Post-Graduate Certificate in Advanced Professional Accounting - Auditing Fundamentals - CSAC 4551 PDF

POST-GRADUATE CERTIFICATE IN ADVANCED PROFESSIONAL ACCOUNTING Auditing Fundamentals – CSAC 4551 Recap from Class 1 Covered Chapters 1 and 2 Describe auditing and its objective Explain information risk, the cause of it and how it is reduced Identify major types of audits and auditors and dis...

POST-GRADUATE CERTIFICATE IN ADVANCED PROFESSIONAL ACCOUNTING Auditing Fundamentals – CSAC 4551 Recap from Class 1 Covered Chapters 1 and 2 Describe auditing and its objective Explain information risk, the cause of it and how it is reduced Identify major types of audits and auditors and distinguish the audit of financial statements from the other (PA) services Define the objective of a financial statement (f/s) audit Use Canadian Auditing Standards (CAS) to describe the auditor’s responsibilities in a f/s audit Audit quality Today’s Class (Class 2) Cover Chapters 3 and 4 Auditor’s legal environment Expectations gap and lawsuits Auditor’s liability and related defenses Auditor’s professional judgment process Audit responsibilities Professional skepticism Management assertions and audit objectives Audit process Auditing Fundamentals Professional Ethics and Legal Liability Chapter 3 Ethics Ethics -can be broadly defined as a set of moral principles or values. Ethical dilemma—a situation in which a decision must be made about the appropriate behaviour. CPA Ontario Code of Professional Conduct The basic ethical principles that guide Canadian auditors’ ethical conduct are found in the CPA Ontario Rules of Professional Conduct. Professional behaviour - Conduct themselves at all times in a manner that maintains the good reputation of the profession and its ability to serve the public interest. Integrity and due care - Be straightforward, honest, and fair dealing in all professional relationships. They are also expected to act diligently and in accordance with applicable technical and professional standards when providing professional services. CPA Ontario Code of Professional Conduct Cont. Professional competence - Maintain a high level of competence. This underscores the need for maintaining individual professional skill and competence by keeping abreast of and complying with developments in the professional standards. Confidentiality - Duty of confidentiality in respect of information acquired as a result of professional, employment, and business relationships. Objectivity - Not allow their professional or business judgment to be compromised by bias, conflict of interest, or the undue influence of others. A Framework for Ethical Decision Making Ethical Blind Spots Decision makers are susceptible to judgment traps or what is referred to as ethical blind spots. An example is failing to see an ethical issue because it is in our self-interest not to notice. Professional Guidance on Ethical Conduct The provincial accounting associations determine the rules of professional conduct for members and students, and have harmonized their rules of professional conduct so that, generally, the same set of rules applies to all PAs in Canada and serves both members and the public. The professional code of conduct in Canada is both principles-based and compliance-based. Independence Independence: impartiality in performing professional services. The auditor must be independent when conducting an audit or review level assurance engagement (independence is not required for a compilation). Independence Is regarded as the auditor’s most critical characteristic. Independence Cont. Independence in fact: the auditor’s ability to take an unbiased viewpoint in the performance of professional services. Independence in appearance: the auditor’s ability to maintain an unbiased viewpoint in the eyes of others. Independence threat analysis Assessment of independence threats for a particular engagement. Forms part of the documentation for the engagement. The documentation should include the threat, a description of the safeguard to eliminate or reduce the threat to an acceptable level, and how that safeguard eliminates or reduces that threat to an acceptable level. Threats to Independence Safeguards to Independence Safeguards to Independence The Expectations Gap and Auditor Litigation There is an expectation gap when two different groups expect different outcomes in a particular situation. Here, we use the term “expectation gap” to refer to the difference between what users expect from the audit and what the audit report actually provides. Business and Audit Failure Business failure happens when a business cannot repay its debts, perhaps due to poor management, a shift in demand, or economic factors. Audit failure happens when the auditor issues an incorrect audit opinion (e.g., an unqualified opinion when it should be qualified). Users will often blame auditors when there is business failure even if there had been no audit failure. Auditor Litigation and the Expectations Gap Type of failure Sources of liability Audit Failure Issued audit opinion on incorrect financial statements Did not exercise due care Did not comply with generally accepted auditing standards (GAAS) Opens the auditor to liability Business failure Business fails or goes bankrupt due to poor management, competition, or economic reasons Users like lenders would want to recover their investment and sue auditors even though auditors have conducted the audit in accordance with GAAS Major Sources of Auditor Liability Client Common source of lawsuits Contractual relationship with auditor Failure to complete a non-audit engagement on the agreed- upon date, inappropriate withdrawal from an audit, failure to discover an embezzlement (theft of assets), and breach of the confidentiality requirements of CPAs. Third parties Shareholders, vendors, bankers and other creditors or investors, employees, and customers. A significant legal hurdle for these claims is establishing that the auditor owed a duty of care. Major Sources of Auditor Liability Securities Act Shareholders - securities class action suits. Securities legislation gives investors the right to sue auditors (in their role as expert) for misrepresentation in their audit report. Investors recover losses from audit firms that are believed to have “deep pockets” Major Sources of Auditors’ Legal Liability Table 3-6 Major Sources of Auditors’ Legal Liability Source of Legal Liability in Assurance Engagements Example of Potential Claim or Charge Common law liability to client Client sues auditor for not discovering a defalcation during the audit. Common law liability to third parties Bank sues auditor for not discovering materially misstated financial statements. Liability under provincial securities acts Purchaser of shares issued by a company sues auditor for not discovering materially misstated financial statements in a prospectus (this is called the “primary market”). Purchaser of shares on the secondary market sues auditor for not alerting the purchaser of material misstatement. Criminal liability Court prosecutes auditor under the Criminal Code of Canada for knowingly issuing an incorrect auditor’s report. The Profession’s Response to Legal Liability The profession as a whole can do a number of things to reduce practitioners’ exposure to lawsuits. Below are some specific activities: – Standard setting – Oppose lawsuits – Educate users – Sanction members for improper conduct and performance The Profession’s Response to Legal Liability Public accountants may also take specific action to minimize their liability. Below are some of the key actions: – Deal only with clients possessing integrity – Maintain independence – Understand the client’s business – Perform quality audits – Document the work properly – Exercise and maintain professional skepticism Question Read 3-28 Page 81 Organize into Groups of 3 Response 1.a Violation. Although it could be argued because management selected the IT hardware and software and the external auditors merely installed it, the firm is not acting as a member of management and, therefore, has no independence problem – the independence rule applies to design and implementation. Installation would fall in the category of implementation. 2.b Violation. The Rules of Professional Conduct state that an LPA cannot supervise client employees, because then the LPA is doing the work of management. Should the auditors then audit work that was conducted by theses employees, there would be a lack of independence. 3.c This one is questionable. Because JKB management selected the specifications and options of the payroll software application, it could be argued that the PA firm did not act as a member of management by customizing the package for the client’s use. However, like in the previous example because the auditor is involved with “customization” it could be interpreted to be implementation. Although payroll is not the core accounting software, it would fall within financial reporting information because it creates source data for the financial statements. Response 4.d No violation. Training is a standard process that explains to employees how to use the software that was provided based upon management specifications. The execution of the work is still supervised by management. 5.e Violation. By determining which of JKB’s products would be offered on the company’s Web site, the external auditors acted as part of JKB’s management. Independence has been impaired. 6.f Violation. Again, the external auditors are acting as members of management by operating the client’s local area network. Auditing Fundamentals Audit responsibilities and objectives Chapter 4 Audit of Financial Statements Audit Committee - Oversight of management and financial statement audit - Auditor appointment - Internal controls / Internal audit reports - Significant judgement areas in accounting Financial Statements Management Auditor - Prepares financial statements - Provide reasonable (not - Implement internal controls absolute) assurance that - Provide info to auditors to financial statements are free conduct the audit from material misstatements; - Audit report Material Versus Immaterial Misstatements Misstatements are usually considered material if the combined uncorrected errors and fraud in the financial statements would likely have changed or influenced the decisions of a reasonable person using the statements. Error Versus Fraud An error is an unintentional misstatement. Fraud and other irregularities are intentional misstatements. For fraud, a distinction can be drawn between “misappropriation of assets,” often called “defalcation” or “employee fraud,” and “fraudulent financial reporting,” often called “management fraud.” Auditing standards require that an audit be designed to provide reasonable assurance of detecting both. Fraudulent Financial Reporting vs Misappropriation of Assets Fraudulent financial reporting harms users by providing them with incorrect financial statement information for their decision making. It is usually committed by management. When assets are misappropriated, stockholders, creditors, and others are harmed because assets are no longer available to their rightful owners. Auditor’s Responsibility to Consider Laws and Regulations To identify instances of noncompliance with other laws and regulations that may have a material effect on the financial statements, the auditor should: – Inquire of management and those charged with governance about whether the entity is in compliance with such laws and regulations. – Inspect correspondence, if any, with the relevant licensing or regulatory authorities. – The auditor should communicate with those charged with governance matters involving noncompliance with laws and regulations. Auditor’s Responsibility to Evaluate Going Concern CAS 570 “Going Concern”, explains that it is the auditor’s responsibility to obtain sufficient appropriate audit evidence regarding, and to conclude on, the appropriateness of management’s use of the going- concern basis of accounting in the preparation of the financial statements. In addition, based upon the evidence obtained, the auditor is responsible for concluding whether there is a material uncertainty about the entity’s ability to continue as a going concern. Professional Skepticism Trust but verify The auditing standards note that professional skepticism—a “questioning mind”—is necessary for the critical assessment of audit evidence. Sound professional judgment also requires the auditor to exercise objectivity. In addition to using a judgment framework, awareness of judgment traps and biases (often referred to as judgment tendencies) can assist auditors and auditing students in making better judgments. Potential Judgment Traps and Biases Confirmation Bias – Put more weight on information that confirms or supports the auditors initial beliefs or preferences. – The end result may be that the auditor does not adequately consider contradictory evidence. Overconfidence Bias – Inability to see different points of view or contradictory evidence – Don’t involve specialists when the auditor should Anchoring – Auditor is anchored by initial number Availability Table 4-2 notes judgment traps and how to avoid them. Class Discussion Read page 120, 4-25 Number 1 Class Discussion - Answer Anchoring When Chen Li saw that the recorded balance for the allowance followed the client’s allowance policy and the fact that AHA’s policy of recording an allowance for hospital receivables equal to the amount of receivables over 180 days old had historically approximated subsequent write-offs, Chen Li likely had difficulty considering an amount different from what was already recorded, despite the effect of recent regulatory changes on hospitals’ ability to pay. This is an example of the anchoring judgment trap. Class Discussion Read page 120, 4-25 Number 2 Group Discussion Availability Sherry Zipersky’s judgment was likely impacted by the complexity of the impairment testing and the time and complexity that would be involved if she reached out to colleagues in her firm to assist in making an independent assessment. The availability of the client’s extensive information and detailed schedules likely convinced her that the impairment assessments were reliable. This is an example of the availability judgment trap. Class Discussion Read page 120, 4-25 Number 4 Group Discussion Overconfidence Allison Garrett’s judgment about the inventory obsolescence reserve was likely negatively impacted by the overconfidence judgment trap. Allison’s experience in auditing clients in the technology equipment manufacturing industry segment led her to believe she could effectively evaluate the obsolescence of inventory by quickly performing substantive analytical procedures. Her overconfidence caused her to rush the judgment about the reserve. Cycle Approach to Segmenting an Audit A common way to divide an audit is to keep closely related types (or classes) of transactions and account balances in the same segment. This is called the cycle approach. Example- sales and collection cycle – sales, sales return, cash receipt and write-offs of bad debts transactions can all be lumped into one cycle Financial Statement Cycles There are five basic cycles: – Revenue and collection; – Acquisition and payment ; – Human resources and payroll; – Inventory and distribution; and – Capital acquisition and repayment. Setting Audit Objectives Management Assertions Audit Objectives Auditor - Transaction-related audit objectives - Auditor obtain sufficient appropriate audit evidence to support all management assertions in the financial statements - Objectives must be met before concluding that transaction is fairly stated. Management Assertions Table 4-4 Management Assertions for Each Category of Assertions Assertions About Classes of Assertions About Account Assertions About Presentation and Transactions and Events Balances Disclosure Occurrence—Transactions and events Existence—Assets, liabilities, and Occurrence and rights and that have been recorded have equity interests exist. obligations—Disclosed events and occurred and pertain to the entity. transactions have occurred and pertain to the entity. Completeness—All transactions and Completeness—All assets, liabilities, Completeness—All disclosures that events that should have been and equity interests that should should have been included in the recorded have been recorded. have been recorded have been financial statements have been recorded. included. Accuracy—Amounts and other data Valuation and allocation—Assets, Accuracy and valuation—Financial relating to recorded transactions liabilities, and equity interests are and other information is disclosed and events have been recorded included in the financial statements appropriately and at appropriate appropriately. at appropriate amounts and any amounts. resulting valuation adjustments are appropriately recorded. Management Assertions Table 4-4 Continued Assertions About Classes of Assertions About Account Assertions About Presentation and Transactions and Events Balances Disclosure Cutoff—Transactions and events have been recorded in the correct accounting period. Classification—Transactions and Classification and understandability— events have been recorded in the Financial and other information is proper accounts. appropriately presented and described and disclosures are clearly expressed. Rights and obligations—The entity holds or controls the rights to assets, and liabilities are the obligation of the entity. Assertions and Transaction-Related Audit Objectives Occurrence: Do recorded transactions exist? Completeness: Have all transactions been included and recorded? Accuracy: Were transactions recorded correctly? Cut-off: Were transactions and amounts recorded on the correct dates? Classification: Are the transactions included in the client’s journals properly classified? Assertions and Balance-Related Audit Objectives Existence: Do all amounts included exist? Rights (Ownership)/Obligations: Are the assets owned? Do the liabilities belong to the entity? Completeness: Are all amounts recorded? Accuracy Valuation: Are the assets recorded at the amounts estimated to be realized? Allocation: Are all amounts included appropriate? Management Assertions and Audit Objectives Example Assertions and Presentation- and Disclosure- Related Audit Objectives Four audit objectives that must be met before the auditor can conclude that presentation and disclosures are fairly stated are: – Occurrence and Rights and Obligations – Completeness – Accuracy and Valuation – Classification and Understandability The overall purpose of all of the above audit objectives is to assess whether the economic reality of what actually occurred is portrayed in the statements. The Audit Process The Audit Process: Risk Assessment In the risk assessment section, the auditor identifies what could go wrong with the financial statements and the approaches for dealing with the risks. – Client Acceptance and Continuance—engagement acceptance risk – Audit Planning—understanding the entity and its environment – Assess Risk of Material Misstatement (RMM)—identify and assess RMM at the financial statement level and at the account and assertion level The Audit Process: Risk Response After the auditor completes the risk assessment, the risk response is developed, consisting of audit programs and tests, to address those risks. – Develop Risk Response—develop overall response (overall audit strategy), determine audit strategy (approach) for each cycle, finalize audit plan, and develop audit programs and further procedures for each cycle – Perform Risk Responses—gather audit evidence, sampling decisions, perform tests of controls (if relying upon controls), perform substantive analytical procedures, and perform substantive tests (including tests of details) – Conclusion—Complete final evidence gathering, evaluate results of tests completed, and conclude if gathered evidence is sufficient, reliable, and appropriate The Audit Process: Reporting The final step of the audit process is the audit report. – Reporting—determine type of audit opinion to issue and issue audit report When the audit is completed and those in charge of governance have approved the financial statements, the public accountant will issue an auditor’s report to accompany the client’s published financial statements.