Auditing Theory Lecture 05 PDF

AUDITING THEORY LECTURE 05 1  POSSIBLE CPALE QUESTIONS MULTIPLE CHOICE: 7. Which of the following statements is not true with respect to assurance, assertion-based assurance, and audit services? a) These services are applied only to financial statements and...

AUDITING THEORY LECTURE 05 1  POSSIBLE CPALE QUESTIONS MULTIPLE CHOICE: 7. Which of the following statements is not true with respect to assurance, assertion-based assurance, and audit services? a) These services are applied only to financial statements and financial statement accounts. b) These services all involve obtaining and evaluating evidence c) These services all involve determining the correspondence of some information to a set of criteria. d) These services all involve issuing a report. 2  POSSIBLE CPALE QUESTIONS MULTIPLE CHOICE: 8. In performing an attestation engagement, a CPA typically: a) Supplies litigation support services b) Assesses control risk at a low level c) Expresses a conclusion about an assertion d) Provides management consulting advice Litigation support services is not the main focus of attestation engagement. This is applicable if the practitioner is conducting fraud investigation. Assesses control risk at a low level contradicts to the fact that a CPA evaluates control risk to the 3  POSSIBLE CPALE QUESTIONS MULTIPLE CHOICE: 8. In performing an attestation engagement, a CPA typically: Provides management consulting advice could not be the end-game of attestation engagement. Management consulting is more on solving problems arising from loopholes in operations, difficulty in the implementation of marketing plan, human resource management etc. Expresses conclusion about an assertion is the typical end-result of an attestation engagement. Because for every engagement of this kind, the 4  POSSIBLE CPALE QUESTIONS MULTIPLE CHOICE: 9. Which of the following are required to have a written report regarding the assertion of another party? Financial statemen Operation Complian Attestation Assurance ts audit al audit ce audit engageme engagem nt ent a Yes Yes Yes Yes Yes ) b Yes Yes Yes Yes No ) c Yes Yes Yes No No5  POSSIBLE CPALE QUESTIONS MULTIPLE CHOICE: 10. Which of the following criteria is unique to the independent auditor’s attest function? a) General competence b) Familiarity with the particular industry of each client c) Due professional care d) Independence General competence, due professional care and independence are already given for each and every auditor. To make the auditor different from the others, he/she must be familiar with the nature of business of the client to make the audit 6  TEST OF CONTROL UNDERSTANDING THE ENTITY’S INTERNAL CONTROL 1. Auditors cannot perform test of control if they do not understand the internal control itself. 2. Simply applying the audit procedures on each area is the test of control. 3. Auditors must have at least basic knowledge on the process for every business undertaking. 4. Understanding internal control always goes hand- in-hand with understanding the risks. 5. Risk assessment is therefore necessary to understand internal control. 6. In testing an entity’s internal control, the auditor wants to prevent the Risk of Material Misstatement 7  TEST OF CONTROL RISK ASSESSMENT PROCESS 1. Design and perform procedures to obtain understanding Risk assessment procedures (RAP) Information obtained in prior audits Discussions among the audit team 2. Identify and assess risk of material misstatements (ROMM) Identify material account balances, class of transactions and disclosures to financial statements. 8  TEST OF CONTROL Transactions & Risk if the Audit documents Internal control was procedure to Sales: Salescontrol invoice not complied Sales test control Obtain Cash sales – and collection without samples of sales receipt should invoice are sales invoice invoice be signed the not valid and collection Sales on person who sales. receipts & account – prepared the Receipt of check if these sales same (maker); cash without were all signed collection invoice and and should be by the maker approved by a receipt would collection mean the and checker, higher ranking receipt money was machine employee (checker) pocketed by validated & 9  TEST OF CONTROL Transactions & Risk if the Audit documents Internal control was procedure to Collection of O.R.control and S.I. not complied Collections test control Compare Receivables: are signed by maybe undeposited Official the maker and pocketed by collections receipts checker. the cashier. Sales invoice Compare Amount with O.R.s & for accounts collection with collected may with P.N. receivable agreement not be in Verify if Promissory (P.N.) accordance collections note for notes Collections with are receivable should be agreement Collection recorded in included in Unrecorded report collection collections – the books. understatement Ledgers & report 10 of cash,  TEST OF CONTROL Transactions & Risk if the Audit documents Internal control was procedure to Purchase of control Check & journal not complied If the issued test Verifycontrol payee of merchandise: vouchers must be check was the check & signed by the payable to a Sales invoice proper maker and party other than issued by checker the supplier, approval of supplier Issued check payment could check & Check voucher must be payable have been journal if paid by cash to the supplier & pocketed by voucher must be properly someone else. Journal Compare acknowledged. Unrecorded item voucher if on Transaction would result to vouchers with account should be understatement journals & Inventory recorded in the of cost of goods ledgers report books and sold and liability Compare inventory report Possible non-inclusion of the items in vouchers &11  TEST OF CONTROL Transactions & Risk if the control Audit procedure documents Internal control was not complied to test control Payment of Official receipt If the payee is a Compare official must bear party other than receipt of supplier payables with the check signature of the the supplier or Official receipt creditor, then, payment. Payee of supplier or issued by the check should be creditor the payment the name of supplier supplier or Check voucher could have been written in the O.R. creditor must be signed by pocketed by Compare the Check voucher the maker & someone else amount paid with checker If the payment is what has been Journals & Payee of the not in agreed upon. vouchers check must be accordance with Verify if vouchers Promissory the supplier or the agreement, are signed by maker creditor & must the company & checker note for notes Verify if the voucher be properly could pay payable was recorded in the acknowledged. penalties journal & posted in Payment should If unrecorded, 12 the ledger.  TEST OF CONTROL Obtain copy Make an Take note of the of company observation and violations & policies and verify make procedures transactions if recommendation the policies & s for the procedures are improvement 13  RISK ASSESSMENT Identified Risks Likelihood to happen Assessment Identified Risks in Company High risk – the pre-audit planning. experience based auditor may Sources are: on reported fraud obtain more Previous audit cases & errors. This samples from reports could happen the population Interviews & again. Moderate risk – walkthrough Industry samples to be Written policies experience based taken could be & manual on reported cases. average Industry If these occurred in Low risk – lesser experience other companies, samples could be taken during the these may happen 14 audit  RISK ASSESSMENT Identified Risks Likelihood to happen Assessment Possible If this happened more This could be unauthorized than once in our own classified as high company because of risk in this issuance of official the neglect of the assessment receipts & other supervisors on The auditor may pre-numbered safekeeping focus on how accountable forms accountable forms, accountable forms this may happen are safekept, again. frequency of If the same thing inventory and happened in other updating of companies, then, it logbook. may happen again in Issuance should be our own company. verified if in 15  RISK ASSESSMENT Identified Risks Likelihood to happen Assessment Bank reconciliation Accountants of some This could be statement is not companies neglected classified as high the preparation risk because regularly being because of the usual failure to prepare prepared volume of workload. bank reconciliation If this was not done in statement would the previous period, result to unreliable there could be a amount of strong possibility that reported cash in this would not likewise bank. be done in the current Errors & other and future periods. irregularities could not be detected 16  RISK ASSESSMENT Identified Risks Likelihood to happen Assessment Failure to comply This very basic This is classified as with the Imprest internal control high risk mechanism is usually Failure to comply Cash System: All disbursements neglected by some may result to the companies especially following: should be through  Temporary SMEs the issuance of The likelihood to borrowing by the checks Petty cash fund happen is very high cash custodian based on the  Some should be experience of most disbursements established for auditors my go to the small expenses Collections for the wrong person day should be 17 deposited intact  RISK ASSESSMENT Identified Risks Likelihood to happen Assessment Subsidiary ledgers If the company is The risk for accounts and using or adapting a assessment could computerized be moderate or notes receivables accounting system, low. are not updated and the accounting The auditor could For staff are well-trained select lesser computerized on the proper samples to accounting transaction codes to determine if these system, non- be used, the likelihood ledgers are to happen could be updated or not. updating could If the ledgers remote. be the wrong however are not transaction updated, the code in the collection 18  RISK ASSESSMENT Identified Risks Likelihood to happen Assessment Employees are not If the company has The assessment aware on the no awareness and would depend on whether the significance of training program company has confidentiality of regarding training program passwords confidentiality of on automated passwords, then there system internal could be a possibility controls that compromise or In either of the case, the risk sharing of password assessment could could happen be from moderate to high 19  EVALUATING CONTROL ENVIRONMENT Areas of Audit Procedures Evaluation Evaluation Integrity and Conduct interviews In some cases, ethical values with some of the auditor may staff discover that Read code of what is actually conduct and doing is communications to different from staff the written policies. This is an audit finding and the auditor may increase the number of20  EVALUATING CONTROL ENVIRONMENT Areas of Audit Procedures Evaluation Evaluation Commitment to Review hiring and Hiring employees competence firing policies. should include Review job processes like (a) interviews (b) description on exams (c) medical. selected employee There should be files. due process in terminating employees. Job description should be the same with what they are doing. 21  EVALUATING CONTROL ENVIRONMENT Areas of Audit Procedures Evaluation Evaluation Participation by Review any self- Self-assessment TCWG (Those in assessments made may include report Review of internal auditor, charge with compliance and governance) qualifications of risk officer, and BOD (Board of visitation of key Directors) and executives in minutes of the branches & offices meeting BOD should be Attend a meeting financially literate The way they as an observer conducted meetings manifests their 22  EVALUATING CONTROL ENVIRONMENT Areas of Audit Procedures Evaluation Evaluation Management’s Review any The presence of philosophy and documentation vison/mission Conduct interviews statement is a operating style good indication with some staff Ideally, management’s philosophy should geared towards strict control but without sacrificing sales and marketing 23  EVALUATING CONTROL ENVIRONMENT Areas of Audit Procedures Evaluation Evaluation Organizational Review structure in Auditors must structure light of best report directly to the board of practices directors through the audit committee There must be at least two independent directors that came from the minority shareholders Observe the 24  EVALUATING CONTROL ENVIRONMENT Areas of Audit Procedures Evaluation Evaluation Assignment of Review any To avoid fraud or authority and documentation any abuse of authority, job responsibility such as job description should description coincide with the access level to any operating system. Job description should be acknowledged by each employee Periodic monitoring of what has been 25  EVALUATING CONTROL ENVIRONMENT Areas of Audit Procedures Evaluation HumanEvaluation resources Review policies and There should be policies and practices and performance- based evaluation practices compliance How is hiring Review employee policy files for staff implemented evaluation, Training – trainings, etc. employee training needs should have been identified Compensation management should meet employee needs26  AUDITOR’S RESPONSES TO EFFECTIVENESS OF CONTROL ENVIRONMENT Audit Conclusion Auditor’s Responses Plan of Action Effective control The auditor will Samples to be environment have more taken will be lesser. confidence in the Focus shall be on entity’s internal large items. control. Lesser mandays Some audit will be spent. procedures maybe performed at interim dates rather than at year- end. 27  AUDITOR’S RESPONSES TO EFFECTIVENESS OF CONTROL ENVIRONMENT Audit Conclusion Auditor’s Responses Plan of Action Ineffective control The auditor needs to There will be more environment perform additional samples to be taken (deficiencies works as: More observations exists) 1. Assigning more on dual access to experienced audit certain premises staff Audit staff will be 2. Conducting more re-oriented on audit procedures specific procedures to be at year end rather performed than at interim More detailed 3. Intensifying the discussions during nature, timing or pre-audit and post 28 extent of substantive  SUBSTANTIVE TESTING Substantive Testing is an audit procedure that examines the financial statements and supporting documentation to see if they contain errors. These tests are needed as evidence to support the assertion that the financial records of an entity are complete, valid and accurate. In substantive testing, the auditor is trying to attest that the amount reported in the financial statements Trial is the same with the supporting balance documents. or FS GENERAL/ SUBSIDIARY LEDGERS 29  SUBSTANTIVE TESTING Supposing the income statement of Zephanie Company shows total representation and entertainment expenses of P235,000 at December 31, 2021. How is substantive testing be done? Below are the procedures: 1. Compare the amount of P235,000 reported in the income statement with the ledger of representation and entertainment expenses. The two records must tally, otherwise, the auditor will perform further investigative procedures. 2. Obtain samples of journal entries through: a) Check voucher – actual payment 30  SUBSTANTIVE TESTING Below are the procedures: 3. If the total amount of the check voucher that was selected was P54,000, the total amount of official receipts attached to the voucher should be P54,000 also. If the total amount is not the same, the auditor will perform additional investigative procedures. 4. Usually, accrual of expenses in the journal voucher have no supporting receipts since there is no cash payment made. The auditor should ascertain the reasonableness of the estimate made. In some instances, there could be billing statement attached, but payment shall be made the following 31  SUBSTANTIVE TESTING In substantive testing, the auditor must satisfy himself on the samples taken that substantially prove the fairness of the amount reported. In the previous example, the auditor must satisfy himself that the samples taken out of the P235,000 clearly represents the validity of the figure reported in the income statement. The weaker the internal control, the larger samples to be taken and vice versa. This is the reason why tests of control is connected with substantive testing. Because the effectiveness of internal control which is the focus of test of 32  TYPES OF SUBSTANTIVE TESTING Below are the three types of substantive testing: 1. Analytical procedures 2. Test of details of transactions 3. Test of details of balances Analytical procedures – is more on conducting analysis on the reasonableness of amount reported or presented in the financial statements. Example: In conducting an audit of transportation expenses, the auditor noticed amounts incurred for tricycle fare. Since tricycle drivers are not issuing official receipts, the auditor will just evaluate the reasonableness of tricycle fare charged to 33  TYPES OF SUBSTANTIVE TESTING Analytical procedures Example: In conducting an audit of interest expense, the auditor may do some analytical approach. Supposing the total interest expense recorded in the income statement is P237,000, and the total amount of loans from banks stood at P3,000,000 at December 31, 2021. How can the auditor determine the reasonableness of interest expense? The following analytical procedures can be performed: 1. Compute for the possible interest rate as follows: P237,000/P3,000,000 = 7.90% 34  TYPES OF SUBSTANTIVE TESTING Test of Details of Transactions: Example: In conducting an audit of cash in bank, the total amount reported in the statement of financial position as of December 31, 2021 was P10,246,000. What substantive procedures shall be performed by the auditor? Below are the suggested procedures: 1. Verify bank reconciliation statement that was prepared at the end of December 2021. The adjusted book and bank balance must be P10,246,000. 2. Send confirmation letter to the bank (for simplicity, 35  TYPES OF SUBSTANTIVE TESTING Test of Details of Transactions: Below are the suggested procedures: 3. The auditor compares the amount of P10,246,000 with the general ledger or subsidiary ledger of cash in bank. 4. The auditor reviews the correctness of bank reconciliation statement for the month of December 2021. Test of Details of Balances: In actual field audit, the procedures performed in the test of details of balances are already performed in 36  TYPES OF SUBSTANTIVE TESTING Test of Details of Balances: Example: The auditor wants to substantiate the correctness of balance of P26,500,000 reported as accounts receivable. What substantive audit procedures shall be performed? The following procedures maybe adapted: 1. Compare the amount of P26,500,000 reported in the statement of financial position with the general ledger of accounts receivable. 2. Get the total of subsidiary ledgers of accounts receivable. The total must tally with the amount of P26,500,000 as reflected in the general ledger. 37  OTHER EXAMPLES OF SUBSTANTIVE TESTING 1. Verify if approved dividends exist by reviewing board minutes of the meeting or board resolution. 2. Verify if approved appropriations of retained earnings are authorized by reviewing management committee actions and approval of the board of directors through board resolutions. 3. Confirm the balances in accounts payable by contacting suppliers or by sending confirmation letters. 4. Observe the conduct of inventory at the end of the year to ascertain correctness of ending inventory to be reflected in the cost of goods sold. 5. Inventory of share capital certificates purchased by the entity in the custody of the corporate 38  CALCULATING PROJECTED MISSTATEMENT IN SUBSTANTIVE TESTING One of the objectives of substantive testing is to prevent or detect material misstatements in the financial statements. Risk on Material Misstatements (ROMM) is one of the significant risks that an auditor must be concerned with. In the preliminary audit planning, identification of ROMM is to be accomplished to make the entire audit process smooth-going and be finished in the allotted time. Below are the three approaches in calculating material misstatement by determining the Estimated Population Audited Amount (EPAA): 39  CALCULATING PROJECTED MISSTATEMENT IN SUBSTANTIVE TESTING Example: Editha Company is being audited. The assigned auditor to audit expenses calculated the projected misstatement and arrived at the following: No. of Carrying Audited Misstateme items Amt Amt nt Populati 4,100 P5,000,00 ? ? on 0 Calculate Sample the projected 200 misstatement 250,000 on expenses P300,000 50,000 under the three approaches. 40  CALCULATING PROJECTED MISSTATEMENT IN SUBSTANTIVE TESTING SOLUTION TO EDITHA COMPANY: This Mean-per unit approach computation EPAA Population size x Average is not = Audited Amount conclusive. EPAA 4,100 x (P300,000÷ 200) The auditor = EPAA 4,100 x P1,500 just want to = EPAA P6,150,000 present an = estimate of Projected Misstatement: the possible Carrying amount of expenses unrecognized P5,000.0 expenses. 00 Estimated population audited 6,150,00 amount Understatement 0 P1,150,0 41  CALCULATING PROJECTED MISSTATEMENT IN SUBSTANTIVE TESTING SOLUTION TO EDITHA COMPANY: Average difference approach Average Average carrying amount – Average difference Average = audited amount (P250,000 ÷ 200) – (P300,000 ÷ 200) difference Average = P1,250 - P1,500 difference Average = P250 difference = Projected Misstatement: 4,100 items x P1,025,0 understate P250 = 00 ment 42  CALCULATING PROJECTED MISSTATEMENT IN SUBSTANTIVE TESTING SOLUTION TO EDITHA COMPANY: Average difference approach Estimated Population Audited Amount (EPAA): Carrying amount of expenses P5,000.0 Projected misstatement 00 1,025,00 Estimated Population Audited 0 P6,025,0 Amount 00 How come the audited amount of P300,000 is greater than the carrying sample amount of P250,000 as given in the problem?  This is because, the supporting documents verified by the auditor totaled P300,000, an 43  CALCULATING PROJECTED MISSTATEMENT IN SUBSTANTIVE TESTING SOLUTION TO EDITHA COMPANY: Ratio approach EPAA Sample audited amount ÷ Sample carrying = amount x Population carrying amount EPAA (P300,000 ÷ P250,000) x P5,000,000 = EPAA 1.20 x P5,000,000 = EPAA P6,000,000 = Projected Misstatement: P6,000,000 – P1,000,0 understate P5,000,000 = 00 ment 44  RISK IN SUBSTANTIVE TESTING When performing substantive tests, auditors encounter non-sampling risk and sampling risks.  Non-sampling risk is the risk that arises from human error; it cannot be quantitatively measured.  Adequate supervision, proper review of audit working papers and adherence to quality control standards can all reduce non-sampling risk.  Sampling risk can be measured quantitatively and when performing substantive tests, an auditor encounters two types of sampling risk: 1. The risk of incorrect rejection 45  RISK IN SUBSTANTIVE TESTING  Sampling risk 1. The risk of incorrect rejection (sometimes called alpha risk) is the risk that the sample supports the conclusion that a recorded balance is materially misstated when it is not.  In selecting samples, those in the population which were excluded may pose risk of non-detection on the part of the auditor.  There maybe some fraud or irregularities that exists on those items not included in the samples. As a result, the auditor maybe46  RISK IN SUBSTANTIVE TESTING  Sampling risk 2. The risk of incorrect acceptance (also called beta risk) is a risk that a sample supports the conclusion that a recorded balance is materially misstated when it is not.  The samples taken by the auditor does not represent irregularity.  This sampling risk may arise if an irregularity occurs and came to the knowledge of management and the board, where in fact, the irregularity was not included in the samples taken. 47  RISK IN SUBSTANTIVE TESTING To minimize exposure to sampling risk, auditors may adapt the following Variable Sampling Plan Techniques: 1. Probability-proportional-to-size sampling technique 2. Classical variables sampling techniques Probability-proportional-to-size sampling technique (PPS) PPS sampling gets its name from the fact that the probability of an item’s being selected from inclusion in the sample is equal to its size in proportion to the size of the whole population. Example (1): In selecting an item to be audited that 48  RISK IN SUBSTANTIVE TESTING Probability-proportional-to-size sampling technique (PPS) Example (2): Supposing an auditor is conducting an audit of representation expenses, the total of which for the whole year is P335,000. If the auditor will choose samples with total amount of P150,000, these would be enough to render an opinion considering that these represents 45% of the population. The general approach to PPS sampling presented in this text includes the assumption that the audited amount of an item should not be less than zero or greater than the recorded amount. In the audit of receivables, the auditor usually 49  RISK IN SUBSTANTIVE TESTING Probability-proportional-to-size sampling technique (PPS) Advantages and Disadvantages of PPS sampling 1. Advantages a) It increases the likelihood of including high-peso value items in the sample b) PPS allows auditors to compute the sample size and evaluate the results by hand or by means of tables c) PPS sampling is easy to use d) PPS sampling enables the auditor to state conclusion in a peso amount. 50  RISK IN SUBSTANTIVE TESTING Probability-proportional-to-size sampling technique (PPS) Advantages and Disadvantages of PPS sampling 2. Disadvantages a) The assumption of PPS sampling that the audited value of a sampling unit is neither less than zero nor greater than the book value may not be consistent with the auditor’s objective. Example: In the audit of receivables, the auditor set-up minimum amounts to be verified. But if the objective of audit is to evaluate reasonableness of doubtful accounts, such 51  RISK IN SUBSTANTIVE TESTING Probability-proportional-to-size sampling technique (PPS) Advantages and Disadvantages of PPS sampling 2. Disadvantages b) Negative balance or zero balances cannot be audited using the PPS sampling. Example: There could be some irregularities on accounts with zero or negative balances. There could be a possibility that a customer’s account became zero because collections were pocketed by either by the people from collection department or from accounting department. 52  RISK IN SUBSTANTIVE TESTING Probability-proportional-to-size sampling technique (PPS) Advantages and Disadvantages of PPS sampling 2. Disadvantages c) When misstatements are found using PPS sampling, the upper misstatement limit maybe too high to be useful. Example: During the audit of expenses, the auditor found out that out of the population of P600,000, irregularities or misstatements exist on samples with amount of P300,000 or 50%. In succeeding audit, the audit supervisor may 53  RISK IN SUBSTANTIVE TESTING Classical variables sampling techniques Classical variable sampling models use normal distribution theory to evaluate selected characteristics of a population on the basis of a sample of items constituting the population. This technique allows the auditor to select and analyze a small subset of the records in an account, and based on the result, estimate the total audited value of the account, and the total amount of monetary misstatement. The estimates are computed as ranges: The point estimate is the midpoint of the range 54  RISK IN SUBSTANTIVE TESTING Classical variables sampling techniques The auditor can also choose to compute a one-sided estimate or range, with a point estimate and only an upper limit, or only a lower limit. The auditor will then compare the estimated range to the book value of the account, or to the misstatement amount that the auditor judged as material, and make TOTAL POPULATION a determination regarding the account. UPPER LIMIT POINT LOWER LIMIT RANGE ESTIMATE RANGE PERCENTAGE PERCENTAGE 55  RISK IN SUBSTANTIVE TESTING Classical variables sampling techniques Simplified example: Maya Company Maya Company is under audit covering the period January 1 to December 31, 2021. The auditor who examined expenses decided to use classical variables sampling techniques and was able to gather the following data on representation and entertainment Carrying amount of representation & entertainment P265,00 expenses: expenses 0 Highest amount incurred P10,50 0 Lowest amount incurred 4,500 56  RISK IN SUBSTANTIVE TESTING Classical variables sampling techniques Simplified example: Maya Company P265,000 P10,500 P3,600 P4,500 P3,600 to P10,500 P3,600 to P4,500 35% 26% The auditor may choose to examine those representation expenses that ranged from P3,600 to P10,500 because of the higher percentage. 57 58