Audit Responsibilities and Objectives Objective of Conducting an

Audit Responsibilities and Objectives

Objective of Conducting an Audit of Financial Statements • The objective of the ordinary audit of financial statements is the expression of an opinion of the fairness with which they present fairly, in all respects, financial position, result of operations, and its cash flows in conformity with GAAP.

Steps to Develop Audit Objectives

• Distinguish management’s responsibility for the financial statements and internal control from the auditor’s responsibility for verifying the financial statements and effectiveness of internal control.

Management’s Responsibilities • Management is responsible for the financial statements and for internal control. • The Sarbanes-Oxley Act increases management’s responsibility for the financial statements. • It requires the CEO and the CFO of public companies to certify the quarterly and annual financial statements submitted to the SEC.

Management’s Responsibilities • The Sarbanes-Oxley Act provides for criminal penalties for anyone who knowingly falsely certifies the statements.

auditor’s responsibility • The auditor is responsible of planning and performing the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. • The auditor is able to obtain reasonable BUT not absolute assurance that material misstatements are detected. • The auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that misstatements (caused by errors or fraud) that are not material to the financial statements are detected.

Material versus immaterial misstatements • Misstatements are considered material if the combined uncorrected errors and fraud in the financial statements would likely have changed or influenced the decision of reasonable person. • It would be extremely costly (and impossible) for auditors to have responsibility for finding all immaterial errors and fraud. • Auditors are responsible for obtaining reasonable assurance.

Reasonable assurance • Assurance is a measure of the level of certainty that the auditor has obtained at the completion of the audit. • Reasonable assurance is a high, but not absolute, level of assurance that the financial statements are free of material misstatements. • The auditor is responsible for reasonable assurance for the following reasons : 1. Testing samples. 2. Estimations. 3. Fraud is extremely difficult to detect.

Errors versus fraud • Errors: are unintentional misstatements. • Fraud: are intentional misstatements. 1. Misappropriation of Assets (Employee Fraud). Harms stockholders and creditors because assets are no longer available. 2. Fraudulent Financial Reporting. (management Fraud). Harms users by providing them incorrect financial statement information for their decision making.

Professional skepticism • The audit must be planned and performed with an attitude of professional skepticism. • Auditor should not assume that management is dishonest, BUT the possibility of dishonesty must be considered.

Auditor’s Responsibilities for Discovering Illegal Acts • Illegal acts : violation of laws or government regulations other than fraud. 1. Violation of tax laws. 2. Violation of environmental protection laws.

Direct-effect illegal acts • Have a direct financial effect on specific account balances in the financial statements. • EX: violation of tax laws affects income tax expenses and income tax payable.

Indirect-effect illegal acts • Affect financial statements only indirectly. • EX: violation of environmental protection laws, financial statements are only affected if there is a fine or sanctions.

Actions when the auditor knows of an illegal act 1. Consider the effect on the financial statements, 2. 3. 4. 5. including the adequacy of disclosures. Effect on the relationship with management (if management knew of the illegal act). Communicate with audit committee to make sure they know of the illegal act. If client refuses of fails to take appropriate action, the auditor may withdrew from the engagement. If client is publicly held the auditor must report to the SEC.

Financial Statements Cycles • Audits are performed by dividing the financial statements into smaller segments or components. • Keeping closely related types (or classes) of transactions and account balances in the same segment. • After the audit of each segment is completed, including interrelationships with other segments, the results are combined. A conclusion can be reached about the financial statements taken as a whole.

Setting audit objectives 1. Transaction related audit objectives. 2. Balance related audit objectives. 3. Presentation and Disclosure audit objectives.

Managements Assertions • Are implied or expressed representations by management about classes of transactions and the related accounts and disclosures in the financial statements. • Assertions are classified 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 • Occurrence: transactions included in the financial statements Actually occurred during the accounting period. Ex: recorded sales. • Is concerned with the possibility of including transactions that should not been included • Relates to account overstatement. • Completeness: all transactions that should be included in the financial statements are in fact included. Ex: all sales are recorded. • Opposite from occurrence. • Is concerned with the possibility of omitting transactions. • Relates to account understatement.

• Accuracy: whether transactions have been recorded at correct amounts. • Classification: whether transactions are recorded in the appropriate accounts. • Cutoff: whether transactions are recorded in the proper accounting period.

Assertions about account balances • Existence: whether assets, liabilities, and equity included in the balance sheet actually existed on the balance sheet date. • Is concerned with the possibility of including amounts that should not been included. • Relates to account overstatement. • Completeness: whether all accounts and amounts that should be presented in the financial statements are in fact included. • Is concerned with the possibility of omitting items. • Relates to account understatement.

• Valuation and Allocation: whether assets, liabilities and owners interests have been included in the financial statements at appropriate amounts, including any valuation adjustments to reflect assets amounts at net realizable value. • Rights and obligations: whether assets are the rights of the entity and whether liabilities are the obligations of the entity.

Assertions about presentation and disclosure • Occurrence and rights and obligations: whether disclosed events have occurred and are the rights and obligations of the entity. • Completeness: whether all required disclosures have been included in the financial statements. EX: all material related party transactions have been disclosed. • Accuracy and valuation: whether financial information is disclosed fairly and at appropriate amounts. • Classification and Understandability: whether amounts are appropriately classified in the financial statements and in the footnotes. EX: classification of inventory.

Management Assertions for Each Category of Assertions About Classes of Transactions and Events Assertions About Account Balances Presentation and Disclosure Occurrence Existence Occurrence and rights and obligations Completeness Accuracy Valuation and allocation Accuracy and valuation Classification and understandability Cutoff Rights and obligations

General Transactions-related Audit Objectives • Occurrence: Recorded transactions exist. • Deals with potential overstatement. • Completeness: Existing transactions are recorded. • Deals with potential Understatement. • Accuracy: A-Recorded transactions are stated at the correct amounts. • B-posting and summarization : Transactions are included in the master files and are correctly summarized. • Classification: Transactions are properly classified. • Timing: Transactions are recorded on the correct dates.

Transaction Related Audit Objectives Management Assertions About Classes of Transactions and Events General Transactionrelated Audit Objectives Specific Sales Transactionrelated Audit Objectives Occurrence Recorded sales are for shipments made to nonfictitious customers Completeness Existing sales transactions are recorded Accuracy Recorded sales are for the amount of goods shipped and are correctly billed and recorded

Transaction Related Audit Objectives Management Assertions About Classes of Transactions and Events General Transactionrelated Audit Objectives Specific Sales Transactionrelated Audit Objectives Accuracy Posting and summarization Sales transactions are properly included in the master file and are correctly summarized Classification Sales transactions are properly classified Cutoff Timing Sales transactions are recorded on the correct dates.

Balance-related Audit Objectives • Existence: amounts included Exist. Inclusion of an A/R from a customer in the trial balance when there is no receivable violates this objective. • Counterpart to the management assertion of existence. • Deals with overstatement. • Completeness: Existing amounts are included. Failure to include an A/R from a customer in the trial balance. • Counterpart to the management assertion of completeness. • Deals with understatement.

• Accuracy: • A) Amounts included are stated at the correct amounts: the amounts should be included at the correct amount. • B) Classification: Amounts are properly classified. EX: classifying assets. • C) Cutoff: Transactions are recorded in the proper period. • D) Detail tie-in: Account balances agree with master file amounts, and with the general ledger.

• Realizable value: Assets are included at estimated realizable value. (reduce historical cost or fair market value is required). • Rights and obligations: Assets must be owned and liabilities must belong to the entity.

Balance Related Audit Objectives (Applied to Inventory) Management Assertions General Balance- Specific Balance-related Audit About Account Balances related Audit Objectives Applied to Inventory Objectives Existence All recorded inventory exists at the balance sheet date Completeness All existing inventory has been counted and included in the inventory summary

Balance Related Audit Objectives (Applied to Inventory) Management Assertions General Balance- Specific Balance-related Audit About Account Balances related Audit Objectives Applied to Inventory Objectives Valuation and allocation Accuracy • Inventory quantities on the client’s perpetual records agree with items physically on hand • Prices used to value inventories are materially correct • Extensions of price times quantity are correct and details are correctly added

Balance Related Audit Objectives (Applied to Inventory) Management Assertions General Balance- Specific Balance-related Audit About Account Balances related Audit Objectives Applied to Inventory Objectives Valuation and allocation Classification Cutoff Inventory items are properly classified as to raw materials, work in process, and finished goods Purchase cutoff at year end is proper Sales cutoff at year end is proper

Balance Related Audit Objectives (Applied to Inventory) Management Assertions General Balance- Specific Balance-related Audit About Account Balances related Audit Objectives Applied to Inventory Objectives Valuation and allocation Detail tie-in Realizable value Rights and obligations Total of inventory items agrees with general ledger Inventories have been written down where net realizable value is impaired The company has title to all inventory items listed Inventories are not pledged as collateral

Presentation and Disclosure Audit objectives (Applied to Notes Payable) Management Assertions About Presentation and Disclosure General Presentationand Disclosurerelated Audit Objectives Specific Presentation and Disclosure-related Audit Objectives Applied to Notes Payable Occurrence and rights and obligations Notes payable as described in the footnotes exist and are obligations of the company Completeness All required disclosures related to notes payable are included in the financial statement footnotes

Presentation and Disclosure Audit objectives (Applied to Notes Payable) Management Assertions About Presentation and Disclosure General Presentationand Disclosurerelated Audit Objectives Specific Presentation and Disclosure-related Audit Objectives Applied to Notes Payable Valuation and allocation Footnote disclosures related to notes payable are accurate. Classification Notes payable are appropriately and classified as to short-term and understandability long-term obligations and related financial statement disclosures are understandable

How Audit Objectives Are Met • The auditor must obtain sufficient appropriate audit evidence to support all management assertions in the financial statements. • The auditor must decide the appropriate audit objectives and evidence to accumulate to meet those objectives on every audit. • To do this auditors follow an audit process. • Audit process: methodology for organizing an audit to ensure that the evidence gathered is both sufficient and appropriate and that all required audit objectives are both specified and met.

Four Phases of a Financial Statement Audit Plan and design Phase I an audit approach Phase II Perform tests of controls and substantive tests of transactions Perform analytical procedures and Phase III tests of details of balances Complete the Phase IV audit and issue an audit report

Phase I Plan and design an audit approach • There are two considerations affecting the approach the auditor selects to accumulate evidence: 1. Sufficient appropriate evidence must be accumulated. 2. The cost of accumulating the evidence should be minimized. • Planning and designing au audit approach can be broken down into several parts : 1. Obtain an understanding of the entity and its Environment. 2. Understand internal control and assess control risk. 3. Assess Risk of material misstatement.

Phase II Perform tests of controls and substantive tests of transactions • By performing TESTS of CONTROLS the auditor can justify reducing planned assessed control risk when controls are believed to be effective. • SUBSTANTIVE Test of Transactions : evaluate the clients recording of transactions.

Phase III Perform analytical procedures and tests of details of balances • Analytical procedures : use comparisons and relationships. EX : examine the sales journal and compare results to prior periods. • Tests of Details : specific procedures intended to test for monetary misstatements in the balances in the financial statements. EX: direct written communication with client’s customers to decide on the accuracy of A/R.

Phase IV Complete the audit and issue an audit report • Reach and overall conclusion as to whether the financial statements are free of material misstatements.