Week 6 Notes - Financial Auditing

**[Week 6 Notes]** **[Analytical Procedures as Substantive Evidence]** **AP as Substantive Evidence** - AP in planning/review stages cannot be used as substantive evidence - If properly designed, AP can be used to test assertions for income statement items - Develop expectation for an...

**[Week 6 Notes]** **[Analytical Procedures as Substantive Evidence]** **AP as Substantive Evidence** - AP in planning/review stages cannot be used as substantive evidence - If properly designed, AP can be used to test assertions for income statement items - Develop expectation for an account balance using plausible relationships you expect to exist (i.e., a quantity X a rate) - Material differences between actual and estimate must be investigated **Quality of AP Evidence** - Quality depends on reliability of data used and precision of estimate - Reliability can be enhanced by using info from strong IC system, or by using other forms of audit evidence to verify data - Precision of estimate is function of level of *disaggregation* of data: Consider factors that cause components of formula to vary and incorporate them **[Materiality II]** **Materiality -- At Account Level** - Representative sample errors at account level must be extrapolated to population to determine "likely misstatement" - E.g., if find \$20,000 in errors in \$250,000 sample of \$1M in total A/R, then "likely misstatement" is \$80,000 (i.e. error rate in sample x pop \$20k/\$250k\*\$1m) - Aggregate all account-level errors and compare to account-level materiality - The point of doing a sample is to get a good representation of what has happened in the population and get an error rate - Sampling could lead to overrepresentation or underrepresentation; both are problematic - However, we have to do sampling because in many situations, it is unfeasible to test the whole population **Materiality -- FS Level** - Must also aggregate errors at account level up to FS level to determine impact on key items like net income and net assets - E.g., \$50K overstatement of A/R and also of Inventory would aggregate to \$100K overstatement of net assets and net income - Compare aggregate errors to FS-level materiality - When we calculate materiality, we calculate it based at what amount would affect a financial statement user's decision - Thus, when we look at the aggregate errors, we are only looking to see if it's under or over materiality (not performance materiality) to see if that would impact the decisions of financial statement users **Materiality -- Evaluation** - If aggregate misstatements are over or are approaching materiality, then: - a\) Get management to recheck areas of highest misstatement and correct - b\) Perform additional audit procedures - c\) Have management correct the misstatements - If material misstatements remain, audit report must contain qualification - Qualified reports are very rare as companies don't want to issue that and would rather just correct the errors - Management doesn't hire auditors; the audit committee does if there is one or the board hires auditors **Types of Misstatements** - Three kinds of misstatements specified: - 1\. **Factual/Known**: no question it is a misstatement - 2\. **Judgmental**: caused by unreasonable mgt. estimate or inappropriate GAAP choice/application - If multiple auditors are suggesting that an adjustment should be made, the company will likely have to maek that adjustment - 3\. **Projected**: misstatement projected from sample to untested population segment - Hardest to prove these misstatements but if an auditor is able to determine the root cause, it might be easier to get management to adjust these errors - However, finding the root cause is difficult - With an adjustment to project misstatements, the known part goes away but the projection is still there **Communication of Misstatements** - Any uncorrected misstatements must be presented to management and audit committee for acknowledgement and sign-off - Small errors (i.e., a \$2,000 misstatement) can only be brought to management and don't need to be presented to the board - Bigger errors should be presented to the board **Revisions to Materiality** - Materiality should not just be revised whenever, such as when errors are fixed - However, materiality can be revised under very specific circumstances - Must revise materiality in the event of becoming aware of information during the audit that would have caused materiality determination to be different initially. - Example -- if set based on budgeted results, and actual results are substantially different - If materiality revised, must consider impact on planned procedures **Case Writing Tips: Materiality** - Determine performance materiality if applicable (i.e., 75% of materiality -- buffer for uncorrected/undetected misstatements) - If there are non-recurring transactions -- add back to derive normalize income (i.e., gain on marketable securities, severance costs, shareholder salaries not taken, etc.) **[Chapter 19: Audit Reports on Financial Statements]** **Levels of Assurance** - High assurance Audit Positive Assurance "In our opinion..." - Middle assurance Review Negative Assurance "Nothing has come to our attention" - No assurance Compilation "No attempt to verify accuracy or completeness of information" **Unqualified Independent Auditor's Report (Unmodified opinion)** - An **unmodified audit opinion**, (aka a "**unqualified**" or a "**clean opinion**") is the most common type of audit report. - Why are most audit reports unqualified? - Because if an auditor tells a company that they are planning to issue a qualified report, the company will just make the adjustments to get an unmodified opinion - Many companies require an unqualified opinion - Title: Independent Auditors' Report - Opinion Paragraph - Basis for Opinion - Key Audit Matters (KAMs) -- LISTED ENTITIES - Other Information Other Than Financial Statements and Auditor's Report - Responsibilities of Management and Those Charged With Governance - Auditor's Responsibilities - Engagement Partner's Name (for listed entities) and Signature of firm - Auditor Address - Audit Date - Figure 19-3 in the textbook provides an example of the elements of the report **Going Concern** - Per **CAS 570**, *Going concern*, if **adequate disclosure** is made in the financial statements about material events or uncertainties that would cause doubt about the entity's ability to continue as a going concern, then the auditor shall issue an **unmodified audit opinion** and include a section in the audit report titled "Material Uncertainty Related to Going Concern." - The section should (1) draw the users' attention to the note in the financial statements, and (2) state the events or conditions that indicate a material uncertainty. - This section would immediately follow the basis of opinion paragraph and would be before the key matters section (if applicable). - If management does not have adequate disclosure about the material uncertainty, then the auditor will either express a **qualified** or **adverse audit opinion**. - If the use of the going concern basis of accounting is not appropriate, then the auditor will issue an **adverse opinion**. **Key Audit Matters (KAMs)** - KAMs -- CAS 701 - Are they required? - Applies to listed entities or when - 1\. KAMs are reported when the auditor decides to report, or - 2\. When law or regulation requires the auditor to communicate key audit matters in the auditor's report - What are KAMs? - Those matters that, in the auditor's professional judgment, were of **[most significance]** in the audit of the entity's financial statements of the current period - How are KAMs selected? - 1\. Selected from matters communicated with TCWG - 2\. Matters that require significant auditor attention - In making the determination of KAMs -- the auditor should take into account: - (1) areas of higher assessed risk of material misstatement, - (2) significant auditor judgements relating to areas in the f/s that involved significant management judgement, and - (3) effect on the audit of significant events or transactions that occurred during the period - Issues related to going concern are KAMs. **Unqualified Opinion with Explanation or Modification** - Several circumstances may permit an unqualified opinion, but raise the need to consider additional information - Emphasis paragraphs (would be after the basis for opinion paragraph, either before or after KAM if present) -- CAS 706 - Emphasis of Matter (EOM) or - The auditor is emphasizing something that is already there (example -- the company already reported something, and the auditor is highlighting it) - Other Matter (OM) - Not in the company's report **Emphasis of Matter Examples** - Used to emphasize something already disclosed in the FS (highlight an issue already disclosed) - Circumstances in which an emphasis of matter paragraph may be necessary are: - Significant uncertainty regarding the future outcome of exceptional litigation or regulatory action. - Early application of a new accounting standard that has a pervasive effect on the financial statements. - A major catastrophe that has had or continues to have an impact on the entity. - Threats of expropriation of assets. - Significant transactions with related parties. - Unusually important subsequent events. **Other Matter(s) Paragraph** - Used to communicate other relevant information that is NOT in the FS - CAS 706, A5--A9, highlights possible circumstances in which the auditor may consider other matter(s) paragraph(s) necessary: - Laws, regulations, or a common practice requires or permits the auditor to elaborate on certain matters. - The auditor has other reporting responsibilities that are in addition to the financial statements. - The entity has prepared more than one set of financial statements (i.e. national framework and IFRS). - The financial statements were prepared for a special purpose (distribution of report is restricted to certain users). **Reservation in the Audit Report** - Two reasons for qualifications in reports: - 1\. Financial statements contain a **departure from GAAP** including inadequate disclosure. - A black text on a white background Description automatically generated - GAAP departure is when GAAP dictates to do something one way, but the company chose to do it a different way - Adverse opinion means that the financial statements do not present fairly and is a matter of professional judgement - 2\. **Scope limitation** (extent of audit work has been limited) inability to obtain sufficient evidence. -  - Disclaimer means that an auditor does not know if the financial statements present fairly **GAAP Departure Reports** - Qualified report (material but not pervasive): - A departure from GAAP in the statements is material to users and can be isolated. - The opinion paragraph is titled "Qualified Opinion" - "Except for" opinion with reference to 'Basis for Qualified Opinion' paragraph. **Qualified Report: Financial Statements Are Materially Misstated but Not Pervasive** - **CAS 705.A3**, highlights the causes of financial misstatements: - An inappropriate accounting treatment (for example, expensing capital assets); - An inappropriate or unreasonable estimate (for example, failure to provide an adequate allowance for doubtful accounts); and - A failure to disclose essential information in an informative manner (for example, failure to adequately disclose a going concern problem or a material contingency). **GAAP Departure Reports -- ADVERSE Opinion** - Adverse report (material and pervasive): - VERY rare - Departures from GAAP in the statements are: - Material and pervasive misstatement(s), affecting numerous accounts and financial statement relationships. - This means that the auditor has concluded that the financial statements, taken as a whole, are materially misstated or misleading. - Adverse opinion "...statements do not present fairly\..." - Title of opinion paragraph is "Adverse Opinion" - Title of Basis of opinion paragraph is "Basis for Adverse Opinion" **Scope Limitation Reports** - Scope Limitations -- auditor is not able to obtain sufficient and appropriate evidence. - Can be due to conditions beyond client's control, or be management imposed - Opinion is Qualified or denied - Qualified opinion "except for..." or - Disclaimer (Denial) of opinion "I am unable to express an opinion....". - Modify opinion paragraph and basis for opinion paragraph **Reliance on Another Auditor or a Specialist** - In Canada, the group auditor takes responsibility for the audit opinion, and only the name of the group auditor appears on the auditor's report. - This means that an auditor must be able to review the work of a specialist or expert to ensure that it is reasonable and that they are using their knowledge the best they can - An auditor is not allowed to disclose that a specialist was used - **CAS 600** and **CAS 620** highlight that during the audit engagement, the auditor is responsible for ensuring that the other auditors or any specialist hired is competent, conducts high quality fieldwork, and maintains confidentiality.