Auditing - Chapter 5 PDF

Chapter 05 Audit Evidence and Documentation COPYRIGHT ©2022 MCGRAW-HILL EDUC...

Chapter 05 Audit Evidence and Documentation COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL EDUCATION. The Relationships Among Audit Risk, Audit Evidence, and Financial Statement Assertions COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-2  Audit Risk The risk that the auditor expresses an inappropriate audit opinion on financial statements that are materially misstated. ◦That is: the risk that the auditors will issue an unqualified opinion on financial statements that contain a material departure from GAAP. Auditors must obtain sufficient appropriate audit evidence to reduce audit risk to a low level in every audit. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL Financial Statement Assertions Management is responsible for the fair presentation of financial statements in conformity with GAAP. ◦Responsible for presenting FS with proper amounts in the accounts, including properly recorded transactions, and properly presented disclosures. Relevant assertions are those that, without regard for controls, have a reasonable possibility of containing a material misstatement; types ◦Assertions about account balances and related disclosures (Accounts) ◦Assertions about classes of transactions and events and related disclosures (Transactions) COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL  Combined Assertions Used in this Text Existence or Occurrence—Assets, liabilities, and equity interests exist and recorded transactions have occurred Rights and Obligations—The company holds rights to the assets, while liabilities are the obligations of the company Completeness—All assets, liabilities, equity interests, and transactions that should have been recorded have been recorded Cutoff—Transactions and events have been recorded in the correct accounting period Valuation, Allocation, and Accuracy—All transactions, assets, liabilities, and equity interests are included in the financial statements at proper amounts Presentation and Disclosure—Accounts are described and classified in accordance with generally accepted accounting principles, and financial statement disclosures are complete, appropriate, and clearly expressed COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL Audit Risk Inherent Risk—Risk of material misstatement of a financial statement assertion before considering controls. Control Risk—The risk that a material misstatement that could occur in an account will not be prevented or detected on a timely basis by internal control. Detection Risk—Risk that the auditors’ procedures will lead them to conclude that a financial statement assertion is not materially misstated when in fact such misstatement does exist. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL Inherent Risk Factors that affect inherent risk: ◦ Nature of the client and its environment ◦ Nature of the particular financial statement element Business characteristics indicative of high inherent risk: ◦ Inconsistent profitability of client ◦ Operating results highly sensitive to economic factors ◦ Going concern problems ◦ Large misstatements detected in prior audits ◦ Substantial turnover, questionable reputation, or inadequate accounting skills of the accounting department High inherent risks can impact whether an audit client is accepted COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL Assertions with High Inherent Risk Inherent risk varies by the nature of the account. ◦ E.g. inventory balance is 20% of PPE balance. Do you spend 20% of your time auditing inventory compared to auditing PPE? In general, assertions with high inherent risk involve: ◦ Difficult-to-audit transactions or balances ◦ Complex calculations ◦ Difficult accounting issues ◦ Significant judgment by management ◦ Valuations that vary significantly based on economic factors COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL Types of Transactions It is helpful to segregate transactions into three types Routine ◦ Recurring financial statement activities recorded in the accounting records in the normal course of business (e.g. sales, purchases, cash disbursements, cash receipts, payroll) ◦ Lower inherent risk Nonroutine ◦ Involve activities that occur only periodically such as the taking of physical inventories, adjusting FS for foreign currency gains and losses ◦ High inherent risk Estimation transactions ◦ Activities that create accounting estimates ◦ Involve management judgments or assumptions (warranties, impairment, allowance for uncollectible accounts) ◦ Highest inherent risk COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL Control Risk Risk that a material misstatement could occur in a FS assertion and not be prevented, or detected and corrected, on a timely basis by internal controls. Function of the effectiveness of both the design and operation of IC in achieving the client’s objectives relevant to the preparation of its FS. Inherent risk and control risk exist independently of the financial statements. ◦ The risk of material misstatement exits regardless of whether an audit is performed. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-10 Detection Risk Risk that the auditors’ procedures will lead them to conclude that a FS assertion is not materially misstated when, in fact, such misstatement does exist. Function of the effectiveness of the audit procedures and their application by the auditors. ◦ Unlike inherent risk and control risk, it does NOT exist when no audit is performed. Instead of “assessing” detection risk, auditors try to restrict it through performance of substantive procedures. Exists, because the auditors’ substantive procedures are not 100 percent effective due to sampling and other factors. Detection risk varies inversely with the risk of material misstatement. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-11 Audit Risk Figure 5.2 COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL Audit Risk Formula AR = IR * CR * DR RMM AR = Audit risk IR = Inherent risk CR = Control risk DR = Detection risk RMM = Risk of material misstatement COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL Appropriateness of Audit Evidence Auditor must obtain sufficient appropriate audit evidence. To be appropriate audit evidence must be: ◦ Relevant (relates to the assertion being addressed) ◦ Reliable (relates to accuracy, completeness, authenticity, and susceptibility to management bias) Principles—Audit evidence is ordinarily more reliable when it is ◦ Obtained from knowledgeable independent sources outside the client company is less susceptible to management bias, although the reliability of the source must be considered ◦ Generated internally through a system of effective controls rather than ineffective controls. ◦ Obtained directly by the auditor rather than indirectly or by inference ◦ Documentary in form rather than oral ◦ Provided by original documents rather than documents digitized or otherwise copied/converted COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL Evaluating Evidence Sufficiency When evaluating sufficiency of audit evidence auditors ◦Apply professional skepticism. ◦Assess (and reassess) the risks of material misstatement at the relevant assertion level. ◦Evaluate the nature, timing, and extent of the audit procedures performed. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-15 Applying Professional Skepticism Maintain a questioning mind, being alert to conditions that may indicate possible misstatements due to fraud or error, and critically assessing audit evidence. Auditors must be aware that they may have received biased or outright incorrect information. ◦ Management’s bias ◦ Significant investments in the company’s stock ◦ Receiving compensation tied to reported net income ◦ Concerns about showing poor company performance ◦ Management may have influenced third parties. For external information, consider if management: ◦ Has the ability to influence the source. ◦ Selects sources it knows are favorably biased toward corroborating management’s information. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-16 Professional Skepticism Cognitive Biases Auditors should be aware that a long history of psychological research has shown that human judgments are vulnerable to limitations which may result in insufficient skepticism and biased decisions. ◦ Anchoring bias—too much reliance upon initial belief and ignoring contrary information encountered after initial belief. ◦ Confirmation bias—Seeking and treating as more persuasive information that is consistent with initial belief. ◦ Availability bias—Overvaluing initial information that comes to one’s mind quickly. ◦ The cause of an unusual relationship is the same as they have experienced several times in prior audits. ◦ Overconfidence bias—Overestimate one’s abilities to make estimates or assessments. ◦ May lead to not collecting enough evidence. ◦ Automation bias—Tendency to favor output generated from automated systems, even when human reasoning or contradictory information raises questions as to whether such output is reliable or appropriate. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-17  Professional Skepticism State and Trait* * Not in the textbook The standards do not contain a multi-dimensional view of PS, but Hurtt (2010) argues there are two types of PS - trait and state – that must be understood in order to fully define, comprehend, and measure PS. Trait skepticism deals with an auditor’s inherent traits, problem-solving skills, ethical predilection, self-confidence, tendency to believe/doubt what they are told (Nelson 2009). A 30-question scale was created by R. Kathy Hurtt (2010) to measure an auditor’s inherent trait skepticism based on six characteristics of PS: Questioning mind, suspension of judgment, search for knowledge = how an auditor examines evidence Interpersonal understanding = importance of understanding the human element Self-esteem and autonomy = demonstrate an auditor’s ability to act on the information gathered COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-18  Professional Skepticism State and Trait* * Not in the textbook State skepticism deals with the temporary condition created by situational variables (Hurtt 2010). For example, state skepticism can be impacted by pressures such as time pressure, remote/in-office audit work, presence of another individual, preferences of a client or manager, and many other variables that are often outside of the auditor’s control. State PS is distinct from trait PS, and most literature does not separate the two components. State PS tends to be flexible, changing with each situation, and while trait PS can change over time, it is less malleable (Robinson et al. 2018). COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-19 The Nature, Timing, and Extent of the Audit Procedures Performed Auditors address obtaining sufficient and appropriate audit evidence using the following overall types of procedures: 1. Risk assessment procedures – designed to obtain an understanding of the client and its environment, including its internal control, to assess the risks of MM. 2. Tests of controls – designed to test the operating effectiveness of controls in preventing or detecting material misstatements. 3. Substantive procedures – designed to detect MM of relevant assertions. Substantive procedures include BOTH analytical procedures and tests of details of account balances, transactions, and disclosures. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-20 Audit Procedures and Examples Figure 5.3 COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-21 Substantive and Analytical Procedures COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-22 Substantive Procedures Substantive procedures include substantive analytical procedures and tests of details. These tests are part of the auditors’ further audit procedures, because their nature, timing, and extent are based on the results of the risk assessment procedures. ◦ nature (type and form), timing (when performed), and extent (quantity of evidence obtained). Tests of details may be divided into three types: ◦ Tests of account balances (tests whether there are misstatements in the ending balance of an account, e.g. AR confirmation) ◦ Tests of classes of transactions (address whether particular types of transactions are valid and have been properly accounted for during the period, e.g. sales transactions) ◦ Tests of disclosures (address whether FS disclosures are properly presented) COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-23  Nature and Timing of Procedures Holding the extent of procedures constant, one may increase the scope of procedures (make them more effective) by either changing the ◦Nature—obtain more reliable evidence ◦ often externally generated evidence. ◦Timing—wait until year-end to obtain evidence from entire set of transactions as contrasted to performing interim testing, say two months prior to year-end and simply updating those procedures. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-24  Extent of Procedures Holding other factors such as the nature and timing of procedures constant: ◦ The greater the risk of material misstatement, the greater the needed extent of substantive procedures ◦ The main way to increase the extent of audit procedures is to examine more items ◦ Sample sizes should reduce detection risk so as to restrict audit risk to a low level COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-25 Analytical Procedures Involve evaluations of FS information by a study of relationships among financial and nonfinancial data. Basic premise underlying the application of analytical procedures is that plausible relationships among data may reasonably be expected to exist and continue in the absence of known conditions to the contrary. So, auditors can use these relationships to obtain evidence about the reasonableness of FS amounts. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-26  General on Analytical Procedures 1 of 3 Timing of analytical procedures ◦Risk assessment (sometimes referred to as planning analytical procedures) ◦Substantive procedures ◦Final review Steps involved ◦ Develop expectation of account (or ratio) balance ◦ Determine amount of difference that can be accepted without investigation ◦ Compare the company’s account (ratio) with the expectation ◦ Investigate and evaluate significant differences COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL General on Analytical Procedures 2 of 3 Developing an expectation ◦ Prior period information ◦ Anticipated results ◦ Relationships among elements of financial information within a period ◦ Industry information ◦ Relationships between financial information and relevant nonfinancial data COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-28 General on Analytical Procedures 3 of 3 Types of Expectations ◦Trend analysis—analyze changes in accounts of a company over time ◦Ratio analysis — compare relationships between two or more financial statement accounts or comparisons of account balances to nonfinancial data ◦ Liquidity (e.g., current ratio) ◦ Leverage (e.g., debt to equity) ◦ Profitability (e.g., gross profit percentage) ◦ Activity (e.g., inventory turnover) COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL  Ratio Analysis Approaches to ratio analysis ◦ Horizontal analysis ◦ Review ratios over time ◦ Cross sectional analysis ◦ Analyze ratios of similar firms at a point in time ◦ Vertical analysis ◦ Analyze relationships within a period ◦ “Common size” statements prepared Other methods ◦ Regression analysis, reasonableness test COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL Identifying Potential Misstatements Figure 5.5 COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL Data Analytics Data analytics is the process of using related and unrelated data sets to provide insights into decisions. CPA firms are increasing using data analytic approaches to improve risk assessment, tests of controls and substantive procedures. ◦ In risk assessment, sophisticated data analytics can improve auditors’ assessments of risk by significantly increasing the sources of data used. ◦ In tests of controls, data analytics may allow the auditors to use technology to test 100 percent of the items in a population by relating data from multiple sources ◦ Substantive procedures may be improved by using data from a number of data sources to improve the efficiency and effectiveness of the procedures. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-32 Audit Evidence for Subjective Areas & Audit Documentation COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-33 Auditing Fair Values In recent years, changes in accounting standards have required companies to significantly increase the use of accounting estimates of fair values. Management must select inputs for valuation methods in applying valuation techniques. Inputs to use in applying valuation techniques (FAS 157) ◦ Level 1 – inputs of observable quoted prices in active markets for identical assets or liabilities ◦ Ex. A closing stock price in WSJ ◦ Level 2 – inputs of observable quoted prices, generally for similar assets or liabilities in active markets ◦ Ex. Company discounts future cash flows on its not publicly traded debt securities at rate used by market for publicly traded debt securities ◦ Level 3 – inputs that are unobservable for the assets or liability ◦ Ex. A private company uses judgment to determine a proper rate to discount the estimated future cash flows of its not publicly traded securities COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL Related Party Transactions Disclosure requirements must be met Primary challenge is identifying undisclosed related party transactions ◦ Determine related parties ◦ Inquiries of management ◦ Review SEC filings, stockholder’s listings and conflict-of-interest statements ◦ Be alert for transactions with related parties and any transactions with unusual terms COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL Functions of Audit Documentation Primary functions: Support the auditors’ compliance with auditing standards Support the auditors’ opinion Secondary functions: Assists continuing and new audit team members in planning and performing the audit Serves as a record of matters of continuing audit interest Assists in supervision and review of the audit Demonstrates the accountability of team members Assists internal reviewers, external peer reviewers, PCAOB inspectors, and successor auditors in performing their roles COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL How Detailed? Depends on: ◦ The nature of the auditing procedure being performed ◦ The risk of misstatement involved in the area being tested ◦ The significance of the evidence to the overall audit ◦ The extent of judgment involved in performing the work ◦ The nature of the findings or results Auditors should document all audit findings that they believe to be significant. ▣ Identify who performed and reviewed the work ▣ Show that the accounting agree or reconcile to the financial statements Should be sufficient to allow an experienced auditor to understand the audit work performed, evidence obtained, and significant conclusions reached. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-37 Confidential Nature of Working Papers Auditors must be given unrestricted access to all information about the client’s business. ◦ This includes confidential information such as profit margins, tentative plans for business combinations, salaries, etc. Much of the confidential information is documented in workpapers. Therefore, workpapers are confidential in nature. The AICPA Code of Professional Conduct includes a rule that generally prohibits a member from disclosing confidential information. Confidential information cannot be divulged outside the client’s organization and within the client’s organization. Workpapers must be safeguarded at all times. ◦ Keeping them, or the computers that can access the workpapers, locked away or password protected. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-38 Ownership of Audit Working Papers Workpapers are the property of the auditors. The client has no right to demand access to the auditors’ working papers. After the audit, the auditor retains the workpapers. At times, clients may find information documented in workpapers from prior years to be useful. ◦ Auditors often are willing to provide this information, but they cannot serve as a substitute for the client’s own accounting records. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-39 Working Papers and Auditors’ Liability Audit file includes the workpapers for a particular engagement and is the principal record of the work performed during the audit. Auditors can use the workpapers in the file as evidence at a later date if charged with negligence. According to the SOX Act of 2002, auditors must maintain documentation for seven years (public companies). Auditors may destroy documentation after five years for nonpublic companies. Am I allowed to change audit documentation after the date of the audit report? ◦ Auditors are given 60 days after the audit report release date to complete the audit file. ◦ They are able to perform routine file-assembling procedures and sign-offs of various checklists and adding subsequent information (e.g. if a confirmation was received after the audit date. ◦ If new information is added after the issuance of the audit report documentation must include: when and by whom changes were made and reviewed, specific reasons for the changes, and the effect, if any, of the changes on the auditors’ conclusions. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-40 Types of Working Papers Working papers vary by client/audit, but there are certain general categories into which most may be grouped. 1 – Audit Administrative Working Papers ◦ Auditing is a sophisticated activity requiring planning, supervision, control, and coordination. Workpapers related to these activities include audit plans, work programs/audit programs, internal control questionnaires and flowcharts, engagement letters, and time budgets. ◦ Memos of the planning process and significant discussions with client management are also considered administrative. 2 – Working Trial Balance ◦ Schedule listing the balances of the accounts in the GL for the CY and PY. It also includes columns for the auditors’ proposed adjustments and reclassifications and for the final amounts that will appear in the FS. ◦ Considered the backbone of the entire set of audit working papers. It is the key schedule that controls and summarizes all supporting papers. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-41 Types of Working Papers COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-42 Types of Working Papers 3 – Lead Schedules ◦ Separate lead schedules are set up to combine similar GL accounts. ◦ E.g. Cash lead schedule may be a spreadsheet that includes four separate bank accounts and trial balance accounts. The total ties to the financial statements for Cash and Cash Equivalents. 4 – Adjusting Journal Entries and Reclassification Entries ◦ Auditors may discover various types of misstatements in the client’s FS and accounting records. ◦ These misstatements may be small in amount, they may arise from the omission of transactions or from using incorrect amounts, or they may result from improper classification or cutoff, or misinterpretation of transactions. ◦ Generally these are accidental errors... They may be the result of fraud occasionally. ◦ Auditors accumulate the misstatements identified and propose AJEs (adjusting journal entries). ◦ Auditors develop RJEs (reclassification journal entries). COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-43  Types of Working Papers 5 – Supporting Schedules ◦ Auditors tend to use this term to describe a listing of the elements or details comprising the balance in an asset or liability account at a specific date. ◦ E.g. a list of amounts owed to vendors that tie to accounts payable would be called a schedule. 6 – Analysis of a Ledger Account ◦ Purpose is to show the changes in an asset, liability, equity, revenue, or expense account during the period covered by the audit. ◦ Auditors compare the beginning balance to the ending balance and explain why/how the account changed. ◦ E.g. PP&E, net – purchases, sales, depreciation 7 – Reconciliations ◦ Auditors prove the relationship between amounts obtained from different sources using reconciliations. ◦ Provide evidence as to the accuracy of one or both of the amounts and are important to the audit of many accounts, including cash, AR, and inventories. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-44 Types of Working Papers 8 – Computational Working Papers ◦ The auditors’ approach to verifying certain types of accounts and other figures is to make an independent computation and compare their results with the amounts shown by the client’s records. ◦ E.g. calculate interest expense, depreciation, PR taxes, income taxes, pension liabilities, and EPS 9 – Corroborating Documents ◦ During the course of an audit, the auditors may gather expository material to substantiate their report. ◦ A common example is copies of minutes of directors’ and stockholders’ meetings. ◦ Articles of incorporation, bylaws, copies of important contracts, bond indentures, mortgages, audit confirmations, and representation letters are all examples as well. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-45 Organization of Working Papers Current files ◦ Current year working papers ◦ Typically organized around the arrangement of the accounts in the client’s FS Permanent files ◦ Items of continuing audit interest ◦ Used to refresh the auditors’ memories on items applicable over a period of many years ◦ Used to provide new staff members with a quick summary of the policies and organization of the client ◦ Used to preserve working papers on items that show relatively few or no changes COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL Guidelines for Preparation of Working Papers Separate, properly identified working paper should be prepared for each topic ◦ Includes a heading with the name of the client company ◦ Clear description of the information presented ◦ Applicable date or the period covered ◦ If the working paper was prepared by the client’s staff, it should be labeled PBC (prepared by client) The preparer of a working paper should date and sign or initial the working paper, the signatures or initials of the reviewers also must appear ◦ Electronic working papers automatically keep track of dates, preparers, and reviewers The nature of verification work performed by the auditors should be clearly indicated on each working papers. As audit working papers are prepared, the auditors will use several different symbols to identify specific steps in the work performed. ◦ These are called TICKMARKS Comments by the auditors indicating their conclusions on each aspect of the work should be included. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-47 Preparation of a Working Paper Figure 5.8 COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL Review of Audit Working Papers Working papers must be reviewed after the preparer has completed the working paper. What do reviewers look for? ◦ All reviewers look to see that the working papers properly document the audit. ◦ The first reviewer tends to be the most technical and is usually performed promptly after the completion of the individual working paper. ◦ The second review is often performed by the partner on the engagement and is performed near the end of the engagement so the reviewer can review the entire set of working papers at one time. COPYRIGHT ©2022 MCGRAW-HILL EDUCATION. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW-HILL 5-49