1

Management

Income Statement

Balance Sheet

Stmt of CF

Management Prepares

1

Users

Basic Mistrust

2

Auditors

Independent Auditor

3

Lends Credibility

4

Auditors serve as

intermediaries between Preparers

and Users of financial

information.

Auditing is a systematic process of . . . obtaining and

evaluating evidence regarding management assertions

to ascertain the degree of correspondence between those assertions and established criteria and

communicating the results.

Auditing DefinedAuditing Defined

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Management Assertions

Existence or Occurrence

Completeness

Valuation or Allocation

Rights and Obligations

Presentation and Disclosure

5

Existence or Occurrence

Whether assets or liabilities of the entity existexist at a given date and

Whether recorded transactions have occurredoccurred during a given period.

6

Completeness

Whether all transactions and accounts that should be presented in the financial statements are so included.

7

Valuation or Allocation

Whether asset, liability, revenue, and expense components have been included in the financial statements at appropriate amounts.

8

Rights and Obligations

Whether

assets are the rights of the entity and

liabilities are the obligations of the entity at a given date.

9

Presentation and Disclosure

Whether particular components of the financial statements are properly

classified,

described, and

disclosed.

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Management Assertions: An

Example

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Inventory Example

Consider a bicycle shop that has just prepared its financial statements and shows an inventory of $50,000.

In order for the inventory to be a correct representation on the financial statements, the inventory must . . .

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The inventory must . . .

Be Complete

All of the transactions regarding the inventory have been recorded prior to year-end;

That is, the company must have recorded all receipts of inventory before year-end.

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The inventory must . . .

Be owned by the company (Rights)

The company had title to all the inventory and has control over the bicycles and other products.

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The inventory must . . .

Be properly valued

At the lower of cost or market at some acceptable valuation method (FIFO, LIFO).

All old or obsolete inventory should be written down to its scrap or wholesale price.

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The inventory must . . .

Be properly disclosed

The inventory methods used (e.g., LIFO, FIFO) must be disclosed;

As well as the nature of the inventory (e.g., bicycles, parts, accessories, and so on.)

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Audit Program . . .

The audit program should gather convincing evidence that . . . The inventory exists

That it is owned

Completely recorded,

Properly valued and

Properly disclosed.

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Audit Program . . .

The amount, timing, and nature of the specific audit tests to be performed will be influenced by:

The integrity of management

The client’s internal control system

The amount of misstatement that could make a difference to a user (materiality).

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Overview of Financial Statement Auditing

Overview of Financial Statement Auditing

Independent Auditor

Obtains & Evaluates Evidence

Audit Report

Other Reports

FASB APB ARB GASB

AICPA AcSEC EITF SEC

Assertions About Economic Events

Ascertain

Degree of

Correspondence

Fin Stmts

20

How’d They do that?

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Evidence . . .

Consists of . . .

The underlying accounting data and all corroborating information available to the auditor.

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Evidence . . .

Must be objectively gathered.

Most audits are performed on a test basis.

Population

Pull sample and then inferinfer from the sample to the population

Objectively Gathered EvidenceObjectively Gathered Evidence

Sample

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Generally Accepted Auditing Standards (GAAS)

Guidelines for Auditors

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Generally Accepted Auditing Standards (GAAS) . . .

. . . are general guidelines to . . . are general guidelines to aid auditors in fulfilling their aid auditors in fulfilling their professional responsibilities professional responsibilities in the audit of financial in the audit of financial statements.statements.

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Auditing Standards . . .

General Standards Three standards relating to the

characteristics of the auditor.

Standards of Field Work Three standards relating to the

conduct of the examination.

Reporting Standards Four standards relating to

communication of results.

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Generally Accepted Auditing Standards (GAAS)

The General Standards

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General Standards . . .

1. The examination is to be performed by a person or persons having adequate technical training and proficiency as an auditor.

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General Standards . . .

2. In all matters relating to the assignment, an independence in mental attitude is to be maintained by the auditor or auditors.

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General Standards . . .

3. Due professional care is to be exercised in the performance of the examination and the preparation of the report.

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Generally Accepted Auditing Standards (GAAS)

The Standards of Field Work

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Standards of Field Work

1. The work is to be adequately planned and assistants, if any, are to be properly supervised.

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Standards of Field Work

2. A sufficient understanding of the internal control structure is to be obtained to plan the audit and to determine the nature, timing, and extent of tests to be performed.

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Standards of Field Work

3. Sufficient competent evidential matter is to be obtained through inspectioninspection, observationobservation, inquiriesinquiries, and confirmationconfirmation to afford a reasonable basis for an opinion regarding the financial statements under examination.

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Generally Accepted Auditing Standards (GAAS)

The Standards of Reporting

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Standards of Reporting

1. The report shall state whether the financial statements are presented in accordance with generally accepted accounting principles.

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2. The report shall identify those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period.

Standards of Reporting

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3. Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report.

Standards of Reporting

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4. The report shall either contain

An opinion regarding the financial statements, taken as a whole, or

An assertion to the effect that an opinion cannot be expressed.

When an overall opinion cannot be expressed, the reasons therefor should be stated.

Standards of Reporting

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In all cases where an auditor’s name is associated with financial statements,

the report should contain a clear-cut indication of the character of the auditor’s examination, if any, and

the degree of responsibility taken.

Standards of Reporting

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Overview

The Audit Risk ModelThe Audit Risk Model

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The Audit Risk Model

Generally Accepted Auditing Standards establish a “model” for carrying out audits.

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The Audit Risk Model

Requires auditors to use their judgment . . .

In assessing risks, and

Then in deciding what procedures to carry out.

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Based on . . .

The auditor’s assessment of various risks and

any tests of controls, the auditor makes judgments about kinds of evidence needed to achieve “reasonable assurance.”

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Some Terms

The Audit Risk ModelThe Audit Risk Model

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The risk that the auditor may unknowingly fail to appropriately modify his/her opinion on financial statements that are materially misstated.

Audit Risk (AR)

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The risk that an assertion is susceptible to a material misstatement, assuming there are no related controls.

Inherent Risk (IR)

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The risk that a material misstatement that could occur in an assertion will not be prevented or detected on a timely basis by the entity’s internal control.

Control Risk (CR)

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The risk that the auditor will not detect a material misstatement that exists in an assertion.

Detection Risk (DR)

50

AR = IR x CR x DR

Highly judgmental

The objective in an audit is to limit audit risk (AR) to a low level, as judged by an auditor.

Mathematially

51

Auditors assess IR and CR along a spectrum

Maximum risk

Moderate risk

Low risk

Audit Risk

52

A maximum risk assessment (i.e., 100%) means that

the auditor believes controls are unlikely to be effective; or

The evaluation of their effectiveness would be inefficient.

Audit Risk

FAF AICPA POB ISB

Securities and Exchange Commission

FASAC FASB

AcSEC ASB Ethics

SECPS Exec

Comm.

PRC QCIC

PITFSEC Reg