Audit Responsibilities and Objectives

1. Audit Responsibilitiesand Objectives Chapter 6

2. Learning Objective 1 Explain the objective of conducting an audit of financial statements.

3. Objective of Conducting an Audit of Financial Statements The primary objective of the audit is to express an opinion on the financial statements. Plus w/ SOX 404 (AS5) – opinion on the effectiveness of internal controls over financial reporting (ICFR) – public companies only!

4. Steps to DevelopAudit Objectives 1 Understand objectives and responsibilities for the audit. 2 Divide financial statements into cycles. 3 Know management assertions about financial statements.

5. Steps to DevelopAudit Objectives 4 Know general audit objectives for classes of transactions, accounts, and disclosures. 5 Know specific audit objectives for classes of transactions, accounts, and disclosures

6. Learning Objective 2 Distinguish management’s responsibilities for the financial statements and internal control from the auditor’s responsibilities for verifying the financial statements and effectiveness of internal control.

7. Responsibilities Management is responsible for the financial statements (prepare) and for internal control (provide an assessment). SOX – Mgt must now certify all f/s (10Qs and 10k) provided to SEC. 10Qs (only review) more reliable now? Actually no evidence! Auditors issue an opinion on fairness of the financial statements and an opinion on ICFR (SOX 404 AS5). For Private Companies – Mgt prepares F/S and auditor opines on F/S

8. Learning Objective 3 Explain the auditor’s responsibility for discovering material misstatements.

9. Auditor’s Responsibilities Material versus immaterial misstatements Reasonable assurance NOT insurance. Why? Errors versus fraud: fraudulent financial reporting and misappropriation of assets: Enron? Worldcom? Tyco? Adelphia? SPEs, capitalization, Jimmy Buffett/10K shower curtains, and a golf course on a mountain Professional skepticism - ?s, critical, unbiased

10. Responsibilities for Discovering Illegal Acts Direct-effect illegal acts: taxes, fine from DEP Indirect-effect illegal acts: hiring practices Evidence accumulation when there is no reason to believe indirect-effect illegal act exists

11. Learning Objective 4 Classify transactions and account balances into financial statement cycles and identify benefits of a cycle approach to segmenting the audit.

12. Transaction Flow Example Transactions Journals Ledger, Trial Balance, and Financial Statements Sales Sales journal General ledger and subsidiary records Cash receipts Cash receipts journal General ledger trial balance Acquisition of goods and services Acquisitions journal Financial statements

13. Transaction Flow Example Transactions Journals Ledger, Trial Balance, and Financial Statements Cash disbursements Cash disburse- ments journal General ledger and subsidiary records Payroll services and disbursements Payroll journal General ledger trial balance Allocation and adjustments General journal Financial statements

14. Relationships Among Transaction Cycles General cash Capital acquisition and repayment cycle Sales and collection cycle Acquisition and payment cycle Payroll and personnel cycle Inventory and warehousing cycle

15. Learning Objective 5 Describe why the auditor obtains a combination of assurance by auditing classes of transactions and ending balances in accounts, including presentation and disclosure

16. Balance and Transactions Affecting Balances Example Accounts Receivable (in thousands) Beginning balance $ 19,454 144,328 $ 20,197 139,020 1,242 3,328 Cash Receipts Dr. Cash Cr. A/R Sales Dr. A/R Cr. Sales Sales returns and allowances Charge-off of uncollectible debts Ending balance

17. Distinguish among the three categories of management assertions about financial information. Learning Objective 6

18. Management Assertions • Assertions about classes of transactions and • events for the period under audit (e.g., completeness, • are all payroll transactions included in F/S?) 2. Assertions about account balances at period end (e.g., existence – are all customer A/R balances valid?) 3. Assertions about presentation and disclosure (e.g., accuracy and valuation – is the breakdown of inventory accurate?)

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

20. Link the six general transaction- related audit objectives to management assertions for classes of transaction. Learning Objective 7

21. General Transactions-related Audit Objectives Occurrence Recorded transactions exist Completeness Existing transactions are recorded Accuracy (accuracy) Recorded transactions are stated at the correct amounts

22. General Transactions-related Audit Objectives Posting and Summarization (accuracy) Transactions are included in the master files and are correctly summarized. Classification Transactions are properly classified. Timing Transactions are recorded on the correct dates.

23. Management Assertions andTransaction-related Audit Objectives Hillsburg Hardware Company: As Applied to Sales Transactions Management Assertions About Classes of Transactions and Events General Transaction- related Audit Objectives Specific Sales Transaction- related Audit Objectives Occurrence Occurrence Recorded sales are for shipments made to nonfictitious customers Completeness Completeness Existing sales transactions are recorded Accuracy Accuracy Recorded sales are for the amount of goods shipped and are correctly billed and recorded

24. Management Assertions andTransaction-related Audit Objectives Hillsburg Hardware Company: As Applied to Sales Transactions Management Assertions About Classes of Transactions and Events General Transaction- related Audit Objectives Specific Sales Transaction- related Audit Objectives Accuracy Posting and summarization Sales transactions are properly included in the master file and are correctly summarized Classification Classification Sales transactions are properly classified Cutoff Timing Sales transactions are recorded on the correct dates.

25. Link the eight general balance- related audit objectives to management assertions for account balances. Learning Objective 8

26. General Balance-relatedAudit Objectives Existence Amounts included exist Completeness Existing amounts are included Accuracy Amounts included are stated at the correct amounts

27. General Balance-relatedAudit Objectives Classification Amounts are properly classified Cutoff Transactions are recorded in the proper period Detail tie-in Account balances agree with master file amounts, and with the general ledger

28. General Balance-relatedAudit Objectives Realizable value Assets are included at estimated realizable value Rights and obligations Assets must be owned

29. Management Assertions andTransaction-related Audit Objectives Hillsburg Hardware Company: As Applied to Inventory Management Assertions About Account Balances General Balance- related Audit Objectives Specific Balance-related Audit Objectives Applied to Inventory Existence Existence All recorded inventory exists at the balance sheet date Completeness Completeness All existing inventory has been counted and included in the inventory summary

30. Management Assertions andTransaction-related Audit Objectives Hillsburg Hardware Company: As Applied to Inventory Management Assertions About Account Balances General Balance- related Audit Objectives Specific Balance-related Audit Objectives Applied to Inventory 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

31. Management Assertions andTransaction-related Audit Objectives Hillsburg Hardware Company: As Applied to Inventory Management Assertions About Account Balances General Balance- related Audit Objectives Specific Balance-related Audit Objectives Applied to Inventory 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

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

33. Link the four presentation and disclosure-related audit objectives to management assertions for presentation and disclosure. Learning Objective 9

34. Management Assertions and Presentation and Disclosure-related Audit Objectives Hillsburg Hardware Company: As Applied to Notes Payable Management Assertions About Presentation and Disclosure General Presentation- and Disclosure- related Audit Objectives Specific Presentation and Disclosure-related Audit Objectives Applied to Notes Payable Occurrence and rights and obligations Occurrence and rights and obligations Notes payable as described in the footnotes exist and are obligations of the company Completeness Completeness All required disclosures related to notes payable are included in the financial statement footnotes

35. Management Assertions and Presentation and Disclosure-related Audit Objectives Hillsburg Hardware Company: As Applied to Notes Payable Management Assertions About Presentation and Disclosure General Presentation- and Disclosure- related Audit Objectives Specific Presentation and Disclosure-related Audit Objectives Applied to Notes Payable Valuation and allocation Valuation and allocation Footnote disclosures related to notes payable are accurate. Classification and understandability Classification and understandability Notes payable are appropriately classified as to short-term and long-term obligations and related financial statement disclosures are understandable

36. Learning Objective 10 Explain the relationship between audit objectives and the accumulation of audit evidence.

37. How Audit ObjectivesAre Met The auditor must obtain sufficient appropriate audit evidence to support all management assertions in the financial statements. F/S→Assertions→Objectives→Specific Tests→Evidence→Opinion An audit process is a methodology for organizing an audit. No one way (why?) = judgment

38. Four Phases of an Audit Phase I Plan and design an audit approach. Phase III Perform analytical procedures and tests of details of balances. Phase II Perform tests of controls (SOX!) and substantive tests of transactions. Phase IV Complete the audit and issue an audit report.

39. End of Chapter 6