • auditors in performing their roles
  25. Sufficiency of Audit Documentation
    ØAudit documentation should be sufficient to:

    • lEnable an experienced auditor to understand the work performed and the significant conclusions reached
    • lIdentify who performed and reviewed the
    • work
    • lShow that the accounting agree or reconcile to the financial statements

    • ØAudit documentation should include all significant audit findings and the actions
    • taken to address them
  26. Working Papers - General
    ØMaintain confidentiality

    ØProperty of the auditors, not the client

    ØRetention – generally required to keep audit files for 7 years

    • ØReport release date:
    • Document completion date – 45/60 days after report release date for public/private.
    • After that date – make note of all additions;
    • no deletions permitted.
  27. Documentation Completion date
    • Public - 45 days
    • Private - 60 days
  28. Types of Working Papers
    • ØAudit administrative working papers
    • ex: engagement letter, budgets

    ØWorking trial balance

    • ØLead schedules
    • ex: subset of YE trial balance, ACCT when grouped together tie to FINCH STMNTS

    ØAdjusting journal entries and reclassification entries

    ØSupporting schedules

    ØAnalysis of a ledger account


    • ØComputational working papers
    • ex: depreciation schedules

    • ØCorroborating documents
    • ex: eternal cofirmations
  29. Types of Working Files
    • ØCurrent files
    • lCurrent year working papers
    • lIndex and cross-referencing

    • ØPermanent files
    • lDocuments useful for several years
    • lItems of continuing audit interest

  30. 2 Required Analytical Procedures
    • 1) Planning - helps with risk analysis
    • 2) Financial Review
Card Set
Auditing Principles - CH5 - Audit Evidence and Documentation
Auditing Principles - CH5 - Audit Evidence and Documentation
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