Week Five - Lecture Five -Materiality PDF

AUDIT PRACTICE AND PROCEDURES II Materiality and Risk Week Five  Recap of Last Class Audit Evidence Types of Audit Evidence Audit Plan Audit Documentation A misstatement in the financial statements can be considered material if kn...

AUDIT PRACTICE AND PROCEDURES II Materiality and Risk Week Five  Recap of Last Class Audit Evidence Types of Audit Evidence Audit Plan Audit Documentation A misstatement in the financial statements can be considered material if knowledge of the misstatement will affect a decision of a reasonable user of the statements.  MATERIALITY The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement. Because auditors are responsible for determining whether financial statements are materially misstated, they must, upon discovering a material misstatement, bring it to the client’s attention so that a correction can be made. If the client refuses to correct the statements, the auditor must issue a qualified or an adverse opinion, depending on the materiality of the misstatement. To make such determinations, auditors depend on a thorough knowledge of the application of materiality. The auditor’s responsibility section in an audit report includes two important phrases that are directly related to materiality and risk. The phrase obtain reasonable assurance is intended to inform users that auditors do not guarantee or ensure the fair presentation of the financial statements. Some risk that the financial statements are not fairly stated exists, even when the opinion is unqualified. The phrase free of material misstatement is intended to inform users that the auditor’s responsibility is limited to material financial information. Materiality is important because it is impractical for auditors to provide assurances on immaterial amounts. Materiality and risk are fundamental to planning the audit and designing an audit approach. Determining materiality requires professional judgment. Auditors follow five closely related steps in applying materiality, as shown in Figure 9-1 The auditor first determines materiality for the financial statements as a whole. Second, the auditor determines performance materiality, which is materiality for segments of the audit (classes of transactions, account balances or disclosures) as shown in the first bracket of the figure. These two steps, which are part of planning, are our primary focus for the discussion of materiality in this chapter. Step 3 occurs throughout the engagement, when auditors estimate the amount of misstatements in each segment as they evaluate audit evidence. Near the end of the audit, during the engagement completion phase, auditors proceed through the final two steps. These latter three steps, as shown in the second bracket in Figure 9-1, are part of evaluating the results of audit tests.  Materiality for Financial Statement as a Whole Auditing standards require auditors to decide on the combined amount of misstatements in the financial statements that they would consider material early in the audit as they are developing the overall strategy for the audit. We refer to this as the preliminary judgment about materiality. It is called a preliminary judgment about materiality because, although a professional opinion, it may change during the engagement. This judgment must be documented in the audit files. The preliminary judgment about materiality for the financial statements as a whole is the maximum amount by which the auditor believes the statements could be misstated and still not affect the decisions of reasonable users. (Conceptually, this is an amount that is $1 less than materiality as defined by the FASB. We define preliminary materiality in this manner for convenience.) This judgment is one of the most important decisions the auditor makes, and it requires considerable professional wisdom. Auditors set a preliminary judgment about materiality to help plan the appropriate evidence to accumulate. During the audit, auditors often change the preliminary judgment about materiality. We refer to this as the revised judgment about materiality. Auditors are likely to make the revision because of changes in one of the factors used to determine the preliminary judgment; that is because the auditor decides that the preliminary judgment was too large or too small. For example, a preliminary judgment about materiality is often determined before year-end and is based on prior years’ financial statements or annualized interim financial statement information. The judgment may be reevaluated after current financial statements are available. Or, client circumstances may have changed due to qualitative events, such as the issuance of debt that created a new class of financial statement users.  Factors Affecting Preliminary Materiality Judgment Several factors affect the auditor’s preliminary judgment about materiality for a given set of financial statements. The most important of these are: Materiality Is a Relative Rather Than an Absolute Concept Benchmarks Are Needed for Evaluating Materiality Qualitative Factors Also Affect Materiality  Factors Affecting Preliminary Materiality Judgment Materiality Is a Relative Rather Than an Absolute Concept - A misstatement of a given magnitude might be material for a small company, whereas the same dollar misstatement could be immaterial for a large one. This makes it impossible to establish dollar-value guidelines for a preliminary judgment about materiality that are applicable to all audit clients. For example, a total misstatement of $10 million would be extremely material for Hillsburg Hardware Co. because, as shown in their financial statements, total assets are about $61 million and net income before taxes is less than $6 million  Factors Affecting Preliminary Materiality Judgment Benchmarks Are Needed for Evaluating Materiality - Because materiality is relative, it is necessary to have benchmarks for establishing whether misstatements are material. Net income before taxes is often the primary benchmark for deciding what is material for profit-oriented businesses because it is regarded as a critical item of information for users. Some firms use a different primary benchmark, because net income often fluctuates considerably from year to year and therefore does not provide a stable benchmark, or when the entity is a not-for-profit organization. Other primary benchmarks include net sales, gross profit, and total or net assets. After establishing a primary benchmark, auditors should also decide whether the misstatements could materially affect the reasonableness of other benchmarks such as current assets, total assets, current liabilities, and owners’ equity. Auditing standards require the auditor to document in the audit files the preliminary judgment about materiality and the basis used to determine it.  Factors Affecting Preliminary Materiality Judgment Qualitative Factors Also Affect Materiality - Certain types of misstatements are likely to be more important to users than others, even if the dollar amounts are the same. For example: Amounts involving fraud are usually considered more important than unintentional errors of equal dollar amounts because fraud reflects on the honesty and reliability of the management or other personnel involved. For example, most users consider an intentional misstatement of inventory more important than clerical errors in inventory of the same dollar amount. Misstatements that are otherwise minor may be material if there are possible consequences arising from contractual obligations. Say that net working capital included in the financial statements is only a few hundred dollars more than the required minimum in a loan agreement. If the correct net working capital were less than the required minimum, putting the loan in default, the current and noncurrent liability classifications would be materially affected Misstatements that are otherwise immaterial may be material if they affect a trend in earnings. For example, if reported income has increased 3 percent annually for the past 5 years but income for the current year has declined 1 percent, that change may be material. Similarly, a misstatement that would cause a loss to be reported as a profit may be of concern.  Determine performance materiality Performance materiality is defined as the amount(s) set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole. Determining performance materiality is necessary because auditors accumulate evidence by segments rather than for the financial statements as a whole, and the level of performance materiality helps them decide the appropriate audit evidence to accumulate. Performance materiality is inversely related to the amount of evidence an auditor will accumulate.  Determine performance materiality Performance materiality can vary for different classes of transactions, account balances, or disclosures especially if there is a focus on a particular area. For example, users of financial statements might expect disclosures of related-party transactions involving the CEO or the purchase price of a newly-acquired subsidiary to be more precise, and therefore auditors might set a lower materiality level in these audit areas. We refer to the process of determining performance materiality as the allocation of the preliminary judgment about materiality Auditors face three major difficulties in allocating materiality to balance sheet accounts: 1. Auditors expect certain accounts to have more misstatements than others. 2. Both overstatements and understatements must be considered. 3. Relative audit costs affect the allocation  AUDIT RISK Auditing standards require the auditor to obtain an understanding of the entity and its environment, including its internal control, to assess the risk of material misstatements in the client’s financial statements.  Audit Risk Model for Planning Auditing standards require the auditor to assess the risk of material misstatements at the overall financial statement level as well as the relevant assertion level for classes of transactions, account balances, and disclosures. Auditors consider these risks in planning procedures to obtain audit evidence primarily by applying the audit risk model. The audit risk model helps auditors decide how much and what types of evidence to accumulate for each relevant audit objective. It is usually stated as follows:  AUDIT RISK MODEL COMPONENTS Planned detection risk is the risk that audit evidence for an audit objective will fail to detect misstatements exceeding performance materiality. There are two key points to know about planned detection risk. Planned detection risk is dependent on the other three factors in the model. It will change only if the auditor changes one of the other risk model factors. Planned detection risk determines the amount of substantive evidence that the auditor plans to accumulate, inversely with the size of planned detection risk. If planned detection risk is reduced, the auditor needs to accumulate more evidence to achieve the reduced planned risk. Inherent risk measures the auditor’s assessment of the susceptibility of an assertion to material misstatement, before considering the effectiveness of related internal controls. If the auditor concludes that a high likelihood of misstatement exists, the auditor will conclude that inherent risk is high. Internal controls are ignored in setting inherent risk because they are considered separately in the audit risk model as control risk.  AUDIT RISK MODEL COMPONENTS Control risk - measures the auditor’s assessment of the risk that a material misstatement could occur in an assertion and not be prevented or detected on a timely basis by the client’s internal controls. The auditor can increase planned detection risk when controls are effective because effective internal controls reduce the likelihood of misstatements in the financial statements. Acceptable audit risk - is a measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued. When auditors decide on a lower acceptable audit risk, they want to be more certain that the financial statements are not materially misstated. Often, auditors refer to the term audit assurance (also called overall assurance or level of assurance) instead of acceptable audit risk.  Assessing Acceptable Audit Risk Auditors must decide the appropriate acceptable audit risk for an audit, preferably during audit planning. First, auditors decide engagement risk and then use engagement risk to modify acceptable audit risk. Engagement risk is the risk that the auditor or audit firm will suffer harm after the audit is finished, even though the audit report was correct. Engagement risk is closely related to client business risk.  Factors Affecting Acceptable Audit Risk 1.The Degree to Which External Users Rely on the Statements - Several factors are good indicators of the degree to which statements are relied on by external users: Client’s size. Distribution of ownership. Nature and amount of liabilities. 2.The Likelihood That a Client Will Have Financial Difficulties After the Audit Report Is Issued - It is difficult for an auditor to predict financial failure before it occurs, but certain factors are good indicators of its increased probability: Liquidity position. Profits (losses) in previous years. Method of financing growth. Nature of the client’s operations. Competence of management. 3.The Auditor’s Evaluation of Management’s Integrity - if a client has questionable integrity, the auditor is likely to assess a lower acceptable audit risk. Companies with low integrity often conduct their business affairs in a manner that results in conflicts with their stockholders, regulators, and customers. It is difficult for an auditor to predict financial failure before it occurs, but certain factors are good indicators of its increased probability: Liquidity position. If a client is constantly short of cash and working capital, it indicates a future problem in paying bills. The auditor must assess the likelihood and significance of a steadily declining liquidity position. Profits (losses) in previous years. When a company has rapidly declining profits or increasing losses for several years, the auditor should recognize the future solvency problems that the client is likely to encounter. It is also important to consider the changing profits relative to the balance remaining in retained earnings. Method of financing growth. The more a client relies on debt as a means of financing, the greater the risk of financial difficulty if the client’s operating success declines. Auditors should evaluate whether fixed assets are being financed with short- or long- term loans, as large amounts of required cash outflows during a short time can force a company into bankruptcy. It is difficult for an auditor to predict financial failure before it occurs, but certain factors are good indicators of its increased probability: Nature of the client’s operations. Certain types of businesses are inherently riskier than others. For example, other things being equal, a start-up technology company dependent on one product is much more likely to go bankrupt than a diversified food manufacturer. Competence of management. Competent management is constantly alert for potential financial difficulties and modifies its operating methods to minimize the effects of short- run problems. Auditors must assess the ability of management as a part of the evaluation of the likelihood of bankruptcy.  Factors Affecting Inherent Risk The auditor must assess the factors that make up the risk and modify audit evidence to take them into consideration. The auditor should consider several major factors when assessing inherent risk: Nature of the client’s business Results of previous audits Initial versus repeat engagement Related parties Complex or nonroutine transactions Judgment required to correctly record account balances and transactions Makeup of the population Factors related to fraudulent financial reporting Factors related to misappropriation of assets  Financial Statements Assertions International auditing standards and AICPA auditing standards classify assertions into three categories: 1. Assertions about classes of transactions and events for the period under audit 2. Assertions about account balances at period end 3. Assertions about presentation and disclosure  Assertions About Classes of Transactions and Events Management makes several assertions about transactions. These assertions also apply to other events that are reflected in the accounting records, such as recording depreciation and recognizing pension obligations. Occurrence - The occurrence assertion concerns whether recorded transactions included in the financial statements actually occurred during the accounting period. For example, management asserts that recorded sales transactions represent exchanges of goods or services that actually took place. Completeness - This assertion addresses whether all transactions that should be included in the financial statements are in fact included. For example, management asserts that all sales of goods and services are recorded and included in the financial statements. The completeness assertion addresses matters opposite from the occurrence assertion. The completeness assertion is concerned with the possibility of omitting transactions that should have been recorded, whereas the occurrence assertion is concerned with inclusion of transactions that should not have been recorded. Accuracy - The accuracy assertion addresses whether transactions have been recorded at correct amounts. Using the wrong price to record a sales transaction and an error in calculating the extensions of price times quantity are examples of violations of the accuracy assertion.  Assertions About Classes of Transactions and Events Classification - The classification assertion addresses whether transactions are recorded in the appropriate accounts. Recording administrative salaries in cost of sales is one example of a violation of the classification assertion. Cutoff - The cutoff assertion addresses whether transactions are recorded in the proper accounting period. Recording a sales transaction in December when the goods were not shipped until January violates the cutoff assertion.  Assertions About Account Balances Assertions about account balances at year-end address existence, completeness, valuation and allocation, and rights and obligations. Existence - The existence assertion deals with whether assets, liabilities, and equity interests included in the balance sheet actually existed on the balance sheet date. For example, management asserts that merchandise inventory included in the balance sheet exists and is available for sale at the balance sheet date. Completeness - This assertion addresses whether all accounts and amounts that should be presented in the financial statements are in fact included. For example, management asserts that notes payable in the balance sheet include all such obligations of the entity. The completeness assertion addresses matters opposite from the existence assertion. The completeness assertion is concerned with the possibility of omitting items from the financial statements that should have been included, whereas the existence assertion is concerned with inclusion of amounts that should not have been included.  Assertions About Account Balances Valuation and Allocation - The valuation and allocation assertion deals with whether assets, liabilities, and equity interests have been included in the financial statements at appropriate amounts, including any valuation adjustments to reflect asset amounts at fair value or net realizable value. For example, management asserts that property is recorded at historical cost and that such cost is systematically allocated to appropriate accounting periods through depreciation. Rights and Obligations - This assertion addresses whether assets are the rights of the entity and whether liabilities are the obligations of the entity at a given date. For example, management asserts that assets are owned by the company or that amounts capitalized for leases in the balance sheet represent the cost of the entity’s rights to leased property and that the corresponding lease liability represents an obligation of the entity.  Assertions About Presentation and Disclosure With increases in the complexity of transactions and the need for expanded disclosures about these transactions, assertions about presentation and disclosure have increased in importance. These assertions include occurrence and rights and obligations, completeness, accuracy and valuation, and classification and understandability. Occurrence and Rights and Obligations - This assertion addresses whether disclosed events have occurred and are the rights and obligations of the entity. For example, if the client discloses that it has acquired another company, it asserts that the transaction has been completed. Completeness - This assertion deals with whether all required disclosures have been included in the financial statements. As an example, management asserts that all material transactions with related parties have been disclosed in the financial statements.  Assertions About Presentation and Disclosure Accuracy and Valuation - The accuracy and valuation assertion deals with whether financial information is disclosed fairly and at appropriate amounts. Management’s disclosure of the amount of unfunded pension obligations and the assumptions underlying these amounts is an example of this assertion. Classification and Understandability - This assertion relates to whether amounts are appropriately classified in the financial statements and footnotes, and whether the balance descriptions and related disclosures are understandable. For example, management asserts that the classification of inventories as finished goods, work-inprocess, and raw materials is appropriate, and the disclosures of the methods used to value inventories are understandable.  General Transaction-Related Audit Objectives The auditor’s transaction-related audit objectives follow and are closely related to management’s assertions about classes of transactions. There is a difference between general transaction-related audit objectives and specific transaction-related audit objectives for each class of transactions. The six general transaction-related audit objectives discussed here are applicable to every class of transactions and are stated in broad terms. Occurrence—Recorded Transactions Exist - This objective deals with whether recorded transactions have actually occurred. Inclusion of a sale in the sales journal when no sale occurred violates the occurrence objective. This objective is the auditor’s counterpart to the management assertion of occurrence for classes of transactions. Completeness—Existing Transactions Are Recorded - This objective deals with whether all transactions that should be included in the journals have actually been included. Failure to include a sale in the sales journal and general ledger when a sale occurred violates the completeness objective. This objective is the counterpart to the management assertion of completeness for classes of transactions.  General Transaction-Related Audit Objectives Accuracy—Recorded Transactions Are Stated at the Correct Amounts - This objective addresses the accuracy of information for accounting transactions and is one part of the accuracy assertion for classes of transactions. For sales transactions, this objective is violated if the quantity of goods shipped was different from the quantity billed, the wrong selling price was used for billing, extension or adding errors occurred in billing, or the wrong amount was included in the sales journal. Posting and Summarization—Recorded Transactions Are Properly Included in the Master Files and Are Correctly Summarized - This objective deals with the accuracy of the transfer of information from recorded transactions in journals to subsidiary records and the general ledger. It is part of the accuracy assertion for classes of transactions. For example, if a sales transaction is recorded in the wrong customer’s record or at the wrong amount in the master file or the sum of all sales transactions posted from the sales journal to the general ledger is inaccurate, this objective is violated.  General Transaction-Related Audit Objectives Classification—Transactions Included in the Client’s Journals Are Properly Classified - As the auditor’s counterpart to management’s classification assertion for classes of transaction, this objective addresses whether transactions are included in the appropriate accounts. Examples of misclassifications for sales are: including cash sales as credit sales, recording a sale of operating fixed assets as revenue, and misclassifying commercial sales as residential sales. Timing—Transactions Are Recorded on the Correct Dates - The timing objective for transactions is the auditor’s counterpart to management’s cutoff assertion. A timing error occurs if a transaction is not recorded on the day it took place. A sales transaction, for example, should be recorded on the date of shipment.  BALANCE-RELATED AUDIT OBJECTIVES Balance-related audit objectives are similar to the transaction-related audit objectives just discussed. They also follow from management assertions and they provide a framework to help the auditor accumulate sufficient appropriate evidence related to account balances. There are also both general and specific balance-related audit objectives. There are two differences between balance-related and transaction-related audit objectives. First, as the terms imply, balance-related audit objectives are applied to account balances such as accounts receivable and inventory rather than classes of transactions such as sales transactions and purchases of inventory. Second, there are eight balance- related audit objectives compared to six transaction-related audit objectives.  Interim Audit Interim audit refers to the examination of books of accounts to check the recording of transactions correctly and the company’s work in the manner legally acceptable before the conduct of any statutory audit. It is an audit conducted between two financial years, and its main objective is early identification of threats and taking corrective measures at an early stage. Objectives of Interim Audit It is conducted to determine the profit of the period and determine whether the company could pay an interim dividend or not, as interim dividend payment by the company results in the value addition of the business in the mind of investors and shareholders. To identify and early detection of fraud and improve the employees’ efficiency as it thoroughly examines the work done by the employees.  Interim Audit Characteristics It is conducted between two periods; it sometimes may also be called a half-yearly audit. It is an in-depth analysis of all the transactions entered into or transacted with the business over a defined period. It is sometimes conducted to determine the book value of a company’s share. The organization whose interim audit is conducted is considered more reliable than those whose interim audit is not conducted. The procedure of Interim Audit The procedure of internal audit varies from business to business and depends on the working of the business enterprise and the voluminous transactions; some of the essential outlay points are as follows:  Benefits of Interim Audit It helps increase the efficiency and effectiveness of the management functioning concerning the accounting and financial part of the business. It is less expensive than other audits that are required to be conducted, and it helps in the easy finalization of final accounts. As the employees are well aware that some other person checks their work, the efficiency and correctness in employees’ work tend to rise. As the books of accounts are finalized on the date by the professional possessing the necessary skills, the company may easily borrow funds from the financial institutions based on the same. As the books of accounts prepared are to be analyzed in-depth, the risk of fraud will significantly fall.  Limitations of Interim Audit It is only to be used by management, and it does not have any connection with investors or lenders, etc. It only covers the financial part of the organization, but the business has several other aspects being reviewed for better results. It increases the burden and mental pressure on the working staff as their work is checked by some outside person. The risk of data manipulation rises to hide the things from being reported or detected. Sometimes due to errors in determining profits accurately to shareholders, the company’s funds may arbitrarily decrease.  FINAL AUDIT Final audit means when the audit is done after the close of financial year or when the final accounts are prepared. The audit is completed in one continuous session. Final audit is also known as a periodic audit. Final audit may be started after the closure of books of accounts at the end of the accounting year.  Advantages of Final Audit 1.Economical - The final audit is beneficial for the business. The auditor can complete the work in time. He can charge the fee on the basis of time spent. This audit is economical from the client’s point of view. 2.Staff Duties - The audit work is started after the completion of accounting work. There is no clash of duties of accounting and audit staff. 3.Convenient for Management The benefit of the final audit is that is convenient for management as well as audit staff. The auditors can start and complete an audit in one session. The queries can be cleared on the same day. 4.Minimum Time Period The time required for final audit is less as compared to continuous audit. The auditors can start and complete many audits. They can raise their income by means of a new audit.  Advantages of Final Audit 5.PLANNED Work - The work of audit is completed under planning. The audit program provides the schedule of time for audit work. According to planned work the auditor can control the audit of many business units. 6.Work Continuity - The flow of audit work goes on without any break from start till its completion. The continuity of work is beneficial for audit staff to clear their questions. The doubts become clear on the same day. 7.No Change In Figures - The benefit of final audit is that change in figures is not possible. The audit work starts after the completion of entries. The books are in the custody of auditors, so manipulation is not easy after completion of accounts. 8.Small Business - The final audit is useful for small-scale business units. The fee charged by the auditor is less as compared to continuous audit. The small income of business can afford small audit fee.  Advantages of Final Audit 9.No Relations - The merit of the final audit is that it provides no chance to audit staff to develop friendly relations with accounting staff. The accounting staffs are not in a position to get undue benefit from audit staff. 10.Full Information - The final audit is useful as it provides full information about business matters. The auditor can take the decision on the spot for completion of audit work and submission of an audit report. 11.Thorough Checking - The benefit of final audit is that there is thorough checking of accounting record. There may be 100 percent checking or sampling. In both cases there is thorough checking. 12.Legal Requirements - The final checking is used to check that legal requirements have been observed in completing the accounting the accounting work. The management is responsible for legal requirements. 13.Performance - The benefit of a final audit is that performance of audit improves. The auditor can determine the weakness of all employees including management. When weakness is eliminated, there is better performance.  Disadvantages of Final Audit 1.Late Correction - The demerit of a final audit is that errors are located after the end of the year. The corrections of errors take time so long errors are not corrected the accounts are incomplete. 2.Accounts Delayed - The demerit of a final audit is that delay occurs in the preparation of accounts. The accounting staffs are unable to close its accounts exactly at the end of the year. There is a delay in finalizing the accounting matters. 3.Audit Report - The demerit of a final audit is that report is not presented in time. It may be submitted one or two months late. The decisions are to be made on the basis of audited accounts. 4.Low Moral Check - The drawback of a final audit is that it has less moral pressure on employees of the business concern. The audit staffs come after one year. The employees are free to commit errors and frauds for twelve months. 5.Planned Frauds - The disadvantage of a final audit is that planned frauds are not detected. The employees have one full year at their disposal to think, plan and commit frauds. The auditors may fail to discover frauds.  Disadvantages of Final Audit 6.Past Data - The audit of accounts relates to previous year’s facts and figures. The past year is a part of history. Whether there were errors or frauds in the books of accounts it has no concern with present or future. 7.Thorough Checking - The drawback of a final audit is that there may not be thorough checking. Audit sampling may be used to complete work. In this case, errors and frauds may not be located. 8.Planning for Future - The budgets and estimates for future may not be prepared in time. As the audit work is started after the end of accounting year it takes time to check the accounting records. The audit work is completed late. So the projected income statements balance sheets and budgets may be prepared late.  Disadvantages of Final Audit The easy and quick discovery of errors is not possible in final audit. The accounts are also not presented very quickly. The accounts staff of the client is not kept regular during the year because they know the auditors will visit after closure of financial year. There is not moral check on the staff of the client. More time and attention is to be paid on the work. If a company has to declare the interim dividend, in that case final audit is not useful. In case of final audit, the audit staff remains idle during whole year because they have to work only after the closure of financial year that too for very little period. Because of limited time, auditor has difficulty to finish the work of all clients in proper time.  Reference http://www.letslearnaccounting.com/final-audit/ Textbook