Chapter 8 Tools Used in Gathering Audit Evidence
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ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) Chapter 8 Tools Used in Gathering Audit Evidence All audits involve sampling because the auditor cannot examine 100% of the transactions during a period. Sampling is a useful tool to gain objective evidence 1. Correctness of an account balance (including necessary to be disclosed) 2. Correctness of the processing Other approaches can be Computerized footing of the account balance Sampling to test valuation Analytical review to determine potential obsolescence Auditors use sampling to gather evidence to: Test controls for the purpose of expressing an opinion on the client’s internal controls Test controls for the purpose of assessing control risk Test for compliance with company policies, governmental regulations, etc Test individual items in account balances as a basis for determining whether material misstatements exist in the account balance From the results of sampling the auditor makes an inference about the underlying population When auditors draw an erroneous inference from sampling, the cause is either non-sampling or sampling risk Non-sampling Risk Occurs when auditor does not appropriately carry out audit procedures or misinterprets results Results from human error Cannot be quantified CPA firms try to minimize through quality control practices Sampling Risk Occurs when sample is not representative of the underlying population Can be controlled through sample size- as sample size increases, samples risk decreases If the sample is 100% of the population, sampling risk is zero: however, this is often not practical ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) If the sample is not representative of the population the auditor may draw an incorrect conclusion about the effectiveness of a control: Auditor assesses control risk too high: Sample indicates control is worse than it really is. As a result, the auditor does not rely on the control and does more substantive testing than necessary (work harder + inefficient) Assessing control risk too high does not directly affect audit quality but does lead to audit inefficiencies Auditor assesses control risk too low: Sample indicates control is better than it really is. As a result, the auditor relies on an ineffective control (without realizing that it’s unreliable) and substantive testing is not rigorous as it should be This increases the risk that material misstatements are not found and an incorrect audit opinion issued If the sample is not representative of the population, the auditor may draw an incorrect conclusion about whether an account balance is presented fairly Incorrect acceptance Sample indicates account balance is not materially misstated when it is. Auditor may issue unqualified opinion on materially misstated statements Because of potential costs associated with incorrect acceptance, auditors should control for this risk Incorrect rejection Sample indicates account balance is materially misstated when it is not Incorrect rejection affects the efficiency of the audit, but does not affect the fairness of the audited financial statements Define the Sampling Unit Sampling units are the individual auditable elements that make up the population Example: sampling units for confirming accounts receivable could be the individual customer’s balance or individual unpaid invoices or a combination of these two Many account balances are comprised of a few large dollar items and many smaller items Dividing a population into two or subgroups based on dollar amount can increase audit efficiency This process (stratification) allow the auditor to examine a significant portion of an account balance even though she/he examines a relatively few items ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) Choosing a Sampling Method There are a number of sampling methods an auditor may use Non-statistical Probability proportional to size (PPS) Classical sampling methods - Mean-per-unit - Ratio estimation - Difference estimation The sampling methods differ in a number of ways: 1. Measure of sampling risk o Statistical methods provide an objective measure of sampling risk o Non-statistical methods do not provide such a measure 2. Tests for account balance o PPS is designed to test for overstatement of an account balance o Classical methods test for both overstatement and understatement 3. Statistical estimates o PPS provides an estimate of the amount of misstatement in the account o Classical methods provide an estimated range of the account balance 4. Sample selection o PPS is a dollar-based approach, each dollar is a sampling unit o Classical samples are selected using a variety of sampling units Whichever sampling method is used, consideration must be given to the risk of misstatement, sampling risk, and the auditor’s assessment of tolerable and expected misstatement Tolerable misstatement Maximum misstatement an auditor will accept before deciding the recorded account balance is materially misstated Expected misstatement Based on results of other substantive tests and auditor’s prior Experience with the client Expected misstatement should be less than tolerable misstatement ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) Analytical Procedures as a Substantive Test Example of analytical techniques, including relationships and sources of data o Financial information for equivalent prior periods, such as comparing the trend of fourth-quarter sales for the past three years and analyzing dollar and percent changes from the prior year o Expected or planned results developed from budgets or other forecasts, such as comparing actual division performance with budgeted performance o Comparison of linked account relationships, such as interest expense and interestbearing debt o Ratios of financial information, such as examining the relationship between sales and cost of goods sold or developing and analyzing common-sized financial statements o Company and industry trends, such as comparing gross margin percentages of product lines or inventory turnover with industry averages o Analysis of relevant nonfinancial information, such as analyzing the relationship between the numbers of items shipped and royalty expense or the number of employees and payroll expense Factors on which effectiveness of substantive analytical procedures depends o Nature of the assertion being tested o Plausibility and predictability of the relationships in the data o Availability and reliability of the data used to develop the expectation o Precision of the expectation that the auditor develops o Rigor of the analytical procedure ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) Analytical Procedure o o o o o Regression analysis Reasonableness test Trend analysis Ratio analysis Scanning Analytical procedures can be used to provided evidence that corroborates an auditor’s already existing information about the correctness of an account balance and should be used when the procedures are o o Reliable More cost-effective than other substantive procedures Analytical procedures are designed to provide independent evidence about account balances-not to replace the client’s underlying estimation process ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) Chapter 9 Auditing for Fraud The Center for Audit Quality (CAQ) is a group affiliated with the AICPA, outlined a framework for future action including a fraud deterrence and detection plan that recognizes the importance of three fundamental principles: A strong, highly ethical tone at the top of an organization that permeates the corporate culture, including an effective fraud risk management program, is essential Skepticism, a questioning mindset that strengthens professional objectivity, is required of all participants involved in preparing financial statement and related reports Strong communication among supply chain participants, including management, the audit committee, internal audit, external audit, and regulatory authorities (where applicable) is key Fraud is defined as international embezzlements or thefts of funds from a company, or the international misstatement of financial account balances in order to achieve a perception that a company is doing better than it really is Traditionally defined into broad categories: Defalcations Fraudulent financial reporting Defalcation Employee takes assets from the organization for personal gain. For example: theft, embezzlement ACFE divides frauds due to o Corruption - Fraudsters use their influence in a transaction to gain personal theft - Example: kickbacks, conflict of interest, bribery, economic extortion o Asset misappropriation - Theft or misuse of organization’s assets - Common schemes: skimming revenues, cash schemes, fraudulent disbursement, inventory theft, payroll fraud Defalcation may create misleading financial statements if stolen assets are reported on the statements Fraudulent Financial Reporting The most common types are: o o o Overstate assets and understate expense Overstate revenues and assets Understate liabilities ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) Lessons Learned from Fraud Cases: Auditors take risk whenever they do not audit the entire company Auditors need to look at economic assumptions underlying a company’s growth Auditors need to assess risk factors and when the risk of fraud is high, they must demand stronger evidence Computer errors should be viewed as a risk factor Dominant clients can be a problem Auditors need to know what motivates management Auditors should not assume all people are honest When fraud risk indicators are discovered, they must be thoroughly investigated General Characteristics of Financial Reporting Frauds and Audit Implications The auditor should not be pressured by the client’s desire to release annual earnings at an early date If there are potential problems with revenue, the audit cannot be completed until there is sufficient time to examine major year-end transactions The auditor must understand complex transactions to determine their economic substance and the parties that have economic obligations The auditor must clearly understand and analyze weaknesses in an organization’s internal controls in order to determine where and how a fraud may take place Audit procedures must be developed to address specific opportunities for fraud to take place, and cannot be addressed by expansion of generalized audit programs The auditor must always exercise professional skepticism when there may be indications of opportunities for fraud to take place Auditing Standards That Reflect a Responsibility to Detect Fraud The auditor has a responsibility to detect and address material misstatements in an organization’s financial statements regardless of whether the misstatements were (a) intentional or just errors, and (b) defalcations or fraudulent financial reporting. Fraud, however, has some characteristics that make its detection complex and difficult o Is always intentional (and thereby intended to be covered up) o Often involves top management who have the ability to override existing controls o Often involves complex transactions that may be difficult to understand o Often starts out small and then increases when it is not detected, thereby making it less susceptible to discovery solely by analytical procedures o Is always a response to an incentive or perceived need by those perpetrating the fraud ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) A Standards-Based Proactive Approach to Fraud Detection The planning process alerts auditors to “red flags” or potential fraud factors that must be addressed on every engagement In planning the audit, and considering the risk of fraud, the auditor must: o Understand the business and the risks it faces o Understand changes in the economy and how changes in the economy might affect the business o Understand potential management motivation to perpetrate a fraud o Identify opportunities for other employees to conduct a defalcation o Analyze current changes in the company’s financial results to determine if the results look reasonable o Identify areas that might be indicative of fraud, or of the potential for fraud Conducting the Financial Statement Audit- Fraud Awareness There are 10 general steps to an effective audit program that integrate fraud risk assessment and fraud procedures into the audit opinion formulation process These steps which are based on the exercise of professional skepticism throughout the engagement, include: 1) Understand the nature of fraud (type of fraud, motivations to commit fraud, and the manner in which fraud may be perpetrated) 2) Conduct brainstorming session to consider potential opportunities, motivation, and rationalization for fraud and share knowledge with other audit team members 3) Obtain additional information that may be useful in identifying and assessing fraud risk 4) Identify the specific fraud risks, including potential magnitude and areas likely to be affected by a fraud 5) Evaluate the quality of the company’s controls and potential effectiveness in mitigating the risk of fraud 6) Adjust audit procedures to assure that the audit adequately addresses the risk of fraud and provides evidence specifically related to the possibility of fraud 7) Gather and evaluate audit evidence 8) Communicate the possibility that fraud exists to management, and, where applicable, to the audit committee and/or the full board 9) Determine the appropriate way in which to report any identified fraud 10) Document the audit approach, starting with Step1 through the completion of all of the steps identified above ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) Chapter10 Auditing Revenue and Related Accounts The cycle Approach Revenue cycle transaction include all the processes ranging from the sale to shipping a product, billing the customer, and collecting cash A company’s revenue cycle transactions reflects its operations A cycle approach is one way to help the auditor focus on the important account balances surrounding a transaction to ensure that sufficient audit evidence is gathered and evaluated Audit Steps for an Integrated Audit Step 1& 2 Consider the Risk of Misstatement in the Revenue Cycle While sales transactions are routine for most organization and do not represent an abnormally high risk, for other organization, revenue recognition may be complicated Difficult audit issues include: o When to recognize revenues - Auditor must understand client’s operations and related GAAP issues - Example: point of sale revenue recognition vs. percentage of completion o Impact of any unusual sales terms and whether title passed to customer o Goods recorded as sales have been shipped o Sales made with recourse or that have significant returns - Example: irrevocable right to return goods The presence of these issues increase inherent risk and the probability of material misstatement Primary risk is net receivables will be overstated, because either receivables have been overstated, or the allowance for uncollectible accounts has been understated Step3 Perform Preliminary Analytical Procedures The auditor then performs a preliminary review and notes that: o There is no unusual year-end sales activity o Accounts receivable growth is consistent with revenue growth o Revenue growth, receivables growth, and gross margin are consistent o There is no unusual concentration of sales made to customers Step4 Develop an Understanding of Internal Controls Although the auditor must understand all components of internal controls, particular attention is paid to significant control procedures and monitoring controls The auditor obtains an understanding of the controls by o walk-through of the processing of transactions o inquiry o observation ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) o review of client documentation It is critical this understanding be documented in the work papers Step5 Identify Important Controls The auditor understands the risks of the revenue cycle The following key controls are identified for testing o Credit authorization and consistency of credit policies o Access to the computerized price list for goods sold o Accuracy of quantities and prices for items shipped and billed o Daily reconciliation of items shipped and items billed Step 6&7 Design and Perform Tests of Internal Control and Analyze the Results The following procedures are used to design and test internal controls o Sample of shipment is selected and traced to invoice o Access to the price table maintained in the computer is tested through an examination of the computer access logs o The invoices are traced into the general ledger o Auditor makes inquires and verifies for changes Step8 Perform Substantive Tests Since revenue is always considered high risk, the auditor performs the following substantive test of details as year-end procedures: o Examines shipments made during the last 15 days of the year and first 15 days of the next year to determine that they are (a) appropriate (normal terms, etc.) and (b) are recorded in the correct time period o Sends a sample of accounts receivable confirmations to customers selected using MUS sampling o Examines the client’s allowance for uncollectible accounts for: - consistency with past years - subsequent collections and - consistency with industry trends Risk related to revenue recognition Recognition of revenue on shipments that never occurred Hidden “side letters” giving customers an irrevocable right to return the product Recording consignment sales as final sales Early recognition of sales that occurred after the end of the fiscal period Shipment of unfinished product Shipment of product before customers wanted or agreed to delivery Creation of fictitious invoices Shipment to customers that did not place an order ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) Shipment of more product than the customer ordered Recording shipments to the company’s own warehouse as sales Shipping goods that have been returned and recording the reshipment as a sale of new goods before issuing credit for the returned sale Criteria for Revenue Recognition Persuasive evidence of an arrangement exists Delivery has occurred or services have been rendered The seller’s price to the buyer is fixed or determinable Collectability is reasonable assured External and Internal Risk Factors External o Analyst expectations o Industry trends o Investigations Internal o Management compensation schemes o Expiration of stock options o Accounting is not centralized o Weak controls o CFO does not have an accounting background o Use of stock option to increase stock’s market value Substantive Tests of Revenue Cutoff Issues Can be performed for sales, sales returns, cash receipts o Provides evidence whether transactions are recorded in the proper period o Cutoff period is usually several days before and after balance sheet due o Extent of cutoff tests depends on effectiveness of client controls Sales cutoff o Auditor selects sample of sales recorded during cutoff period and vouches back to sales invoice and shipping documents to determine whether sales are recorded in proper period o Cutoff tests assertions of existence and completeness o Auditor may also examine terms of sales contracts Sales return cutoff o Client should document return of goods using receiving reports o Reports should date, description, condition, quantity of goods o Auditor selects sample of receiving reports issued during cutoff period and determines whether credit was recorded in the correct period ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) Types of Confirmations Positive confirmations o Customers are asked to agree the amount on the confirmation with their accounting records and to respond directly to the auditor whether they agree with the amount or not o Positive confirmation requires a response o If customer does not respond, auditor must use alternative procedures Negative Confirmations o Customers are asked to respond only if they disagree with the balance (nonresponse is assumed to mean agreement) o Less expensive since there are no additional procedures if customer does not respond o May be used when all of the following are present - Confirming a large number of small customer balances - Environment risk for receivables is assessed as low - Auditor believes customers will give proper attention to confirmations ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) Chapter 11 Audit of Acquisition and Payment Cycle and Inventory The acquisition and payment cycle includes identifying products or services, purchasing, receiving, approving payments, and paying for goods and services received. Major accounts include inventory, cost of goods sold, accounts payable and expense. Acquisition and payment cycle consists of five distinct activities Requisition for goods or services Purchase of goods or services according to company policies Receipt of goods and services Approval of items for payment Cash disbursement Integrated Audit of Acquisition and Payment Cycle Phases I and II of the Audit Opinion Formulation Process o Continually update information on business risk o Analyze potential motivations to misstate accounts in the acquisition and payment cycle o Perform preliminary analytical procedures to determine if unexpected relationships exist in the accounts o Develop an understanding of the internal controls in the acquisition and payment cycle that are designed to address the risks identified in the three previous steps Phases III and IV of the Audit Opinion Formulation Process o Determine the important controls that need to be tested o Develop a plan for testing internal controls and perform the tests of key controls in the acquisition and payment cycle o Analyze the results of the tests of controls o Perform planned substantive procedures based on the potential for misstatement and the information gathered Risk Related to the Acquisition and Payment Cycle Acquisition cycle deals with receipt of all goods and services Misstatements may occur just because of the volume of transactions Frauds that have taken place include the following: o Employee theft of inventory o Employee schemes involving fictitious vendors as means to transfer payments to themselves o Executives misusing travel and entertainment accounts and charging them as company expense o Schemes to classify expense as assets o Manipulation of “restructuring reserves” to manage future income Number of potential fraud indicators that affect the cycle include: ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) o o o o Inventory growing at a rate greater than sales Expenses significantly above or below industry norms Capital assets growing faster than the business and for which there are not strategic plans Significant reduction of “reserves” Substantive Tests of Accounts Payable The auditor’s main concern is that accounts payable will be understated. Therefore, emphasis is placed on testing the completeness assertion Typical substantive tests include: o Analytical review of related accounts (e.g. Expense accounts) o Tests of subsequent disbursements o Reconcile vendor statements or confirm accounts payable Analytical Review of Related Expense Accounts Used to determine if accounting data indicates understatement of expense. If understatement is likely, auditor expands tests of accounts payable Analytics used on clients with low control risk Test Subsequent Disbursements Auditor samples cash disbursements after the end of the year Determines if disbursements are for audit year transactions by vouching back to source documents (purchase order, vendor invoice, receiving report) If disbursement is for audit year transaction, auditor reprocesses the transaction to see if it was properly recorded as a payable Reconciling Vendor Statements or Confirmations with Payables Auditor requests vendors’ monthly statements or sends confirmation to major vendors Auditor reconciles vendor statement or confirmation with client balance in the accounts payable subsidiary ledger Substantive Tests of Expense Accounts Auditing payables and cash disbursements provides indirect evidence about expense accounts Additional analysis of selected expense accounts is usually merited The auditor should consider management is more likely to o Understate rather than overstate expenses o Classify expenses as assets rather than vice versa Substantive audit procedures include: ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) o o o Detailed tests of transactions Analytical review Review of unusual entries Inventory and Cost of Goods Sold Audit of inventory is complicated by a number of factors including: o Variety of items o High volume of activity o Various (complex) valuation o Difficulty in identifying obsolete or defective inventory o Many frauds involve the inventory account o Easily transportable making it subject to double counting o May be stored at multiple locations, some may be remote o May be returned by customers Inventory and cost of goods sold accounts are prone to errors Inventory frauds are one of the most common frauds used by management to manage earnings and misrepresent the financial position of the company A well-designed inventory control system should ensure: o All purchases are authorized o Accounting system ensures timely, accurate, and complete recording o Receipt of inventory properly accounted for o Costs properly identified and assigned to products o All products are systematically reviewed for obsolescence o New products introduced only after market studies and quality control tests have been made Substantive Tests of Inventory and Cost of Goods Sold o Existence : observe year-end physical inventory o Completeness: cutoff tests o Rights: review long-term contracts, etc. o Valuation: direct tests and analytics o Disclosure: review GAAP Procedures for Observing a Client’s Physical Inventory o Meet with client to discuss their plan to count inventory o Review client’s plans for counting and tagging inventory o Review inventory counting procedures with audit personnel o Determine whether specialists are needed to identify inventory items o Observe the counting inventory and note the following: - The first and last tag numbers in each section - Account for all tag numbers to prevent later insertion of additional inventory items o Document conclusion as to quality of the inventory counting process After the inventory count, the auditor should: o Trace the test counts to the client’s inventory records ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) o o Trace the number of high-dollar items to the client’s inventory records Trace the obsolete or damaged inventory to the client’s inventory records to see if the items have been written down Cost of Goods Sold o Audit of Cost of Goods Sold can be direct tied to the audit of inventory o If beginning and ending inventories have been verified and acquisitions have been tested, cost of goods sold can be directly calculated o Auditor should also apply analytics to cost of goods sold to see if there are any significant variations-either overall or by product line ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) Chapter 13 Audit of Long-lived Assets and Related Expense Accounts Integrated Audit of Long-Lived Assets and Related Expenses Phases I and II of the Audit Opinion Formulation Process o Continually update information on business risk o Analyze potential motivations to misstate long-lived asset and related expense accounts o Perform preliminary analytical procedures and document how the audit testing should be modified o Develop an understanding of the internal controls over long-lived assets and related expense accounts Phases III and IV of the Audit Opinion Formulation Process o Determine the important controls that need to be tested o Develop a plan for testing internal controls and perform the tests of key controls on cash and other liquid asset accounts o Analyze the results of the tests of controls o Perform planned substantive procedures Risks Associated to Long-Lived Assets o Ways fixed assets can be used to manage earnings: - Change estimated useful lives and residual values - Capitalize costs that should be expensed, such as repairs and maintenance - Improperly accounting for asset restructuring or acquisition - Failing to properly perform asset impairment adjustments - Account for capital leases as operating leases Risks Associated with Fixed Assets and Related Expenses o Incomplete recording of asset disposals o Environmental liabilities or claims related to violations of safety and protection regulations o Obsolescence of assets o Restructuring charges related to changes in the nature of the business o Incorrect valuation of assets acquired as part of a group purchase o Incorrect recording of assets, hidden by complex ownership structures designed to keep assets (and related liabilities) off the books o Amortization or depreciation schedules that do not reflect the economic use of the asset o Failure to properly recognize impairments in value Disposal and Fully Depreciated Equipment Many organizations do not exercise the same degree of control over asset disposals as they do for acquisitions Audit procedures are designed to test that ALL disposals have been recorded ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) o o o o Use generalized audit software to prepare a printout of fully depreciated (or nearly fully depreciated) equipment and then attempt to locate it Review acquisition documents for trade-ins Review the property ledger to make sure that the traded-in asset has been removed Ask client about any assets that have been removed. Trace to the property ledger to make sure asset has been removed Asset Impairment There may be significant declines in the value of fixed assets due to technological obsolescence, or new manufacturing techniques If there is evidence of asset impairment, valuation must be assessed Two approaches to valuating impaired assets: 1) Estimate the future economic benefits to be derived from the asset 2) Obtain an independent assessment of the value of the asset For the first approach, auditors perform a recoverability test to determine if asset is impaired For the second approach, the auditor may o Obtain appraisal from independent and qualified appraisal firm o Review current transactions to determine if there has been a decrease in purchase price Discontinued Operation Company should write net assets down to net realizable value In assessing fair market value, auditor will normally: o Request estimate of value from an investment broker o Discount estimate future cash flows to develop estimate of value The nature of the discontinuance decision and the amount of write-down should be fully disclosed in the notes to the financial statements Depreciation Expense and Accumulated Depreciation The procedures used to test depreciation will depend on the controls over depreciation and the risk associated with the engagement and account balance Low risk – analytical procedures: o Current estimate of depreciation is calculated and modified for additions and disposals during the year o Ratios are computed to determine reasonableness of current depreciation High risk – test the details: o Foot the property ledger and agree to the general ledger o Recalculate depreciation for sample of items ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) Intangible Assets May be difficult to determine which costs should be capitalized especially for internally developed intangibles Auditor will review client accounting to ensure per GAAP May be difficult to determine appropriate amortization period o Expected economic life or legal life, whichever is shorter o should review trade publications for competition and new product introductions o should make inquiries of client and legal counsel o should review client procedures for determining when intangibles become impaired Natural Resource o o o o o o o o Most companies have procedures for identifying costs Auditor should test capitalization for new assets by examining documents Many companies use geologists to estimate amount of natural resources Auditor may hire a specialist to review any geological analysis Depletion is based on units of production approach Auditor may use analytics like current depletion compared to prior years Auditor may analyze production data then recomputed depletion Auditor should examine the reasonableness of procedures used by management to estimate cost Leases Reasons for leases include: o Finance the use of the asset instead of making an outright purchase o Acquire the use of the asset for relatively short periods of time without having to buy and then sell it o Acquire the use of asset for an extended period of time but keep the asset and related liability off the balance sheet o Maintain a flexible operating profile, that is, substitute short-term variable costs for fixed costs Audit Approach: o Obtain copies of lease agreements o Review lease expense account o Develop a schedule of all future lease obligations o Review the client’s disclosure of lease obligations ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) Chapter 15 Ensuring Audit Quality in Completing the Audit Assuring that the audit is conducted in a high-quality manner is paramount to fulfilling users’ expectations about the auditor’s role in the capital markets Factors affecting audit quality include: Audit Firm Culture Skills and Qualities of the Engagement Team Effectiveness of the Audit Process Reliability and Usefulness of Audit Reporting Factors Outside the Control of Auditors that Affect Audit Quality As the auditor completes the audit, various types of review activities are conducted to ensure that the client’s financial statements are materially correct and to ensure high audit quality Reviewing Contingencies Contingent losses that are probable, reasonably estimated, and remote should be accrued and disclosed Contingent losses that are reasonably possible, and remote contingencies disclosed because of common practice, should be disclosed in the notes to the financial statements Contingencies include: o Threat of expropriation of assets in a foreign country o Litigation, claims, and assessments o Guarantees of debts of others o Obligations of banks under standby letters of credit o Agreements to repurchase receivables that have been sold o Purchase and sale commitments Responsibilities o Management is responsible for identifying, evaluating, and accounting for contingencies o Auditor is responsible for determining client has properly identified, accounted for, and disclosed material contingencies Source of Evidence o Primary sources include management and client’s legal counsel o Additional sources include corporate minutes, contracts, correspondence from government agencies and bank confirmations ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) Letter of Audit Inquiry Primary source of corroborative evidence concerning litigation, claims, and assessments is the client’s legal counsel Letter of inquiry should include: o Identification of the company, its subsidiary and the date of the audit o Management’s list that describes and evaluates its contingencies o A request that the attorney furnish auditor with the following: - Comment on the completeness of management’s list and evaluations - Any limitations on the attorney’s response Letter of inquiry is good for establishing completeness of potential liabilities and providing factual information about contingencies. However because audit workpapers are not privileged, attorney responses will be less than forthcoming about the likelihood of unfavorable outcomes, and the estimated amount of any potential losses An attorney’s refusal to provide the requested information is a scope limitation sufficient to preclude issuing an unqualified opinion Review of Significant Estimates Management estimates provide opportunities for the entity to manage or even manipulate earnings Companies may underestimate liabilities or impairment of asset values to achieve reported earning goals The auditor provides reasonable assurance that o Management has information system to develop estimates material to the financial statements o Estimates are reasonable o Estimates are presented per GAAP In evaluating management estimates, the auditor concentrates on key factors and assumptions that are o Significant to the accounting estimate o Sensitive to variations o Deviations from historical patterns o Susceptible to misstatement and bias o Inconsistent with current economic trends Evaluating Adequacy of Disclosure Third standard of reporting states “When informative disclosures are not reasonably adequate, the auditor must note that fact in the auditor’s report” Disclosures can be made either on the face of the financial statements and/or in the notes to the statements ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) Performing Analytical Review Analytical procedures are required in both planning phase and the final review phase Audit team analyzes the data from an overall business perspective Engagement Quality Review Concurring partner review o Independent review by experienced auditor who is not part of audit team o Sarbanes/Oxley Act requires for audits of public companies Partner rotation o Sarbanes/Oxley Act requires new audit engagement and concurring review partner every 5 years o Does not apply to CPA firms with less than 10 partners and 5 public company audit clients Documentation of an engagement quality review include: o Who performed the engagement quality review o Documents reviewed by the quality engagement reviewer o Significant discussions held by the engagement quality reviewer o Date the engagement quality reviewer Assessing Subsequent Events Subsequent events occur after the balance sheet date. Types of subsequent Events o o o o o o Type 1 subsequent events provide evidence about conditions that existed at the balance date The financial statement numbers should be adjusted to reflect this information; footnote disclosure may also be necessary Example of type 1 subsequent events: - Major customer files for bankruptcy during subsequent period, its deteriorating financial condition existed prior to the balance sheet date - Lawsuit settled for different amount than accrual - Stock dividend or split during the subsequent period - A sale of inventory below carrying value provides evidence that the net realizable value was less than cost at year end Type2 subsequent events provide evident about conditions that did not exist at the balance sheet date The financial statement numbers should not be adjusted for these events , but they should be considered for disclosure Example of Type 2 subsequent events: - Uninsured casualty loss that occurs after the balance sheet date - Significant lawsuit initiated for incident occurring after the balance sheet date ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning) - Significant loss due to natural disaster occurring after the balance sheet date - Major decisions made during the subsequent period such as to merge, discontinue a line of business, or issue new securities - Material change occurs in the value of investment securities Audit procedures used to identify subsequent events include: o o o o Read minutes of meetings of the board of directors, stockholders, and other authoritative groups held after year-end Read interim financial statements: investigate significant changes Inquire of management about significant changes / unusual accounting adjustments If subsequent event occurs after end of fieldwork but before audit report is issued, auditor must decide whether to single or dual date the audit report Single date – using the date of this event as the date of the audit report Dual date- using the dates of the original audit report and the date of the event, to disclose the work done only on that events after the original audit report date Going-Concern Assumption Auditor is required to evaluate client’s ability to remain a going concern for a period not to exceed one year from the balance sheet date Indicators of potential going concern problems include o Negative trends in key financial areas like cash flow, sales, profits o Internal matters such as loss of key personnel, and outdated facilities and/or products o External matters, such as new legislation, loss of significant customer or supplier, uninsured casualty loss o Other matters, such as loan default, inability to pay dividends, attempted debt restructuring o Significant changes in the competitive market and the competitiveness of the client’s products If there is substantial doubt about ability of client to remain a going concern, auditor should: o Discuss the situation with management o Assess management’s plan to overcome problems o Consider the effects on the financial statements o Consider the effects on the audit report ACT3641 Auditing1 Textbook: Auditing, 8th Edition, Audrey A. GRamling, Larry E. Rittenberg, and Karla M. Johnstone (South-Western CENGAGE Learning)
