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AUDITING CHAPTER 2

AUDITING CHAPTER 2. Standards, Materiality, & Risk By David N. Ricchiute. TOPICS. Audit & Attestation standards Auditing concepts Audit risk Materiality in financial statement audit. EARLY DEVELOPMENT OF STANDARDS. 1941 Accounting Series Release (ASR)#21 SEC requires audit report

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AUDITING CHAPTER 2

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  1. AUDITINGCHAPTER 2 Standards, Materiality, & Risk By David N. Ricchiute

  2. TOPICS • Audit & Attestation standards • Auditing concepts • Audit risk • Materiality in financial statement audit GBW Ch. 2 8th ed

  3. EARLY DEVELOPMENT OF STANDARDS • 1941 Accounting Series Release (ASR)#21 • SEC requires audit report • Audit conducted in accordance with generally accepted standards • 1948 AICPA approves generally accepted auditing standards (GAAS) GBW Ch. 2 8th ed

  4. RECENT DEVELOPMENT OF STANDARDS • 1970s practitioners criticized GAAS as not sufficiently specific • 1986 Attestation standards developed • Umbrella for engagement standards • GAAS applies exclusively to financial statement audits GBW Ch. 2 8th ed

  5. COMPARING GAAS & ATTESTATION AttestationGAAS GBW Ch. 2 8th ed

  6. GENERAL STANDARDS AttestationGAAS GBW Ch. 2 8th ed

  7. FIELDWORK STANDARDS AttestationGAAS GBW Ch. 2 8th ed

  8. REPORTING STANDARDS AttestationGAAS GBW Ch. 2 8th ed

  9. STANDARDS FOR PUBLIC COMPANY ENGAGEMENTS • Sarbanes-Oxley Act of 2002 • Creates Public Company Accounting Oversight Board (PCAOB) • Delegates authority to PCAOB to • Oversee, regulate accounting and auditing professions • Develop accounting, auditing standards or • Accept accounting standards from FASB • Accept auditing standards from AICPA GBW Ch. 2 8th ed

  10. AUDITING CONCEPTS • Independence • Due care • Evidence • Reporting GBW Ch. 2 8th ed

  11. INDEPENDENCE EXPLAINED • In fact • State of mind • Attitude of impartiality • In appearance • Free of overt interest in client GBW Ch. 2 8th ed

  12. CONSULTING & PUBLIC COMPANY ENGAGEMENTS 2000 … consulting & other services may shorten the distance between the auditor & management. Independence—if not in fact, then certainly in appearance—becomes a more elusive proposition. … In this dual role, the auditor, who guards the integrity of the numbers, now both oversees & answers to management. Arthur Levitt, Jr., “Renewing the Covenant with Investors” Speech at NYU Center for Law & Business, 5/10/00. GBW Ch. 2 8th ed

  13. SEC PUBLIC COMPANIES INDEPENDENCE REFORMS 2000 • Engagement team model of independence • Team & immediate family prohibited from investments in clients • Increased restrictions for IT and internal audit consulting • Required disclosure audit/nonaudit fees in proxy statement GBW Ch. 2 8th ed

  14. SARBANES-OXLEY, & INDEPENDENCE 2002 • Establishes PCAOB • Addresses accountability for corporate & criminal fraud • Limits audit firm’s consulting services to public company clients • Client board of directors to approve consulting services provided by auditor GBW Ch. 2 8th ed

  15. SERVICES PROHIBITED BY SARBANES-OXLEY For public companies: • Bookkeeping, other accounting services • Information systems design, implementation • Valuation or appraisal services • Actuarial services • Internal audit outsourcing services • Management functions, human resources • Broker, dealer, investment advisor • Legal, expert services • Other services to be determined GBW Ch. 2 8th ed

  16. SEC, INDEPENDENCE, & PUBLIC COMPANIES 2003 • Further independence regulations • Rotate engagement partner 5-7 years • Restrict firm’s independence for 1 year when client hires member of audit team • Violates independence if auditor’s compensation based on selling service other than attest • Require auditor report certain matters to client’s audit committee • Critical accounting policies GBW Ch. 2 8th ed

  17. DUE CARE EXPLAINED • Care when providing professional services • Adequate training for professional services GBW Ch. 2 8th ed

  18. DUE CARE IN LAW Every man who offers his service to another & is employed assumes the duty to exercise such skill as he possesses with reasonable care & diligence. …if one offers his service, he is understood as holding himself out to the public as possessing the degree of skill commonly possessed by others in the same employment & if his pretensions are unfounded, he commits a species of fraud upon every man who employs him . . . Cooley on Torts GBW Ch. 2 8th ed

  19. DUE CARE & WORLDCOM 2002 • 2nd largest long-distance carrier restated financial statements for 5 quarters • Network access fees capitalized instead of expensed • Overstated net income by $11 billion • Overstated balance sheet by $75 billion • Not GAAP • Auditor knew but did not challenge GBW Ch. 2 8th ed

  20. DUE CARE &PRUDENT PRACTITIONER • Foresee unreasonable risk to others • Attend to extra risks • Consider unusual circumstances or relationships • Identify unfamiliar situation & take precautions • Resolve doubt • Keep current • Review work of assistants GBW Ch. 2 8th ed

  21. DUE CARE OPERATIONALIZED • Auditor obtains knowledge of business to understand events, transactions, practices with significant effect on financial statements • Plan audit to limit audit risk to low level • Assess possible errors on balance sheet GBW Ch. 2 8th ed

  22. EVIDENCE EXPLAINED • Underlying accounting data • Journals, ledgers, reconciliations, accounting manuals • Corroborating information • Receiving reports, invoices, contracts, representations from 3rd parties GBW Ch. 2 8th ed

  23. EVIDENCE • Basis for all decisions • Evidential matter • Planning & supervision • Internal control GBW Ch. 2 8th ed

  24. EVIDENCE: SUFFICIENCY & COMPETENCE • Sufficiency • Quantity useful evidence collected at reasonable cost • Competence • Validity: varies with source • Relevance: related to assertion GBW Ch. 2 8th ed

  25. EVIDENCE HIERARCHY • Independent sources more reliable than management • Banks, debtors • Evidence obtained directly more persuasive than indirect evidence from management • Physical examination, observation, computation, inspection • Effective internal control systems produce more reliable evidence GBW Ch. 2 8th ed

  26. PLANNING & SUPERVISION EXPLAINED • Planning • Developing objectives & strategy • Supervision • Directing assistants toward objectives • Determining when objectives are met GBW Ch. 2 8th ed

  27. INTERNAL CONTROL • Policies & procedures of management & board of directors • Provides reasonable assurance their objectives will be achieved • Auditor must understand client’s internal controls • To plan audit • To design audit tests GBW Ch. 2 8th ed

  28. REPORTING EXPLAINED • Report states conclusion • Attestation report • Whether management’s assertion conforms with stated criteria • Audit report • Whether financial statements conform to GAAP GBW Ch. 2 8th ed

  29. AUDIT REPORT CONCLUSION In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the company . . ., & the results of its operations and its cash flows . . ., in conformity with generally accepted accounting principles. GBW Ch. 2 8th ed

  30. STRATEGY FOR RISK • Risk of omissions or misstatements • Design engagement to control material omissions or misstatements • Provide reasonable not absolute assurance of detecting omissions or misstatements GBW Ch. 2 8th ed

  31. ATTESTATION RISK Probability that attester may unknowingly fail to modify a written conclusion about an assertion that is materially misstated D. N. Ricchiute, Auditing, 8th ed. GBW Ch. 2 8th ed

  32. AUDIT RISK Probability that auditor may unknowingly fail to modify opinion on financial statements that are materially misstated D. N. Ricchiute, Auditing, 8th ed. GBW Ch. 2 8th ed

  33. COMPONENTS OF AUDIT RISK • Client sources of risk • Inherent risk • Control risk • Auditor source of risk • Detection risk GBW Ch. 2 8th ed

  34. COMPONENTS OF AUDIT RISK DEFINED • Inherent risk • Risk that errors will occur • Control risk • Risk that internal controls won’t prevent, detect, correct errors • Detection risk • Risk that audit procedures won’t find errors GBW Ch. 2 8th ed

  35. INHERENT RISK SOURCES Risk that errors will occur • Business • Industry • Management’s predisposition to manage earnings • Aggressive use of GAAP • Specific accounts • Liquid assets vs. nonliquid assets GBW Ch. 2 8th ed

  36. CONTROL RISK SOURCES Risk that internal controls won’t prevent, detect, correct errors • Outdated technology • Outdated software • Lack of respect for controls by top management GBW Ch. 2 8th ed

  37. DETECTION RISK SOURCES Likelihood that errors could occur and not be detected by audit procedures • Nature of audit procedures • Extent of audit procedures • Timing of audit procedures • Auditor’s judgment GBW Ch. 2 8th ed

  38. AUDIT RISK MODEL:SAS No. 47 AR = IR x CR x DR DR = AR IR x CR GBW Ch. 2 8th ed

  39. AUDITOR’S BUSINESS RISK The probability that a practitioner might incur damages despite issuing an appropriate report • Ex.: litigation • Factors affecting auditor’s business risk • Aggressive financial reporting • Management integrity or reputation • Conflicts of interest & regulatory problems • Industry characteristics GBW Ch. 2 8th ed

  40. AUDITOR’S RESPONSE TO BUSINESS RISK • If business risk is higher, adjust audit risk assessment • Set audit risk lower • Decrease acceptable level of detection risk • Increase evidence • Drop client • If assurance levels all same, do not adjust audit risk GBW Ch. 2 8th ed

  41. AUDIT FAILURE DEFINED • Failing to perform procedures that would reduce audit risk to a relatively low level • Ex.: Sunbeam Sunbeam’s auditor a) identified reserves not in compliance with GAAP; b) proposed adjustments which management rejected; c) accepted reserves as stated after incorrectly applying materiality analysis GBW Ch. 2 8th ed

  42. MATERIALITY The magnitude or an omission or misstatement of accounting information that, in the judgment of a reasonable person relying on the information, would have been changed or influenced by the omission or misstatement.1 Statement of Financial Accounting Standards No. 2, “Qualitative Characteristics of Accounting Information,” Stamford: FASB, 1980, par 132. GBW Ch. 2 8th ed

  43. MATERIALITY IN PRACTICE • Preliminary estimate of materiality for planning guides audit effort, evidence collection • SAS No. 22, “Planning & Supervision” GBW Ch. 2 8th ed

  44. AUDIT RISK, MATERIALITY, AUDIT EFFORT • Inverse relationship between audit risk and materiality • Low audit risk suggests it would take larger amounts to be material • Inverse relationship between materiality and audit effort (hours worked) • Higher materiality threshold suggests less audit effort GBW Ch. 2 8th ed

  45. QUANTITATIVE MATERIALITY CRITERIA • Effect on • Net income • Total assets • Total revenue GBW Ch. 2 8th ed

  46. SAS 99 ON MATERIALITY • Auditors should • Not rely solely on quantitative materiality criteria • Judge materiality of misstatements both individually & in aggregate • Recognize that intentional but immaterial misstatements are inappropriate & may be unlawful GBW Ch. 2 8th ed

  47. QUALITATIVE MATERIALITY CONSIDERATIONS • Misstatement may not be immaterial if: • Affects debt compliance requirements • Masks change in earnings • Conceals unlawful transaction • Prompts undue expectations • Hides failure to meet analysts’ expectations • Associated with an estimate • Affects management’s compensation GBW Ch. 2 8th ed

  48. ALLOCATING PRELIMINARY MATERIALITY ESTIMATES • On the basis of • Relative magnitude of financial statement accounts • Relative variability of financial statement accounts • Professional judgment GBW Ch. 2 8th ed

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