Chapter 5 Professional Auditing Standards and the Audit Opinion Formulation Process

1. Chapter 5Professional Auditing Standards and the Audit Opinion Formulation Process

2. Learning Objectives • Identify and compare the various auditing standards that provide guidance on the audit opinion formulation process • List and discuss the foundational principles underlying the auditing standards • List the phases and related activities in the audit opinion formulation process • Explain the concept of accounting cycles and discuss their importance to the audit opinion formulation process

3. Learning Objectives • Describe the assertions that are inherent to financial statements and explain their importance to the audit opinion formulation process • Define audit evidence and describe the purpose and types of audit procedures used to obtain audit evidence • Discuss the importance of audit documentation and provide examples • Discuss audit activities in Phase I of the audit opinion formulation process

4. Learning Objectives • Discuss audit activities in Phase II of the audit opinion formulation process • Discuss audit activities in Phase III of the audit opinion formulation process • Discuss audit activities in Phase IV of the audit opinion formulation process • Discuss audit activities in Phase V of the audit opinion formulation process

5. Learning Objectives • Apply the concepts related to the auditor’s assessment of internal control design effectiveness, implementation, and operating effectiveness • Apply the frameworks for professional decision making and ethical decision making to issues involving conducting an audit

6. THE AUDIT OPINION FORMULATION PROCESS

7. PROFESSIONAL JUDGMENT IN CONTEXT - Importance of Adhering to Professional Auditing Standards • Adhering to the professional auditing standards is viewed as conducting a quality audit • Lack of adherence heightens the risk of issuing an unqualified audit opinion on financial statements that are materially misstated • Highlighted in the 2004-2006 audits of Thornton Precision Components, Limited (TPC) performed by Ernst & Young, LLP UK (E&Y UK)

8. PROFESSIONAL JUDGMENT IN CONTEXT - Importance of Adhering to Professional Auditing Standards • What is the role of auditing standards and their underlying principles in promoting a quality audit? (LO 1, 2) • How does the fundamental concept of professional skepticism relate to audit quality? (LO 2) • What audit evidence is necessary for opining on a client’s financial statements? (LO 6) • How does audit documentation provide evidence related to audit quality? (LO 7)

9. PROFESSIONAL JUDGMENT IN CONTEXT - Importance of Adhering to Professional Auditing Standards • What audit activities are conducted during the audit opinion formulation process to provide reasonable assurance about a client’s financial statements? (LO 8, 9, 10, 11, 12) • How does professional judgment and ethical decision making contribute to audit quality? (LO 14)

10. Learning Objective 1 Identify and Compare the Various Auditing Standards that Provide Guidance on the Audit Opinion Formulation Process

11. Professional Auditing Standards • Auditors in the United States follow auditing guidance issued by: • American Institute of Certified Public Accountants (AICPA) • Public Company Accounting Oversight Board (PCAOB) • International Auditing and Assurance Standards Board (IAASB) • Common objective - Provide assurance to public that audits are conducted in a quality manner

12. Professional Auditing Standards • Require auditors to develop and communicate: • Opinion on financial statements • Client’s internal control over financial reporting • Vary according to the nature of organization audited • Audit compliance depends on: • Domicile of the organization • Where its stock is publicly traded

13. AICPA’S AUDITING STANDARDS BOARD - CLARITY PROJECT • Made standards easier to read, understand, and apply • Converged its standards with the International Standards on Auditing (ISAs), issued by the IAASB • Standards were written using drafting convention called the clarity format • Issued the clarified standards in a single Statement on Auditing Standard (SAS No. 122) in 2012

14. Each standard of Clarity format presented in following sections Introduction • Purpose and scope of the standard Objective • Context in which the requirements are set Definitions • Relevant meanings of terms in standards Requirements • Actions required to achieve objective of the standard Application and other explanatory material • Cross-references to the requirements • Guidance for applying requirements of standard

15. Auditing Standards Issued by the IAASB • Objectives • Set auditing, assurance, and other related standards • Facilitate convergence of international and national auditing and assurance standards • Enhance quality and consistency of practice throughout the world • Strengthen public confidence in the global auditing and assurance profession

16. Auditing Standards Issued by the IAASB • Standards should to be understandable, clear, and consistent • Launched a program in 2004 to enhance clarity of its ISAs • Clarity Project was completed in 2009 • As of 2013, a set of its clarified standards comprises of: • 36 ISAs • 1 International Standard on Quality Control (ISQC)

17. Each standard of Clarity format presented in following sections Introduction • Purpose and scope of subject matter of ISA Objective • Clear statement of the objective of the auditor Definitions • For applicable terms included Requirements • For each objective are provided Application and other explanatory material • Explains what a requirement means or intends to cover

18. Auditing Standards Issued by the PCAOB • Apply to auditors of U.S. public companies • Issued sixteen Auditing Standards (ASs) as of 2013 • PCAOB interim standards - Standards adopted from AICPA • Requirement for public company auditors, unless superseded by a PCAOB standard • Standards issued by AICPA after April 16, 2003, not included

19. Exhibit 5.1 - Comparison of U.S. and International Auditing Standards

20. Learning Objective 2 List and Discuss the Foundational Principles Underlying the Auditing Standards

21. PCAOB Guidance - General standards • Require • Audit to be performed by individuals having adequate technical training and proficiency as an auditor • Auditors to be independent: • In fact, i.e., in reality in terms of mental attitude and • In appearance, i.e., in how the auditor is perceived by users • Audit to be conducted with professional care expected of a prudent auditor

22. PCAOB Guidance - Fieldwork standards • Applicable to conduct of the audit • Require auditors to: • Properly plan and supervise the audit • Develop an understanding of client’s controls • Prerequisite for developing audit tests • Obtain audit evidence by performing audit procedures

23. PCAOB Guidance - Reporting standards • Applicable to communicating auditor’s opinion • Require auditors to: • State whether financial statements are presented in accordance with the applicable financial reporting framework (i.e., GAAP or IFRS) • Identify conditions where accounting principles are not consistently observed • Review disclosures for adequacy and state in the report if disclosures are not reasonably adequate • Express an opinion on financial statements as a whole or state that an opinion cannot be expressed

24. AICPA Guidance - Purpose and premise of audit • Purpose - Enhance degree of confidence that users can place in financial statement • Premise - Management has responsibility to: • Prepare financial statements • Maintain internal control over financial reporting • Provide auditor with relevant information and access to personnel

25. AICPA Guidance - Responsibilities • The auditor’s responsibilities include • Having appropriate competence and capabilities to perform audit • Complying with ethical requirements • Maintaining professional skepticism throughout the audit

26. AICPA Guidance - Performance • Obtain assurance that financial statements are free from material misstatement • Limitations - Lack of absolute assurance about financial statements being free from misstatement • Requires an auditor to: • Plan and supervise work • Determine materiality levels • Identify risks of material misstatement • Design and implement audit responses to assessed risks

27. AICPA Guidance - Reporting • Expressing either of the following • Financial statements are free of material misstatement • Stating that an opinion cannot be expressed

28. Integrated audit • Combines audits of an organization’s financial statements and its internal control over financial reporting • In this audit: • Opinion provided on effectiveness of internal control over financial reporting • Additional audit work done to be able to issue that opinion

29. Auditing in Practice - Benefits of Integrating the Audits • Integrating audits of internal controls and of financial statements makes sense • Both the tests of controls and direct tests of account balances provide evidence related to each other • Example: • Tests of controls provide indirect evidence that financial statements are free from misstatement • Further, if material misstatements found in account balances or disclosures, it implies that there were material weaknesses in internal controls

30. Learning Objective 3 List the Phases and Related Activities in the Audit Opinion Formulation Process

31. EXHIBIT 5.2 - OVERVIEW OF CLIENT’S PREPARATION OF FINANCIAL STATEMENTS AND MANAGEMENT REPORT ON INTERNAL CONTROL

32. Exhibit 5.3 - Activities of each Phase of the Audit Opinion Formulation Process

33. Important Concepts Affecting Audit Opinion Formulation Process • Accounting cycles • Management assertions • Audit evidence and audit procedures • Documentation

34. Learning Objective 4 Explain the Concept of Accounting Cycles and Discuss Their Importance to the Audit Opinion Formulation Process

35. Accounting Cycles • Recording and processing transactions that affect a group of related accounts • Begin when a transaction occurs and ends when it is recorded in financial statements • Break the audit into manageable sections of related accounts

36. Accounting Cycles • Auditor focuses on: • Flow of transactions within a particular cycle • Identifying: • Points where material misstatement can occur • Controls that have been designed and implemented to mitigate those risks • Understanding risks and controls within each cycle • Helps determine specific audit procedures to be used and specific audit evidence to be obtained

37. Exhibit 5.4 - Illustrations of Cycles and Related Accounts

38. Learning Objective 5 Describe the Assertions that Are Inherent to Financial Statements and Explain Their Importance to the Audit Opinion Formulation Process

39. Financial Statement Assertions • Assertions made by management • Existence • Completeness • Rights and obligations • Valuation • Presentation and disclosure • Related evidence is obtained for accounts and disclosure in financial statements

40. MANAGEMENT’S FINANCIAL STATEMENT ASSERTIONS IN PCAOB STANDARDS

41. Learning Objective 6 Define Audit Evidence and Describe the Purpose and Types of Audit Procedures Used to Obtain Audit Evidence

42. Audit Evidence and Procedures • Audit evidence: Information used by auditor in arriving at conclusions on which the opinion is based • Audit procedures: Procedures designed to obtain audit evidence to support audit opinion(s) • Risk assessment procedures • Provide information for assessing the risks of material misstatement in the financial statements • Do not provide sufficient evidence upon which to base an audit opinion • Used for purposes of planning the audit

43. Audit Evidence and Procedures • Tests of controls: Designed for evaluating operating effectiveness of controls in preventing, or detecting and correcting, material misstatements, typically at assertion level • Substantive procedures • Designed for detecting material misstatements at assertion level • Comprising of tests of details and substantive analytical procedures

44. Audit Procedures • Sufficient appropriate audit evidence: Measure of the quantity of audit evidence about following factors of audit procedures • Nature • Timing • Extent • Audit program • Lists audit procedures to be followed in gathering evidence • Helps monitor progress and supervising work

45. Exhibit 5.6 - Types of Audit Procedures

46. Learning Objective 7 Discuss the Importance of Audit Documentation and Provide Examples

47. Audit Documentation • Record of audit procedures performed, relevant audit evidence obtained, and conclusions the auditor reached • Known as working papers or workpapers

48. Purposes of Audit Documentation • Assisting engagement team in: • Planning and performing audit • Supervising and reviewing audit work • Retaining a record of matters of continuing significance to future audits • Enabling internal or external inspections of completed audits • Assisting auditors in understanding work performed in prior year

49. Examples of Audit Documentation • Audit programs • Analyses prepared by client or auditor • Memorandums • Summaries of significant findings or issues • Letters of confirmation and representation • Checklists • Correspondence concerning significant findings or issues

50. Learning Objective 8 Discuss Audit Activities in Phase I of the Audit Opinion Formulation Process