Auditing 3.

1
Week 1.1

Chapter 2: Professional standards

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Edwald Mentink

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Agenda
Part 1
Financial statement Auditing Auditing Standards Errors and fraud Problem 2.14, 2.16, 2.26, 2.27

Part 2

Quality Control Peer review & Inspection Problem 2.19, 2.33, 2.38, 2.39

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Financial Statement
A financial statement is intended to present fairly, fairly in all material respects, respects the financial position and operating operating results results of a company. Procter & Gamble

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Auditing

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Auditing
Purpose of an audit Provide an opinion whether or not a financial statement is in accordance with the applicable financial reporting framework. The framework is ordinarily GAAP (Generally Accepted Accounting Principles)

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Auditing
Premise of an auditManagement (and those charged with governance) have responsibility to: Prepare financial statements in accordance with applicable financial reporting framework. Provide the auditor with needed information and unrestricted access to those in the entity from whom the auditor determines it necessary to obtain audit information.

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Auditing
Personal responsibility of the auditorAppropriate competence and capabilities to perform audit in accordance with standards, including maintaining professional skepticism and exercising professional judgment throughout the audit. Professional skepticismA questioning mind and a critical assessment of audit evidence.

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Auditing
Auditor actions in performing the audit Obtain reasonable assurance about whether financial statements are free from error or fraud. The auditor is unable to obtain absolute assurance due to: Nature of financial reporting. Nature of audit procedures. Need to conduct audit within a reasonable period of time.

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Auditing
Reporting the results of an auditExpress in a written report an opinion on findings (or statement that opinion cannot be expressed). The opinion is on whether the financial statements are in accordance, in all material respects, with the applicable financial reporting framework.

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The 10 Generally Accepted Auditing Standards

General Standards Standards of Field Work Reporting Standards

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General Standards
Adequate technical training and proficiency Independence in mental attitude is to be maintained Due professional care is to be exercised

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Standards of Field Work

Auditor must adequately plan and properly supervise work Auditor must obtain a sufficient understanding of entity, and its environment, including internal control to assess risk of material misstatement and to design further audit procedures Auditor must obtain sufficient appropriate audit evidence to afford a reasonable basis for the opinion

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Standards of Reporting
State whether the financial statements are presented in accordance with GAAP Identify circumstances in which such principles have not been consistently applied Informative disclosures are adequate unless otherwise stated in the report Report should clearly state the degree of responsibility being assumed by the auditors by expressing an opinion or stating that one cannot be expressed, and the reason therefore

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Auditor Responsibility for the Detection of Errors and Fraud

Obtain information to assess the inherent risks and fraud risks Information about the company and its environment Discussion among audit team members Inquiries of management and others Risk assessment analytical procedures, including those involving revenue Assess the risk of errors and fraud that may cause the financial statements to contain a material misstatement.

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Auditor Responsibility for the Detection of Errors and Fraud

Plan and perform the audit to obtain reasonable assurance that material misstatements, whether caused by errors or fraud, will be detected. Exercise due care in planning, performing and evaluating the results of audit procedures, and the proper degree of professional skepticism to achieve reasonable assurance that material misstatements due to error or fraud will be detected.

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Problem 2.14

A CPA-firm offers only opinions no guarantees, yet we respect and accept these opinions. What does a CPA have to do to earn this acceptance?

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Problem 2.14

The public accounting firm must observe generally accepted auditing standards. By following these standards, the CPA can issue an audit report that includes a reasonable assurance that the financial statements do not contain material misstatements due to errors or fraud. Reasonable (not absolute) assurance is necessary due to the nature of financial reporting (the necessary use of judgment), the nature of audit procedures (they do not provide absolutely conclusive evidence) the need to conduct an audit within a reasonable period of time at a reasonable cost. Accordingly, the auditor expresses an opinion on the financial statements, not a statement of fact.

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Problem 2.16

What is a material amount from the perspective of auditors? Give an example of how that amount may differ based on the nature of the item.

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Problem 2.16

A material amount is an amount that is sufficiently important to influence decisions made by reasonable users of financial statements.

The amount may differ by account based on specific account characteristics.

For example, a $100,000 shortage of cash may be extremely material to a small company, and a shortage of that amount might lead to bankruptcy. But, a $100,000 valuation overstatement of equipment may be of less significance if the company continues to produce its products and operate as in the past

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Problem 2.26

An attitude of independence is a most essential element of an audit by a firm or CPA. Describe several situations in which the CPA firm might find it somewhat difficult to maintain this independent point of view.

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Problem 2.26

A firm of certified public accountants might find it difficult to maintain an attitude of independence during the audit of financial statements if the public accounting firm or a partner in the firm: Derived a major portion of the firm's income from one client; Had a personal financial interest in the company being audited; Made the fee contingent upon the obtaining of a bank loan by the client; Was financially indebted to the client; Was a member of the board of directors of the client company or otherwise participated in the management of the company.

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Problem 2.27

Jane Lee, a director of a nonpublic corporation with a number of stockholders and lines of credit with several banks, suggested that the corporation appoint as controller John Madison, a certified public accountant on the staff of the auditing firm that had made annual audits of the corporation for many years. Lee expressed the opinion that this move would effect a considerable savings in professional fees because annual audits would no longer be needed. She proposed to give the controller , if appointed, an internal auditing staff to carry on such continuing investigations of accounting data as appeared necessary. Evaluate this proposal.

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Problem 2.27

If the certified public accountant is appointed controller of the corporation, he or she loses the independent status. The interests of outside groups like creditors, bankers, or stockholders are best protected when independent CPAs examine the financial statements prepared by management of the corporation. An internal auditor under the direction may be a highly desirable step, but it does not eliminate the need for an independent audit.

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Elements of Quality Control

Leadership responsibilities for quality within the firm (tone at the top) Relevant ethical requirements Acceptance and continuance of clients and engagements Human Resources Engagement performance Monitoring

QC Element 1: Leadership responsibilities for quality within the firm

Firms internal culture recognizes that quality is essential in performing engagements and recognizes the need to perform work that complies with professional standards and regulatory and legal requirements and issue reports that are appropriate in the circumstances. Example: Assign management responsibilities so that commercial considerations do not override the quality of work performed.

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QC Element 2: Relevant ethical requirements

Firm and its personnel comply with relevant ethical requirements. Example: At least annually, the firm should obtain written confirmation of compliance with its independence policies and procedures from all firm personnel who are required to be independent.

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QC Element 3: Acceptance and Continuance

Firm will undertake to continue relationships and engagements only where the firm: 1. Has considered client integrity. 2. Is competent to perform the engagement. 3. Can comply with legal and ethical requirements. Example: Background information is gathered on all prospective audit clients, including the attitude of principal owners, key management, and those charged with governance on matters such as aggressive accounting and internal control over financial reporting.

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QC Element 4: Human Resources

Firm has personnel with the capabilities, competence, and commitment to ethical principles to: 1. Perform engagements in accordance with professional standards and regulatory and legal requirements. 2. Enable the firm to issue reports that are appropriate in the circumstances. Example: Design effective recruitment processes and procedures to help the firm select individuals meeting minimum academic requirements established by the firm, and maturity, integrity and leadership.

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QC Element 5: Engagement Performance

Firms engagements are consistently performed in accordance with professional standards and regulatory and legal requirements, with policies and procedures addressing: 1.Engagement performance. 2.Supervision responsibilities. 3.Review responsibilities. Example: Design policies and procedures that address the tracking of progress of each engagement.

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QC Element 6: Monitoring
Firms policies and procedures established for each of the elements are suitably designed and effectively applied. Example: Working papers, reports, and client financial statements are reviewed to assess compliance with the firms quality control policies and procedures.

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Peer Reviews
Members of AICPA Conducted by CPAs or other CPA firms Two types of peer reviews System review Study of CPA firms system of quality control Select sample of firms engagements and examine related working paper files Engagement review Sample of CPA work including reports to evaluate appropriateness Less in scope than system review Report: pass, pass with deficiencies, or fail

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Problem 2.19

What is the meaning of quality control and peer review as these terms relate to the operation of a CPA-firm? Is peer review mandatory?

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Problem 2.19

Quality control means policies and procedures which help assure that each audit meets at least a minimum standard of quality. Peer reviews refer to a study and appraisal by an independent CPA of a CPA firms work. Two types of peer review: system review : the evaluator considers the CPA firms system of quality control to perform accounting and auditing work engagement review: the evaluator studies and evaluates a sample of a CPA firms actual accounting work Peer reviews are indeed mandatory

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Problem 2.33

Match each of the following statements with the appropriate type of auditorsreport. A. Adverse D. Disclaimer Q. Qualified S. Standard unmodified
Statement Type of Audit Report

The auditors are unable to determine the overall fairness of the financial statements.
This is the report most clients prefer. A limitation on the scope of the audit is significant, but not so as to overshadow an overall opinion The financial statements are not fairly presented A material departure from GAAP exists, but not so material as to overshadow an overall opinion.

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Problem 2.33

Match each of the following statements with the appropriate type of auditorsreport. A. Adverse D. Disclaimer Q. Qualified S. Standard unmodified
Statement Type of Audit Report

The auditors are unable to determine the overall fairness of the financial statements.
This is the report most clients prefer. A limitation on the scope of the audit is significant, but not so as to overshadow an overall opinion The financial statements are not fairly presented A material departure from GAAP exists, but not so material as to overshadow an overall opinion.

D. Disclaimer

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Problem 2.33

Match each of the following statements with the appropriate type of auditorsreport. A. Adverse D. Disclaimer Q. Qualified S. Standard unmodified
Statement Type of Audit Report

The auditors are unable to determine the overall fairness of the financial statements.
This is the report most clients prefer. A limitation on the scope of the audit is significant, but not so as to overshadow an overall opinion The financial statements are not fairly presented A material departure from GAAP exists, but not so material as to overshadow an overall opinion.

D. Disclaimer
S. Standard unmodified

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Problem 2.33

Match each of the following statements with the appropriate type of auditorsreport. A. Adverse D. Disclaimer Q. Qualified S. Standard unmodified
Statement Type of Audit Report

The auditors are unable to determine the overall fairness of the financial statements.
This is the report most clients prefer. A limitation on the scope of the audit is significant, but not so as to overshadow an overall opinion The financial statements are not fairly presented A material departure from GAAP exists, but not so material as to overshadow an overall opinion.

D. Disclaimer
S. Standard unmodified Q. Qualified

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Problem 2.33

Match each of the following statements with the appropriate type of auditorsreport. A. Adverse D. Disclaimer Q. Qualified S. Standard unmodified
Statement Type of Audit Report

The auditors are unable to determine the overall fairness of the financial statements.
This is the report most clients prefer. A limitation on the scope of the audit is significant, but not so as to overshadow an overall opinion The financial statements are not fairly presented A material departure from GAAP exists, but not so material as to overshadow an overall opinion.

D. Disclaimer
S. Standard unmodified Q. Qualified A. Adverse

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Problem 2.33

Match each of the following statements with the appropriate type of auditorsreport. A. Adverse D. Disclaimer Q. Qualified S. Standard unmodified
Statement Type of Audit Report

The auditors are unable to determine the overall fairness of the financial statements.
This is the report most clients prefer. A limitation on the scope of the audit is significant, but not so as to overshadow an overall opinion The financial statements are not fairly presented A material departure from GAAP exists, but not so material as to overshadow an overall opinion.

D. Disclaimer
S. Standard unmodified Q. Qualified A. Adverse Q. Qualified

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Problem 2.38

Hide-It Team Case!

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Problem 2.38

Hide-It: a No, this is not an error since errors are unintentional.

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Problem 2.38

Hide-It: b This situation does appear to involve misstatements due to misappropriation of assets. It is a misstatement due to fraudulent financial reporting because of the omission of the information from the financial statements. If the $100,000 withdrawals have been abstracted for personal use, the situation also involves a misstatement arising from misappropriation of assets.

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Problem 2.38

Hide-It: c Certain laws have a direct effect on the financial statement amounts and are considered on every audit. An example is income tax law that affects the amount of income tax expense in the financial statements of most clients. This situation involves what appears to be non-compliance with a law that has a "direct effect" since, at a minimum, taxes have not been paid on the income involved.

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Problem 2.38

Hide-It: d The auditors will need to consider whether withdrawal is necessary, perhaps after consultation with their attorney. The case suggests that the unrecorded deposits occurred prior to current management involvement with the company. Note, however, that interest was earned during the period this management has been with the company, and withdrawals have been made during this same period. The auditors would wish to consider when current management became aware of the account and the nature of the withdrawals when considering whether to resign from the engagement.

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Problem 2.39

Enormo Corporation Research and Discussion Case

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Problem 2.39

Enormo Corporation When the auditors discover illegal acts by a public client, they should consider three major factors. First, the auditors should consider the effect of the acts on the client's financial statements, including the possibility of fines and loss of business. Second, the illegal acts may affect the auditors' assessment of the integrity of management. In deciding whether to continue to serve the client, the auditors should consider the nature of the illegal acts and management's response to the acts after they are uncovered. Third, the auditors should consider whether the occurrence of the illegal act indicates that there is a material weakness in the companys internal control over financial reporting.

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Problem 2.39

Enormo Corporation The following courses of action are available to the auditors: The auditors could issue an unqualified opinion and take no further steps regarding the illegal activities, since the effect of the acts on the financial statements is not material. The auditors could issue a qualified opinion because the financial statements depart from generally accepted accounting principles, in that they fail to disclose the illegal acts. This course of action could be argued on the basis that any illegal activities by the client are material. The auditors could withdraw from the engagement, because the client's failure to take actions to prevent such activities indicates that Enormo's management lacks sufficient integrity.

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Problem 2.39

Enormo Corporation We believe that the auditors should consider withdrawing from the engagement. Enormo's top management seems far too complacent regarding these activities. Their refusal to take any action to prevent the acts in the future provides a signal to lower level management that top management approves of illegal acts.

See you next week!

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