Auditor Responsibilities: Assurance, Skepticism, & Fraud

• Auditors are responsible for understanding audit responsibilities and objectives

Reasonable Assurance

• Refers to gaining a high level of confidence that financial statements don't have material misstatements from fraud or error, yet is not absolute

Professional Skepticism

• Auditors maintain a questioning mindset
• Requires auditors to be alert to conditions that indicate possible misstatements or fraud
• Requires auditors to critically assess audit evidence

Errors vs. Fraud

• Both errors and fraud result in misstatements in financial statements
• Key difference: Intent
• Errors are unintentional mistakes caused by oversight, misunderstanding, or misapplication of accounting principles
• Fraud is intentional and done to deceive users of financial statements, and often involves manipulation, falsification, or omission of data

Types of Fraud

• Fraudulent Financial Reporting: Involves intentional misstatements or omissions of information in financial statements to deceive users, make the company appear more profitable, meet targets, or manipulate stock prices.
• Examples of fraudulent financial reporting:
  • Fictitious revenues: Recording sales that never happened
  • Manipulating expenses: Delaying expense recognition to inflate profits
  • Improper asset valuation: Overstating asset values like inventory or receivables
  • Inappropriate disclosures: Leaving out important information or misleading notes
• Misappropriation of Assets (Asset Theft): Involves stealing or misusing the company's assets for personal gain
  • Examples of misappropriation:
    • Embezzlement: Employees diverting company funds for personal use.
    • Theft of inventory: Stealing physical goods.
    • Payroll fraud: Creating fake employees and collecting their paychecks.
    • Expense reimbursement fraud: Submitting fake or inflated expenses.
• Corruption: Involves abuse of power or position to gain personal benefits
  • Examples:
    • Bribery: Paying or receiving money to influence decisions
    • Kickbacks: Secret payments to secure favorable treatment
    • Conflict of interest: Undisclosed relationships that affect business decisions

Management's Assertions

• Implied or expressed representations by management about transactions, accounts, and disclosures in financial statements
• Directly related to the financial reporting framework used by the company
• Types of assertions:
  • Existence or occurrence: Assets or liabilities exist at a given date, and recorded transactions occurred during the period
  • Completeness: All transactions and accounts that should be presented in the financial statements are included
  • Valuation or allocation: Assets, liability, equity, revenue, and expense components are included in the financial statements at appropriate amounts
  • Rights and obligations: The public company holds or controls rights to the assets, and liabilities are obligations of the company at a given date
  • Presentation and disclosure: The components of the financial statements are properly classified, described, and disclosed

Transaction Related Audit Objectives

• Concerned with the validity and accuracy of transactions recorded in the accounting system
• Objectives:
  • Occurrence: Transactions recorded actually happened and relate to the entity
  • Completeness: All transactions that should be recorded are recorded
  • Accuracy: Transactions are recorded at correct amounts
  • Posting and Summarization: Transactions are correctly posted to the ledger and properly summarized
  • Classification: Transactions are recorded in the proper accounts
  • Timing (or Cutoff): Transactions are recorded in the correct accounting period

Balance Related Audit Objectives

• Focus on the balances of accounts presented in the financial statements
• Objectives:
  • Existence: Assets, liabilities, and equity balances exist at the balance sheet date
  • Completeness: All assets, liabilities, and equity balances that should be recorded are recorded
  • Accuracy: Account balances are recorded at correct amounts
  • Classification: Balances are properly classified in the financial statements
  • Cutoff: Transactions near year-end are recorded in the correct period
  • Detail Tie-In: Details in the subsidiary ledger agree with general ledger balances
  • Realizable Value: Assets are stated at amounts expected to be realized
  • Rights and Obligations: The entity holds rights to recorded assets and has obligations for recorded liabilities

Forms of Audit Evidence

• Physical Examination: Direct inspection or count of tangible assets by the auditor.
  • Example: Counting inventory in the warehouse, inspecting fixed assets like equipment.
• Confirmation: Auditor obtains written verification from independent third parties.
  • Example: Confirming accounts receivable balances with customers, confirming bank balances with banks.
• Inspection of Documents (Documentation): Examining client's documents and records (both internal and external).
  • Example: Inspecting purchase invoices, bank statements, contracts.
• Analytical Procedures: Auditor analyzes financial data trends, ratios, and relationships to identify inconsistencies.
  • Example: Comparing current year sales to prior years, analyzing gross margin trends.
• Inquiry: Obtaining verbal or written information from knowledgeable people inside or outside the entity.
  • Example: Asking management about revenue recognition policies, inquiring about pending lawsuits.
• Recalculation: Auditor independently checks mathematical accuracy.
  • Example: Recalculating depreciation expense, verifying invoice totals.
• Reperformance: Auditor independently executes procedures or controls originally performed by the client.
  • Example: Reperforming the bank reconciliation, reprocessing transactions.
• Observation: Watching processes or procedures being performed by others.
  • Example: Observing inventory counts, watching employees perform internal controls.

Sufficient Audit Evidence

• Relates to the quantity of audit evidence collected
• Gathering enough evidence to draw a reasonable conclusion Influencing Factors:
  • Risk of Misstatement: Higher risk necessitates more evidence.
  • Quality of Evidence: Superior quality reduces the need for large quantities.
  • Nature of Account/Transaction: Complex areas require more evidence.

Competent Audit Evidence

• Pertains to the quality of audit evidence
• Competence
  • The evidence must be relevant to the assertion being tested
  • Reliable, meaning trustworthy in source and method of acquisition
• Factors affecting competence:
  • Source: External sources generally more reliable than internal ones
  • Nature: Direct observation, original documents, and confirmations are more reliable
  • Timing: Evidence gathered closer to the balance sheet date is preferable
  • Controls: With strong internal controls, internally generated evidence can be more reliable

Audit Risk

• Risk that the auditor expresses an inappropriate opinion on materially misstated financial statements

Inherent Risk

• The susceptibility of a company's financial statements to material misstatement, assuming there are no related internal controls
• Factors of Inherent Risk:
  • Complexity of transactions
  • Estimates needed
  • Susceptibility to fraud
• Industries with complex financial instruments have heightened inherent risk

Engagement Letter

• Engagement letter outlines the objective and scope of the audit:
  • States the audit's main goal is the financial statement audit
  • Specifies the time period covered, like the year-end date
  • Mentions any additional services included i.e internal control review
• Auditor Responsibilities:
  • Committing to conduct the audit using the appropriate auditing standards
  • Obtaining reasonable assurance that the financial statements do not have material misstatements
  • Acknowledging there are some limitations, and detection of all fraud/errors is not guaranteed
• Management Responsibilities:
  • Responsible for preparation and presentation of the financial statements by the appropriate accounting framework
  • Requires implantation, design and maintenance of effective internal controls
  • Must provide auditor with full access to information, documents and explanations
  • Must aim to prevent/detect any fraud
• Identification of the Applicable Financial Reporting Framework:
  • Designates the accounting standards used to prepare the financial statements
• Describes the type of audit opinion that will be issued
• Contains the limitations of the engagement
  • States that the audit is not designed to detect all fraud or guarantee absolute assurance
  • Confirms the use of sampling and judgement in audit procedures

Fees & Billing Terms

• Fee structure laid out by either a fixed payment, hourly, or estimated cost
• Payment schedule, and required method
• Other Optional Sections:
  • Confidentiality clauses
  • Use of electronic communication
  • Involvement of third party or internal auditors
  • Terms specific to the client

Business Risk

• The risk that a company's objectives and strategies may not be achieved
• Impacting its profitability, operations, reputation, or survival

Preliminary Analytical Review Procedures

• Performing procedures preliminary helps the auditor by:
• Understanding the Client's Business and Industry
  • Helps the auditor achieve a better big picture view of how the company operates
• Identifying Areas of Potential Risk
  • Helps the auditor spot the unexpected trends related to financial data
• Assisting in Setting the Audit Strategy
  • Helps identify risk , aiding effort towards high risk areas
  • Helps determine nature, timing, and audit procedure extent needed
• Aiding in Developing Expectations through comparing current year data too:
  • Prior years
  • Industry benchmarks
  • Budgeted amounts
  • Note that significant deviations will prompt further investigation
• Early Detection of Possible Fraud or Errors
  • Numbers that seem too good to be true or that have unexpected patterns may indicate fraudulent activity
• Common Techniques Used:
  • Trend analysis of financial data over time
  • Comparison to forecasts or budgets

Materiality

• Materiality definition: The magnitude of an omission or misstatement of financial information that could influence the economic decisions of users

Planned Detection Risk

• It the risk that auditors fail to detect misstatements in financial statements
• The only audit component that auditors can control
• Also serves as a base set with auditor assessment of inherent risk and overall control

Control Risk

• Risk that material misstatements are not prevented on time
• Risk internal entities fail to detect on time

Audit Risk Model

• Audit Risk Equation: AR = IR x CR x DR
• Control and Inherent Risks are assessed by the auditor, but these aspects are not controlled by auditor
• A response is mandatory by the auditor when risk is high

Auditor Control

• DR is exclusively controlled by the auditor
• Auditors respond with more audit details/procedures when risk is high

Bank Confirmations

• A formal written request sent by the auditor to a client's bank to verify specific information related to the client's accounts and banking activities
• This written act is more reliable than some audit forms, as it comes directly from a third party (the bank)
• Basic procedures for auditing a prepared bank account by a client: Obtain the Bank Reconciliation
• Gather a client's bank reconciliation for the audited date Obtain the Bank Confirmation & Bank Statement
• Review bank reconciliation on:
• the ending balance per bank , directly from bank
• the bank statement for the specific date

Account Balance Verification

• Tie the book balance per reconciliation to the general ledger or cash account balance
• Examine the Outstanding Checks, by: - Checking legitimacy on the client's check ledger Subsequent period bank statements (to see if checks cleared after year-end).
• Examine Deposits in Transit
  • Trace deposits, with matching deposit slips
  • Check that clearing deposits appeared on the statement shortly after the reconciliation state
• Unusual reconciling items to investigate: - Unusual adjustments and possible misstatements - Old outstanding checks that haven't cleared to inspect for adjustment issues - Verify that charges ,income, and errors from the bank are reconciled -Ensure transactions just before and after year-end are recorded in the correct period