AUDITING
A RISK-BASED APPROACH TO
CONDUCTING A QUALITY AUDIT
9th Edition
Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg
CHAPTER 5
PROFESSIONAL AUDITING STANDARDS AND THE
AUDIT OPINION FORMULATION PROCESS
Copyright © 2014 South-Western/Cengage Learning
LEARNING OBJECTIVES
1.
2.
3.
4.
Identify and compare the various auditing standards
that provide guidance on the audit opinion
formulation process
List and discuss the foundational principles
underlying the auditing standards
List the phases and related activities in the audit
opinion formulation process
Explain the concept of accounting cycles and
discuss their importance to the audit opinion
formulation process
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LEARNING OBJECTIVES
5.
6.
7.
8.
Describe the assertions that are inherent to
financial statements and explain their importance
to the audit opinion formulation process
Define audit evidence and describe the purpose
and types of audit procedures used to obtain audit
evidence
Discuss the importance of audit documentation and
provide examples
Discuss audit activities in Phase I of the audit
opinion formulation process
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LEARNING OBJECTIVES
9.
10.
11.
12.
Discuss audit activities in Phase II of the audit
opinion formulation process
Discuss audit activities in Phase III of the audit
opinion formulation process
Discuss audit activities in Phase IV of the audit
opinion formulation process
Discuss audit activities in Phase V of the audit
opinion formulation process
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LEARNING OBJECTIVES
13.
14.
Apply the concepts related to the auditor’s
assessment of internal control design effectiveness,
implementation, and operating effectiveness
Apply the frameworks for professional decision
making and ethical decision making to issues
involving conducting an audit
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THE AUDIT OPINION FORMULATION
PROCESS
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PROFESSIONAL JUDGMENT IN CONTEXT - IMPORTANCE
OF ADHERING TO PROFESSIONAL AUDITING STANDARDS
• Adhering to the professional auditing standards is
viewed as conducting a quality audit
• Lack of adherence heightens the risk of issuing an
unqualified audit opinion on financial statements
that are materially misstated
• Highlighted in the 2004-2006 audits of Thornton
Precision Components, Limited (TPC) performed by
Ernst & Young, LLP UK (E&Y UK)
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PROFESSIONAL JUDGMENT IN CONTEXT - IMPORTANCE
OF ADHERING TO PROFESSIONAL AUDITING STANDARDS
• What is the role of auditing standards and their
underlying principles in promoting a quality audit?
(LO 1, 2)
• How does the fundamental concept of professional
skepticism relate to audit quality? (LO 2)
• What audit evidence is necessary for opining on a
client’s financial statements? (LO 6)
• How does audit documentation provide evidence
related to audit quality? (LO 7)
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PROFESSIONAL JUDGMENT IN CONTEXT - IMPORTANCE
OF ADHERING TO PROFESSIONAL AUDITING STANDARDS
• What audit activities are conducted during the audit
opinion formulation process to provide reasonable
assurance about a client’s financial statements? (LO
8, 9, 10, 11, 12)
• How does professional judgment and ethical decision
making contribute to audit quality? (LO 14)
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LEARNING OBJECTIVE 1
IDENTIFY AND COMPARE THE VARIOUS
AUDITING STANDARDS THAT PROVIDE
GUIDANCE ON THE AUDIT OPINION
FORMULATION PROCESS
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PROFESSIONAL AUDITING STANDARDS
• Auditors in the United States follow auditing
guidance issued by:
• American Institute of Certified Public Accountants
(AICPA)
• Public Company Accounting Oversight Board (PCAOB)
• International Auditing and Assurance Standards Board
(IAASB)
• Common objective - Provide assurance to public that
audits are conducted in a quality manner
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PROFESSIONAL AUDITING STANDARDS
• Require auditors to develop and communicate:
• Opinion on financial statements
• Client’s internal control over financial reporting
• Vary according to the nature of organization audited
• Audit compliance depends on:
• Domicile of the organization
• Where its stock is publicly traded
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AICPA’S AUDITING STANDARDS BOARD
- CLARITY PROJECT
• Made standards easier to read, understand, and
apply
• Converged its standards with the International
Standards on Auditing (ISAs), issued by the IAASB
• Standards were written using drafting convention
called the clarity format
• Issued the clarified standards in a single Statement
on Auditing Standard (SAS No. 122) in 2012
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EACH STANDARD OF CLARITY FORMAT
PRESENTED IN FOLLOWING SECTIONS
Introduction
•Purpose and scope of the standard
Objective
•Context in which the requirements are set
Definitions
•Relevant meanings of terms in standards
Requirements
•Actions required to achieve objective of the standard
Application and other explanatory material
•Cross-references to the requirements
•Guidance for applying requirements of standard
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AUDITING STANDARDS ISSUED BY THE
IAASB
• Objectives
• Set auditing, assurance, and other related standards
• Facilitate convergence of international and national
auditing and assurance standards
• Enhance quality and consistency of practice throughout
the world
• Strengthen public confidence in the global auditing and
assurance profession
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AUDITING STANDARDS ISSUED BY THE
IAASB
• Standards should to be understandable, clear, and
consistent
• Launched a program in 2004 to enhance clarity of its
ISAs
• Clarity Project was completed in 2009
• As of 2013, a set of its clarified standards comprises
of:
• 36 ISAs
• 1 International Standard on Quality Control (ISQC)
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EACH STANDARD OF CLARITY FORMAT
PRESENTED IN FOLLOWING SECTIONS
Introduction
•Purpose and scope of subject matter of ISA
Objective
•Clear statement of the objective of the auditor
Definitions
•For applicable terms included
Requirements
• For each objective are provided
Application and other explanatory material
•Explains what a requirement means or intends to cover
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AUDITING STANDARDS ISSUED BY THE
PCAOB
• Apply to auditors of U.S. public companies
• Issued sixteen Auditing Standards (ASs) as of 2013
• PCAOB interim standards - Standards adopted from
AICPA
• Requirement for public company auditors, unless
superseded by a PCAOB standard
• Standards issued by AICPA after April 16, 2003, not
included
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EXHIBIT 5.1 - COMPARISON OF U.S. AND
INTERNATIONAL AUDITING STANDARDS
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LEARNING OBJECTIVE 2
LIST AND DISCUSS THE FOUNDATIONAL
PRINCIPLES UNDERLYING THE AUDITING
STANDARDS
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PCAOB GUIDANCE - GENERAL
STANDARDS
• Require
• Audit to be performed by individuals having adequate
technical training and proficiency as an auditor
• Auditors to be independent:
• In fact, i.e., in reality in terms of mental attitude and
• In appearance, i.e., in how the auditor is perceived by
users
• Audit to be conducted with professional care expected
of a prudent auditor
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PCAOB GUIDANCE - FIELDWORK
STANDARDS
• Applicable to conduct of the audit
• Require auditors to:
• Properly plan and supervise the audit
• Develop an understanding of client’s controls
• Prerequisite for developing audit tests
• Obtain audit evidence by performing audit procedures
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PCAOB GUIDANCE - REPORTING
STANDARDS
• Applicable to communicating auditor’s opinion
• Require auditors to:
• State whether financial statements are presented in
accordance with the applicable financial reporting
framework (i.e., GAAP or IFRS)
• Identify conditions where accounting principles are not
consistently observed
• Review disclosures for adequacy and state in the report if
disclosures are not reasonably adequate
• Express an opinion on financial statements as a whole or
state that an opinion cannot be expressed
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AICPA GUIDANCE - PURPOSE AND
PREMISE OF AUDIT
• Purpose - Enhance degree of confidence that users
can place in financial statement
• Premise - Management has responsibility to:
• Prepare financial statements
• Maintain internal control over financial reporting
• Provide auditor with relevant information and access
to personnel
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AICPA GUIDANCE - RESPONSIBILITIES
• The auditor’s responsibilities include
• Having appropriate competence and capabilities to
perform audit
• Complying with ethical requirements
• Maintaining professional skepticism throughout the
audit
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AICPA GUIDANCE - PERFORMANCE
• Obtain assurance that financial statements are free
from material misstatement
• Limitations - Lack of absolute assurance about financial
statements being free from misstatement
• Requires an auditor to:
•
•
•
•
Plan and supervise work
Determine materiality levels
Identify risks of material misstatement
Design and implement audit responses to assessed risks
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AICPA GUIDANCE - REPORTING
• Expressing either of the following
• Financial statements are free of material misstatement
• Stating that an opinion cannot be expressed
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INTEGRATED AUDIT
• Combines audits of an organization’s financial
statements and its internal control over financial
reporting
• In this audit:
• Opinion provided on effectiveness of internal control
over financial reporting
• Additional audit work done to be able to issue that
opinion
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AUDITING IN PRACTICE - BENEFITS OF
INTEGRATING THE AUDITS
• Integrating audits of internal controls and of financial
statements makes sense
• Both the tests of controls and direct tests of account
balances provide evidence related to each other
• Example:
• Tests of controls provide indirect evidence that financial
statements are free from misstatement
• Further, if material misstatements found in account
balances or disclosures, it implies that there were
material weaknesses in internal controls
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LEARNING OBJECTIVE 3
LIST THE PHASES AND RELATED ACTIVITIES IN
THE AUDIT OPINION FORMULATION PROCESS
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EXHIBIT 5.2 - OVERVIEW OF CLIENT’S PREPARATION OF
FINANCIAL STATEMENTS AND MANAGEMENT REPORT ON
INTERNAL CONTROL
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EXHIBIT 5.3 - ACTIVITIES OF EACH PHASE OF THE
AUDIT OPINION FORMULATION PROCESS
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IMPORTANT CONCEPTS AFFECTING AUDIT
OPINION FORMULATION PROCESS
• Accounting cycles
• Management assertions
• Audit evidence and audit procedures
• Documentation
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LEARNING OBJECTIVE 4
EXPLAIN THE CONCEPT OF ACCOUNTING
CYCLES AND DISCUSS THEIR IMPORTANCE TO
THE AUDIT OPINION FORMULATION PROCESS
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ACCOUNTING CYCLES
• Recording and processing transactions that affect a
group of related accounts
• Begin when a transaction occurs and ends when it is
recorded in financial statements
• Break the audit into manageable sections of related
accounts
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ACCOUNTING CYCLES
• Auditor focuses on:
• Flow of transactions within a particular cycle
• Identifying:
• Points where material misstatement can occur
• Controls that have been designed and implemented to
mitigate those risks
• Understanding risks and controls within each cycle
• Helps determine specific audit procedures to be used and
specific audit evidence to be obtained
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EXHIBIT 5.4 - ILLUSTRATIONS OF CYCLES
AND RELATED ACCOUNTS
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LEARNING OBJECTIVE 5
DESCRIBE THE ASSERTIONS THAT ARE INHERENT TO
FINANCIAL STATEMENTS AND EXPLAIN THEIR
IMPORTANCE TO THE AUDIT OPINION
FORMULATION PROCESS
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FINANCIAL STATEMENT ASSERTIONS
• Assertions made by management
•
•
•
•
•
Existence
Completeness
Rights and obligations
Valuation
Presentation and disclosure
• Related evidence is obtained for accounts and
disclosure in financial statements
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MANAGEMENT’S FINANCIAL STATEMENT
ASSERTIONS IN PCAOB STANDARDS
Existence or Occurrence
• Refers to existence of assets and liabilities
• Refers to occurrence of recorded transactions
Completeness
• Refers to inclusion of all transactions and accounts in financial statements
Valuation or Allocation
• Refers to inclusion of accounts in financial statements at appropriate
amounts
Rights and Obligations
• Refers to assets being the rights of an organization
• Refers to liabilities being the obligations of an organization
Presentation and Disclosure
• Refers to components of financial statement being properly classified,
described, and disclosed
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LEARNING OBJECTIVE 6
DEFINE AUDIT EVIDENCE AND DESCRIBE THE
PURPOSE AND TYPES OF AUDIT PROCEDURES
USED TO OBTAIN AUDIT EVIDENCE
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AUDIT EVIDENCE AND PROCEDURES
• Audit evidence: Information used by auditor in
arriving at conclusions on which the opinion is based
• Audit procedures: Procedures designed to obtain
audit evidence to support audit opinion(s)
• Risk assessment procedures
• Provide information for assessing the risks of material
misstatement in the financial statements
• Do not provide sufficient evidence upon which to base an
audit opinion
• Used for purposes of planning the audit
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AUDIT EVIDENCE AND PROCEDURES
• Tests of controls: Designed for evaluating operating
effectiveness of controls in preventing, or detecting
and correcting, material misstatements, typically at
assertion level
• Substantive procedures
• Designed for detecting material misstatements at
assertion level
• Comprising of tests of details and substantive
analytical procedures
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AUDIT PROCEDURES
• Sufficient appropriate audit evidence: Measure of the
quantity of audit evidence about following factors of
audit procedures
• Nature
• Timing
• Extent
• Audit program
• Lists audit procedures to be followed in gathering
evidence
• Helps monitor progress and supervising work
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EXHIBIT 5.6 - TYPES OF AUDIT
PROCEDURES
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LEARNING OBJECTIVE 7
DISCUSS THE IMPORTANCE OF AUDIT
DOCUMENTATION AND PROVIDE EXAMPLES
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AUDIT DOCUMENTATION
• Record of audit procedures performed, relevant
audit evidence obtained, and conclusions the auditor
reached
• Known as working papers or workpapers
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PURPOSES OF AUDIT
DOCUMENTATION
• Assisting engagement team in:
• Planning and performing audit
• Supervising and reviewing audit work
• Retaining a record of matters of continuing
significance to future audits
• Enabling internal or external inspections of
completed audits
• Assisting auditors in understanding work performed
in prior year
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EXAMPLES OF AUDIT
DOCUMENTATION
• Audit programs
• Analyses prepared by client or auditor
• Memorandums
• Summaries of significant findings or issues
• Letters of confirmation and representation
• Checklists
• Correspondence concerning significant findings or
issues
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LEARNING OBJECTIVE 8
DISCUSS AUDIT ACTIVITIES IN PHASE I OF THE
AUDIT OPINION FORMULATION PROCESS
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PHASE I - MAKING CLIENT ACCEPTANCE
AND CONTINUANCE DECISIONS
• Preconditions for accepting auditing engagements
• Use of an acceptable financial reporting framework
• Agreement of management to acknowledge and
understand its responsibilities
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AUDITING IN PRACTICE - ACCEPTING A
NEW AUDIT ENGAGEMENT
• Communicate with predecessor auditor
• Following issues should be addressed
• Information regarding integrity of management
• Disagreements with management about accounting
policies, auditing procedures
• Communications to management and those in charge
with governance regarding:
• Fraud and noncompliance with laws
• Deficiencies and material weaknesses in internal control
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AUDIT ENGAGEMENT LETTER
• Document specifying responsibilities of client and
auditor that includes the following:
• Objective and scope of audit of financial statements
• Responsibilities of auditor and management
• Statement that some material misstatements may not be
detected due to inherent limitations of audit and internal
control
• Identification of applicable financial reporting framework
for preparation of financial statements
• Reference to expected form and content of any reports to
be issued
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LEARNING OBJECTIVE 9
DISCUSS AUDIT ACTIVITIES IN PHASE II OF THE
AUDIT OPINION FORMULATION PROCESS
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PHASE II - PERFORMING RISK
ASSESSMENT
• Identifying relevant risks and determining audit
procedures required to address them
• Continuing clients - Update information from
previous year’s audit
• New clients - the risk assessment process is more
time consuming
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IDENTIFYING AND ASSESSING RISKS OF
MATERIAL MISSTATEMENT
• Essential to audit planning
• Requires identification of significant:
• Accounts
• Disclosures
• Relevant assertions
• Auditor establishes a materiality level overall and for
specific accounts and disclosures
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EXHIBIT 5.7 - EXAMPLES OF SOURCES
OF RISK OF MATERIAL MISSTATEMENT
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RISKS AT ASSERTION LEVEL
• Inherent risk
• The susceptibility of an assertion to a misstatement, due to
error or fraud, that could be material, individually or in
combination with other misstatements, before
consideration of any related controls
• Control risk
• The risk that a misstatement due to error or fraud that
could occur in an assertion and that could be material,
individually or in combination with other misstatements,
will not be prevented or detected on a timely basis by the
organization's internal control
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RISK ASSESSMENT PROCEDURES
• Inquiries for information to assist in identifying risks
of material misstatement due to fraud or error
• Preliminary analytical procedures
• Observation and inspection of documentation
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TYPES OF CONTROLS
• Entity-wide controls
• Transaction controls
• Fraud-related controls
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AUDITING IN PRACTICE - CONTROLS TO
ADDRESS FRAUD RISK
• PCAOB has identified the following
• Controls over significant, unusual transactions, particularly
those resulting in unusual journal entries
• Controls over journal entries and adjustments made in the
period-end financial reporting process
• Controls over related-party transactions
• Controls related to significant management estimates
• Controls mitigating incentives for, and pressures on,
management to falsify financial results
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TYPES OF PROCEDURES TO
ASSESS DESIGN EFFECTIVENESS
• Inquiry of appropriate personnel
• Observation of the organization’s operations
• Inspection of relevant documentation
• Performance of walkthroughs
• Documentation of preliminary assessment of control
design and basis for that assessment
• Understand the approach used by management for
conclusions on effectiveness of internal control
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AUDITING IN PRACTICE - DOCUMENTING AUDITOR’S
UNDERSTANDING OF AN ORGANIZATION’S INTERNAL
CONTROLS
• Process of documentation uses:
• Narratives
• Flowcharts
• Questionnaires
• Once documented, in subsequent years audit firms
focus on:
• Changes in the system
• Effectiveness of monitoring controls
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ASSESSING RANGE OF CONTROL RISK
• High control risk
• Weak internal controls
• Auditor cannot rely on controls to reduce substantive
procedures for account balances
• Assessing control risk as low
• Strong internal controls
• Auditor will test operating effectiveness of controls to
reduce substantive procedures for account balances
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AUDITING IN PRACTICE – EXAMPLE FOR WEAK INTERNAL
CONTROL DESIGN AND LINKS TO SUBSTANTIVE AUDIT
PROCEDURES
• Scenario - Client’s internal control design assessed
as ineffective that makes a preliminary assessment of
control risk as high
• Requires expanding substantive tests for sales
returns by:
• Arranging to be on hand at year end to observe the
taking of physical inventory
• Determining if receipts for items returned by
customers are issued in the correct time period
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AUDITING IN PRACTICE – EXAMPLE FOR WEAK INTERNAL
CONTROL DESIGN AND LINKS TO SUBSTANTIVE AUDIT
PROCEDURES
• Reviewing credit memos issued shortly after year end
• Increasing number of accounts receivable
confirmations sent to the client’s customers
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ADDITIONAL CONSIDERATIONS FOR AN
INTEGRATED AUDIT
• Risk assessment procedures apply to:
• Audit of internal control over financial reporting
• Audit of financial statements
• Top-down approach - Used for audit of internal control
over financial reporting to select controls to test
• Begins at financial statement level
• Focuses on entity-wide controls
• Works down to significant accounts and disclosures and
their relevant assertions
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RESPONDING TO IDENTIFIED RISKS OF
MATERIAL MISSTATEMENT
• Purpose of risk assessment procedures
• Identify risks of material misstatement
• Determine where misstatements in financial
statements may occur
• Design appropriate audit strategy
• Controls reliance audit: Includes tests of controls
and substantive procedures
• Substantive audit: Includes substantive procedures
and does not include tests of controls
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RESPONDING TO IDENTIFIED RISKS OF
MATERIAL MISSTATEMENT
• Selecting specific audit procedures to respond to
identified risks
• Assembling an audit team having knowledge, skill,
and ability needed to address assessed risks
• Emphasizing the need for professional skepticism
• Providing an appropriate level of supervision for
assessed risks
• Incorporating elements of unpredictability in
selection of audit procedures
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EXHIBIT 5.8 - RESPONDING TO IDENTIFIED RISKS
THROUGH EVIDENCE DECISIONS
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ADDITIONAL CONSIDERATIONS FOR AN
INTEGRATED AUDIT
• Audit strategy that includes tests of controls to
accomplish objectives of both audits
• Sufficient evidence related to operating effectiveness
of controls to support auditors:
• Control risk assessments for purposes of the audit of
financial statements
• Opinion on internal control over financial reporting as
of year-end
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FRAUD CONSIDERATIONS
• Performing tests of controls and substantive
procedures susceptible to fraud risks
• Performing procedures related to risk of
management override of controls
• Examining journal entries
• Reviewing accounting estimates for biases
• Evaluating business rationale for significant unusual
transactions
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LEARNING OBJECTIVE 10
DISCUSS AUDIT ACTIVITIES IN PHASE III OF THE
AUDIT OPINION FORMULATION PROCESS
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PHASE III - OBTAINING EVIDENCE ABOUT
INTERNAL CONTROL OPERATING EFFECTIVENESS
• Auditor tests controls
• Determine whether controls are operating effectively
at year-end or throughout the year
• Auditor obtains more persuasive audit evidence
• As the reliance auditor places on effectiveness of a
control increases
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AUDITING IN PRACTICE - RISK ASSESSMENT PROCEDURES
AND TESTS OF OPERATING EFFECTIVENESS OF CONTROLS
• Auditor’s risk assessment procedures include
• Inquiring about management’s use of budgets
• Inspecting documentation of management’s
comparison of monthly budgeted and actual expenses
• Inspecting reports pertaining to the investigation of
variances between budgeted and actual amounts
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SELECTING CONTROLS TO TEST
• Involves choosing controls that effectively indicate
capability to address the assessed risk of material
misstatement for relevant assertions
• Auditor selects:
• Entity-wide controls
• Reduce number of control activities selected for testing
• Transaction controls
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EXHIBIT 5.9 - LINKING FINANCIAL STATEMENT
ASSERTIONS AND SELECTING CONTROLS TO TEST
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TYPES OF CONTROLS AND EXAMPLES OF
CONCEPTS AFFECTING CONTROL TESTING
Computerized Controls
Determining changes to important
computer applications during the
year
If there are changes,
testing integrity of
controls after
changes
Considering
submitting test
transactions through
the system to
determine its
performance
Taking a random
sample of
transactions for
determining:
a) Operations of key
controls
b) Completion of
process
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Reviewing
exception reports
and determining:
a) Proper exceptions
being noted
b) Exceptions go to
authorized
personnel with
adequate follow-up
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TYPES OF CONTROLS AND EXAMPLES OF
CONCEPTS AFFECTING CONTROL TESTING
Manual Controls
Documented evidence for control
to be working; taking sample of
transactions to determine control
operation evidence
Taking a sample of
transactions and
examining
evidence
supporting that the
controls are
working
Authorizations
Taking a sample of
reconciliations to
determine that:
a) They were
performed by an
authorized person
b) They were
performed properly
Reconciliations
Reviewing
documentation of
selected
transactions to
determine:
a) Proper
authorization
b) Recorded in
correct time period
Taking a sample of
reports used to
identify unusual
transactions and
review them to
determine:
a) Regular usage
b) Identification of
unusual items
Reviews for unusual transactions
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TYPES OF CONTROLS AND EXAMPLES OF
CONCEPTS AFFECTING CONTROL TESTING
Controls over Adjusting
Entries
Documented evidence for
controls over normal journal
entries and their regular
application
Taking a sample of adjusting entries and
reviewing to determine:
a) Supporting documentation
b) Appropriate entry
c) Entry made in correct accounts
Giving special attention to significant entries
made near year end
d) Proper authorization of entry
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TYPES OF CONTROLS AND EXAMPLES OF
CONCEPTS AFFECTING CONTROL TESTING
Controls over Accounting
Estimates
Documented evidence for
controls over estimates ensuring
accuracy of data, consistency in
performance, regularly updating
the model
All entries being properly
authorized
Ensuring estimates are
updated for current
economic conditions
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Finding evidence that data
used for estimation come
from reliable sources
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FIRST APPROACH TO TESTING
CONTROLS
• Take sample of customer orders and trace it through
the system to determine whether:
• There was proper review of credit and
• Credit authorization or denial was proper
• Advantage - Most effective because it helps in
determining that the control worked effectively
• Requires documentation of all credit applications and
purchase orders required
• Based on audit sampling
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SECOND APPROACH TO TESTING
CONTROLS
• Taking a sample of recorded items and tracing back
to credit approval process
• Provides evidence on proper credit approval for all
items presently recorded
• Does not provide evidence as to whether other items
should have been approved for credit, but had not
been approved
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THIRD APPROACH TO TESTING
CONTROLS
• Uses a computer audit program and develops a printout of account balances exceeding their credit
authorization
• Cost-effective
• Requires an inference about the control
• Covers only the operation of the controls related to
the current account balances
• 100% evaluation of each item currently recorded
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TESTING THE OPERATING
EFFECTIVENESS
• Auditor tests relevant principles of components of:
•
•
•
•
Control environment
Risk assessment
Information and communication
Monitoring
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RESULTS OF TESTS OF CONTROLS FOR
FINANCIAL STATEMENT AUDIT
• If control deficiencies are identified
• Assess them to determine whether preliminary control
risk assessment should be modified
• Record the implications for substantive procedures
• If no control deficiencies are identified
• Assess whether preliminary control risk assessment is still
appropriate
• Determine extent that controls can provide evidence on
accuracy of account balances
• Determine planned substantive audit procedures
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RESULTS OF TESTS OF CONTROLS FOR
FINANCIAL STATEMENT AUDIT
• Determine how much assurance about reliability of
account balances can be obtained from the effective
operation of controls
• Within any audit, level of assurance will vary across:
• Accounts
• Disclosures
• Assertions
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LEARNING OBJECTIVE 11
DISCUSS AUDIT ACTIVITIES IN PHASE IV OF THE
AUDIT OPINION FORMULATION PROCESS
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PHASE IV - OBTAINING SUBSTANTIVE EVIDENCE ABOUT
ACCOUNTS, DISCLOSURES, AND ASSERTIONS
• Substantive procedures include:
• Substantive analytical procedures
• Tests of details of account balances
• Considerations in determining appropriate
substantive procedures:
• Source of potential misstatement
• Extent and type of potential misstatement
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EXHIBIT 5.12 - FACTORS AFFECTING
SUBSTANTIVE PROCEDURES TO BE PERFORMED
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LEARNING OBJECTIVE 12
DISCUSS AUDIT ACTIVITIES IN PHASE V OF THE
AUDIT OPINION FORMULATION PROCESS
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PHASE V - COMPLETING THE AUDIT
AND MAKING REPORTING DECISIONS
• Completing various review and communication
activities
• Making a decision about what types of opinions
should be issued
• Deciding on the appropriate opinion to be issued
• It can be based on financial statements and internal
control
• It can be issued in one report or in two separate
reports
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LEARNING OBJECTIVE 13
APPLY THE CONCEPTS RELATED TO THE AUDITOR’S
ASSESSMENT OF INTERNAL CONTROL DESIGN
EFFECTIVENESS, IMPLEMENTATION, AND OPERATING
EFFECTIVENESS
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MANAGEMENT ASSESSMENT OF
CONTROLS
• Factors considered in deciding whether to categorize
a deficiency as significant or not
• Risk that is being mitigated and whether other controls
operate effectively
• Materiality of related account balances
• Nature of deficiency
• Volume of transactions affected
• Subjectivity of account balance that is subject to
control
• Rate at which control fails to operate
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MANAGEMENT ASSESSMENT OF
CONTROLS
• Deficiency of segregation of duties
• Did not rise to a significant deficiency or a material
weakness
• Management decides to use this deficiency as a
motivation to centralize purchases
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MANAGEMENT ASSESSMENT OF
CONTROLS
• Deficiency of lack of approval considered as a
significant deficiency based on the following
rationale:
• Major departure from an approved process
• Could lead to purchase of unauthorized goods
• Could be shipped elsewhere and lead to material
misstatement in financial statements
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AUDITOR ASSESSMENT OF CONTROLS
• Auditor reviews:
• Management’s documentation of its internal control
• Management’s evaluation and findings related to
internal control effectiveness
• Auditor then gathers evidence on operating
effectiveness of these controls
• By taking a random sample auditor needs to
independently determine that the controls are working
or not
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AUDITOR ASSESSMENT OF CONTROLS
• Implications for substantive procedures in financial
statement audit:
• Auditor will do limited testing of inventory quantities
at year end
• Auditor will assess year-end inventory for potential
obsolescence
• Auditor will continue to examine all adjusting entries at
the end of the year
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