AUDITING
CHAPTER 7
Audit Process & Detecting Fraud
By
David N. Ricchiute
TOPICS
Audit process
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Client acceptance, client strategies, planning,
interim & year end work
Auditor’s responsibility to detect, report fraud
GBW 8th ed., Ch. 7
PRELIMINARY STEPS IN
AUDIT PROCESS
Communication with audit committee
Accepting, continuing engagements
Understand client’s business strategies
Planning
Interim, year-end audit work
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AUDIT COMMITTEES:
History
1940 SEC ASR #19 encouraged
1978 required by NYSE
1999 recommendations from Blue
Ribbon on audit committee
effectiveness
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Consistency of accounting principles
Clarity, completeness of financial
statements
GBW 8th ed., Ch. 7
SEC & SARBANES-OXLEY
RULES: Post 2000
Mandates
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Reviews of public company financial
statement interim reports
Disclosure in proxy statements whether
audit committee discussed
 Financial statements with management
 Estimates, uncertainties, unusual transactions,
new accounting principles, independence with
auditor
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QUALITY OF EARNINGS
Auditor must discuss quality not just
acceptability of accounting principles &
earnings with Audit committee (SAS 89)
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Consistency in use of accounting principles
Clarity, completeness of financial
statements
GBW 8th ed., Ch. 7
ACCEPTING, CONTINUING
ENGAGEMENTS
Establish policies, procedures to accept,
continue clients (Stmt. Quality Control
Stds. No. 1 )
For new client
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Evaluate ability to service client
Review financial statements
Inquire about reputation, bankruptcy
Investigate key managers
GBW 8th ed., Ch. 7
COMMUNICATIONS WITH
PREDECESSOR
Successor auditor initiates
communication
Predecessor auditor obtains permission
to disclose confidential information
(Rule 301)
Is prior auditor’s resignation,
replacement linked to (SAS 84)
Disagreement with management?
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Management integrity?
Other reasons?
GBW 8th ed., Ch. 7
UNDERSTANDING WITH
CLIENT
Objectives & limitations of engagement
Management’s responsibilities
Example: financial statement audit
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Objective: express opinion whether
statements
 Present fairly
 In all material respects
 In conformity with GAAP
SAS 83 & SSAE 7
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GBW 8th ed., Ch. 7
MANAGEMENT’S
RESPONSIBILITIES
Financial statements
Establishing, maintaining effective
internal over financial reporting
Assuring compliance with laws &
regulations
Making records, information available
Confirming representations made during
engagement
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ENGAGEMENT LETTERS
Drafted by auditor for CEO’s signature
Written agreement to state purpose of
engagement & role of auditor
Optional but recommended by SAS 84
which requires some form of written
understanding in work papers
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GBW 8th ed., Ch. 7
PROPOSED ADJUSTING
JOURNAL ENTRIES (AJE)
SAS 88 “Audit Adjustments”
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Management’s responsibility to record
material proposed adjustments
Management must confirm responsibility
for adjustments at year end in
representation letter
Auditor informs audit committee of
management’s responsibilities for
adjustments
GBW 8th ed., Ch. 7
UNDERSTANDING
CLIENT’S BUSINESS
Auditor considers effects of client
business & strategies on
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Risks
Strategies to overcome risk
Transactions, events as products of
management’s strategies
GBW 8th ed., Ch. 7
CLIENT STRATEGY
TEMPLATE-Strategies
Growth strategy
Financial goals & operating
priorities
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CLIENT STRATEGY
TEMPLATE-Characteristics
Characteristics of business
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Major business units
Markets
Products
Customers
Competitors
Strategic alliances & joint ventures
Potential adverse influences
GBW 8th ed., Ch. 7
BUSINESS: Units, Markets,
Products, Customers
Demonstrate value of product
R&D to develop new products
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FINANCIAL GOALS,
OPERATING PRIORITIES: Merck
Remain in top quartile
Maximize revenue growth
Preserve profitability of core business
Achieve full potential
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ERRORS VS. FRAUD
Errors
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Unintentional misstatements or omissions
in financial statements
Fraud
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Fraudulent financial reporting: intentional
misstatement or omission
Misappropriation of assets: theft
GBW 8th ed., Ch. 7
PLANNING
Risk of misstatement from fraud
First quarter planning
Second quarter planning
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RISK OF FRAUD: Auditor’s
Responsibility
Discuss risk with staff
Obtain pertinent information
Identify & assess risks
Plan according to assessment
Evaluate evidence
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GBW 8th ed., Ch. 7
RISK OF FRAUD: Other
Aspects
Professional skepticism
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No presumption of dishonesty balanced
with possibility of misstatement due to
fraud
Fraud screens
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Some financial ratios help
 Asset quality
 Total accruals to total assets
 Days sales in receivables
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GBW 8th ed., Ch. 7
IDENTIFYING, ASSESSING
RISK OF FRAUD
Fraud triangle
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Incentives, pressures to commit fraud
Opportunities to commit fraud
Management’s rationalizations for
committing fraud
GBW 8th ed., Ch. 7
FIRST-QUARTER
PLANNING
Review prior-year audit work
Review 1st quarter results
Prepare preliminary audit time budget
Consider adverse influences
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GBW 8th ed., Ch. 7
SECOND-QUARTER
PLANNING
Review 2nd quarter results
Finalize budget
Perform analytical procedures
Prepare preliminary planning memo
Coordinate staff with client
Prepare interim audit programs
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INTERIM AUDIT WORK:
Controls & Programs
Understand internal control
Perform tests of controls
Assess control risk
Prepare preliminary audit programs
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YEAR-END AUDIT WORK
Coordinate with client
Finalize audit program
Perform substantive tests, analytical
procedures
Evaluate audit test results
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Material errors, fraud
Subsequent events
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YEAR-END AUDIT
DOCUMENTATION
Management, legal representations
Audit documentation review
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Staff work reviewed
Audit reports
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