Auditing Principles and Practices

Audit Responsibilities and Objectives

• Lecturer: Shauntai Burke
• Date: October 14, 2024
• Time: 6 PM

Lesson Overview

• Trial Balances: Total debits must equal total credits. Temporary adjustment accounts are created if there's a mismatch. Ledgers are then corrected.
• Reporting: Changes in financial position encompass retained earnings, income statement, and balance sheet.
• Management vs. Auditor Responsibilities:
  • Management: Responsible for financial statements, internal controls, and CEO/CFO certification (Sarbanes-Oxley Act).
  • Auditor: Responsible for verifying statements for fairness, and the effectiveness of internal controls. They issue an opinion on the financial statements.
• Objectives of Conducting an Audit:
  • Explain the purpose of an audit.
  • Differentiate management and auditor responsibilities about financial statements.
  • Classify accounting information into cycles.
  • Identify the benefits of the cycle approach.
  • Explain the auditor's role in discovering material misstatements.
  • Explain the rationale for how auditors use a combination of accounting standards throughout classes of transactions and account balances.
  • Describe the relationship between audit objectives and evidence gathering.

Audit Temperature Check (Breakout Rooms 1 & 2)

• Describe the cycle approach to auditing.
• What are the advantages of dividing the audit into different cycles?

Audit Temperature Check (Breakout Rooms 3 & 4)

• Discuss the differences between errors, fraud, and illegal acts. Provide an example for each.
• Describe the actions an auditor should take when an illegal act is identified or suspected.

Objectives of an Audit

• Companies produce financial statements that provide information about their financial position and performance.
• This information is used by stakeholders, especially shareholders, who do not manage the company.
• Owners rely on independent assurance that the statements fairly present the financial position and performance.

Objectives of Conducting an Audit of Financial Statements

• The objective is to enable the auditor to express an opinion about whether the financial statements are materially correct, according to International Financial Reporting Standards or another relevant framework.

Objectives of an Audit (Steps)

• Understand the objectives and responsibilities for the audit.
• Divide financial statements into cycles.
• Know management assertions about financial statements.
• Know general audit objectives for classes of transactions, accounts, and disclosures.
• Know specific audit objectives for classes of transactions, accounts, and disclosures.

Management's Responsibilities for Preparing the Financial Statements

• Management is responsible for the financial position and performance information of companies.
• They are responsible for sound accounting policies, adequate internal controls, and fair representation.
• SOX (Sarbanes-Oxley Act, in the US) increased management's responsibility, requiring quarterly and annual financial statement certifications submitted to the SEC.

Auditor's Responsibilities for Verifying Financial Statements

• The responsibilities are confined to expressing an opinion on whether financial statements are materially correct. Management's responsibility extends beyond just these representations.
• This duty does not relieve management or those charged with governance (e.g. board of directors) of their responsibilities.
• Auditors are required to plan and perform the audit to obtain reasonable assurance about whether statements are free from misstatement, whether by error or fraud.

Auditor's Responsibilities for Verifying Financial Statements (Overall Objectives)

• Obtain assurance that financial statements are free from material misstatement, whether due to fraud or error.
• Report on the financial statements.
• Communicate auditor findings as required by accounting standards.

Auditor's Responsibilities for Verifying Financial Statements (Material vs. Immaterial)

• Misstatements are considered material if combined uncorrected errors or fraud would impact decisions of a reasonable user.
• Quantifying materiality can be challenging, but obtaining reasonable assurance about materiality is the auditor's responsibility.

Auditor's Responsibilities for Verifying Financial Statements (Reasonable Assurance)

• Assurance is the level of certainty the auditor obtains at the audit's conclusion.
• Reasonable assurance is high but not absolute. Auditors aren't guarantors of correctness; a material misstatement may remain undetected.

Auditor's Responsibilities for Verifying Financial Statements (Reasonable Assurance Cont.)

• If auditors were required to be certain of every assertion, audit costs would increase to an impractical level.
• Auditors are still responsible for conducting the audit in accordance with auditing standards.

Auditor's Responsibilities for Verifying Financial Statements (Error vs. Fraud)

• Auditing standards differentiate between unintentional errors and intentional fraud (e.g., manipulating or overlooking inventory cost).

Auditor's Responsibilities for Verifying Financial Statements (Error vs. Fraud Cont.)

• Misappropriation of assets (e.g., employee theft) and fraudulent financial reporting (e.g., overstating sales to increase reported earnings) are two main forms of fraud.

Auditor's Responsibilities for Verifying Financial Statements (Professional Skepticism)

• Auditing standards require an attitude of professional skepticism in all aspects of the audit.
• This requires a questioning mind and critical assessment of audit evidence. Auditors shouldn't automatically assume management is honest (but neither should they automatically assume they are dishonest).

Auditor's Responsibilities for Detecting Material Errors

• Auditors largely focus on planning and performing audits to detect unintentional mistakes by management and staff.
• Errors are found in calculations, omissions, misunderstandings about accounting standards, or summarization errors.

Auditor's Responsibilities for Detecting Material Fraud

• Auditing standards don't differentiate between detecting errors and fraud.
• Auditors obtain reasonable assurance that statements are free from material misstatements.
• Fraud is typically harder to detect because perpetrators try to conceal it, but there's still a responsibility to detect it.

Auditor's Responsibilities for Discovering Illegal Acts

• Illegal acts are violations of law (other than fraud); examples include tax law violations or environmental law violations.
• Direct-effect illegal acts directly affect account balances in financial statements (e.g., tax violations affecting tax expense).
• The auditor's role in direct-effect illegal acts is the same as for errors and fraud.

Auditor's Responsibilities for Discovering Illegal Acts (Indirect-Effect)

• Indirect-effect illegal acts have an indirect effect on the financial statements (e.g., fines and potential liability arising from environmental violations).

Auditor's Responsibilities for Discovering Illegal Acts (Evidence and Actions)

• Auditors might look at client discussions, IRS reports, etc. to detect possible illegal acts.
• Their job is to evaluate, not guarantee, detection.

Management vs Auditor's Responsibility

• Management:
  • Prepare financial statements in accordance with the applicable financial reporting framework.
  • Design, implementation, and maintenance of internal controls.
• Auditor:
  • Plan and perform the audit to obtain reasonable assurance that financial statements are free from misstatements.
  • Assess the risk of material misstatements.
  • Express an opinion on the financial statements.

Classification of Accounting Information into Cycles

• Auditors need to understand the entity's control activities to review the accuracy of financial statements.
• Accounts are mapped to their related transaction cycles; an entity may have established controls over sales and collection, but not over cash, for instance.

Financial Statement Cycles

• The cycle approach focuses on closely related transactions and balances. (Sales/collections cycle, acquisition/payment cycle, etc.)
• This helps organize audits into manageable parts.

Financial Statement Cycles (Relationships Among Cycles)

• Companies start by acquiring capital (cash), then use cash to acquire inventory, labor, etc.
• Flows of cash are part of different related cycles. A cycle approach can make complex audits more understandable.

Setting Audit Objectives

• Auditors use the cycle approach to test transactions that make up ending balances and to test account balances themselves.
• Assuming the prior year's balance was fairly stated, the current balance can be reasonably assured as correct if transactions are correctly accounted for.

Setting Audit Objectives (Practical Considerations)

• Complete assurance in every transaction class can be impractical in an audit.
• Efficiency and effectiveness in audits often involve a combination of assurance for transaction classes and ending balances.

Setting Audit Objectives (Presentation and Disclosure)

• The third category includes audit objectives that relate to how information is presented and disclosed in financial statements.

How Audit Objectives Are Met

• Meeting audit objectives requires accumulating sufficient and appropriate audit evidence to support all management assertions in financial statements.
• A well-defined audit methodology ensures that audit evidence is collected in support of these objectives.

How Audit Objectives Are Met (Public Companies)

• If a client is a public company, the auditor must also consider reporting on the effectiveness of internal control over financial reporting. This is mandated by standards such as those set by the PCAOB.

Summary

• The main objective of an audit is to express an opinion about the fairness of the financial statements.
• The auditor notifies users about the results through their report.
• Management is responsible for the information in those statements.
• Audits are segmented using a cycle approach to deal with relevant transactions and related accounts.
• Cycle approach relates to how journals record and summarize the information in order to be presented in financial statements.

Reference

• Fundamental of Financial Accounting - Phillips, Libby, Libby
• Issue 8. Global Perspectives and Insights, Internal Audit and External Audit ... (TheIIA)

This quiz covers key concepts in auditing, including the purpose of trial balances, management responsibilities, audit cycles, and the roles of auditors. Test your knowledge on the fundamental objectives of audits and the implications of the Sarbanes-Oxley Act. Perfect for students of accounting and auditing.