9.401 Auditing
Chapter 5
Audit Responsibilities and Objectives
Auditor’s Responsibility…..
To accumulate evidence to determine if the
f/s are fairly stated in accordance with
GAAP in all material respects,
 and to issue an appropriate report

Managements’s
Responsibility…..
Adopting sound accounting policies
 Maintaining adequate internal control
 Generating financial statements. Still mgmt
responsibility even if:
 Auditor provided bookkeeping services
 Auditor prepared f/s
 Auditor offered suggestions

Auditor vs. Management

When auditor and management disagree on
a material issue:
 If management capitulates, issue clean
opinion
 Auditor can’t force management to alter
financial statements
 If management refuses, auditor must
qualify opinion
Auditors and Errors


Errors
=unintentional misstatements of f/s
• Mistake in gathering or processing data
• Incorrect estimate from oversight or
misinterpretation of facts
• Mistake in application of GAAP relating to
amount, classification, presentation or
disclosure
Auditors seek reasonable, not absolute, assurance
that f/s contain no material errors….
Why not provide absolute
assurance?
Can’t because:
 Use of sampling
 Auditors use judgment, which is fallible
 F/S contain estimates
 Audit evidence is persuasive, not
conclusive
 Internal control has limitations
 Won’t because prohibitive costs exceed
benefits

Auditors and Fraud
Employee Fraud
=usually theft of assets from company
 Management Fraud
=intentional misstatement of f/s, usually to
deceive stakeholders

Auditors and Fraud

Auditors have less responsibility towards
fraud because:
 Object of concealment
 Can be hard to find if:
 Employees are colluding
 Management is overriding internal
controls
Auditors and Fraud

Auditors must be alert to factors increasing
consider the risk of misstatements:
 means and opportunity
 (eg. Weak internal controls, areas of judgment
or complexity, dominant mgmt, decentralized
org)
 motive
 (eg. High expectations, financial problems,
bonuses, IPO’s)
 mgmt character and engagement
 (eg. Aggressive, dishonest, evasive)
 New client, assets subject to misappropriation
Auditors and Fraud

If risk of fraud is high:
 Be critical of accounting policies
 Use more experienced personnel
 Close supervision
 Do more work, more effective procedures,
and closer to year end (=nature, timing
and extent)
 Consider withdrawing from engagement
Throughout Audit

Exercise professional scepticism
 Assume good faith of management
 Be aware that management could be
dishonest
 Be alert to red flags which call
management good faith into question
Red Flag Examples:
Handwritten records usually computerized
 Evasive, uncooperative management
 Unrealistic time deadlines set by mgmt
 Limitation in scope imposed by mgmt
 Conflicting or unsatisfactory evidence
 Unsupported or unusual transactions,
particularly close to year end
 Fewer confirmation responses than expected
or significant differences found

What to do when red flags
appear:
Perform additional work to confirm or dispel
suspicions.
 If suspicions are confirmed:
 Talk to appropriate level of mgmt
 Talk to audit committee
 Consider effect on rest of audit
 Consider effect on evidence already
gathered
 Consider if you should resign from auditconsult a lawyer

Auditors and Illegal Acts
Auditors are less likely to find illegal acts
than errors:
 May not be directly related to audit
 Auditor may be unaware of laws
 Detecting violations may be outside of
auditor’s expertise, question of law
 May be concealed
 The more the illegal act has a “direct effect”
on f/s, the greater the auditor’s responsibility

Auditors and Illegal Acts
Auditors should at minimum:
 Identify laws whose violation affects f/s
 Ask management about policies designed
to prevent illegal acts
 Obtain written representation from mgmt
 If auditor DOES discover an illegal act:
 Inform mgmt and audit committee
 Consider effect on f/s and audit report
 Consider effect on audit evidence, mgmt
good faith

How to perform an audit
Financial statements are made up of
Account Balances, which are made up of
Transactions
 The financial statements contain implied
management assertions. Auditing these
assertions leads to objectives which can be
balance related (when auditing account
balances) or transaction related (when
auditing transactions)

Management Assertions

Existence or Occurrence


Completeness


Assets, liabilities and equities exist and thatExistence
a transaction occurred that pertains to the
entity
There are no unrecorded assets, liabilitiesCompleteness
or transactions
Ownership or Rights and Obligations

Assets of the company is owned by entity Ownership
at given date, liabilities represent
obligations
Management Assertions
Valuation
Valuation or Measurement
 Assets or liabilities recorded at appropriate
carrying value; transactions recorded in proper
amount and allocated to proper period Presentation
 Presentation and Disclosure
 An item is disclosed in accordance with GAAP

Assertions and Objectives
Mgmt Assertion
Balance Objective
Transaction Objective
Existence
Existence
Occurrence
(=existence+ownership)
Completeness
Completeness
Completeness
Valuation/
Measurement
Valuation/
Measurement
Accuracy
Cutoff
Timing
Ownership
Ownership
Presentation/
Disclosure
Presentation/
Disclosure
Classification
Detail tie in
Posting
Which assertions are violated?
1)
2)
3)
4)
According to the company books, there are 25
delivery vans but your physical count reveals that
they only have 20.
The company forgot to record on their financial
statements that they will likely have to pay a
settlement of two million dollars in connection
with a civil lawsuit.
The company has several accounts receivable
from customers who have declared bankruptcy.
The company does not show the breakdown
between current and non-current assets and
liabilities on the financial statements.
Which assertions are violated?
5)
6)
7)
8)
A non-profit organization often receives sizable
cash donations but only issues receipts if the
donor requests them. It is possible that some
cash is pocketed by the employees.
The company calculates amortization on their
machinery using an estimated useful life of 60
years, which seems unreasonably long given the
probability of technological obsolescence.
The company failed to include in their financial
statements an inventory shipment received
immediately before year end.
The inventory of a second hand clothing store is
recorded on their financial statements, when it is
actually inventory on consignment.
Which assertions are addressed by these procedures?
1)
2)
3)
4)
You send out confirmations to accounts
receivable customers recorded in the company
books.
You check to see that the inventory you counted
in the warehouse is recorded in the company
books.
You recalculate the amortization of prepaid
insurance.
You request that the company’s major suppliers
send you a copy of your client’s statement of
account that you will check with your
company’s records.
Which assertions are addressed by these procedures?
5)
6)
7)
8)
You compare the ratio of the allowance for
doubtful accounts to accounts receivable with the
ratio of prior years.
You check sales invoices after the year end to see
if the inventory selling price was higher than its
original cost.
For each investment, you check if the amount of
dividend revenue earned from portfolio
investments corresponds with dividends declared
according to the “Dividend Record Guide”.
You check to see if the level of sales returns
recorded after the year end seems to be normal.
Phases of Audit
Planning
 Obtain knowledge of business
 Understand internal control and assess risk
 Tests of Controls
 Analytical procedures and substantive tests
of balances
 Complete audit and issue report
