FinancialAuditing(PDFBookPage+2=PhysicalbookPage).pdf - Frederick Choo Financial and Integrated Audits 1 Table of Contents 1 Financial and Integrated

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Unformatted text preview: Frederick Choo Financial and Integrated Audits 1 Table of Contents 1 Financial and Integrated Audits 3 2 The Auditor's Professional Environment 23 3 The Auditor's Ethical Environment 47 4 The Auditor's Legal Environment 75 5 Audit Plan - Preplan and Documentation 103 6 Audit Plan - Objectives 137 7 Audit Plan - Evidence 165 8 Audit Plan - Internal Control 191 9 Audit Plan - Materiality and Risk 229 10 Audit Plan - Program and Technology 255 11 Audit Sampling for Tests of Controls 283 12 Audit Sampling for Tests of Balances 304 13 Revenue Cycle - TOC and TOB 324 14 Expenditure Cycle - TOC and TOB 362 15 Inventory Cycle - TOC and TOB 396 16 Payroll Cycle - TOC and TOB 430 17 Capital Cycle - TOC and TOB 452 18 General Cash and Investments - TOC and TOB 476 19 Completing the Audit 504 20 Audit Report 540 2 21 Other Audit Engagements 588 Appendix A 630 Appendix B 631 Appendixes C D E 632 Appendix F 633 Financial and Integrated Audits - Frederick Choo Chapter 1 Financial and Integrated Audits Chapter Learning Outcomes (LOs) Checklist After reading this chapter, you should be able to: LO1-1 Understanding the reason for auditing. LO1-2 Distinguish among auditing, attestation, and assurance services. LO1-3 Differentiate between financial audit and integrated audit. LO1-4 Differentiate between assurance and consulting services. LO1-5 Explain the different categories of audit and types of auditor. LO1-6 Explain the organizational structure, category, and hierarchy of CPA firms. 3 4 1 Financial and Integrated Audits Chapter 1 Financial and Integrated Audits Definition of Auditing Auditing may be defined as: "A systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users." Source: Committee on Basic Auditing Concepts, Statement of Basic Auditing Concepts AAA, 1973, p.2. Several key phrases of this definition merit special comment in Table 1-1. TABLE 1-1 Definition of Auditing Key Phrase A systematic process Objectively evaluating and examining of evidence Assertions about economic actions and events Degree of correspondence between assertions and established criteria Communicating results to interested users Comments Auditing is a logically structured and planned inquiry process. Auditing involves independently obtaining and gathering evidence, such as confirmations of balances, and objectively evaluating the sufficiency and appropriateness of this evidence. These are assertions made explicitly and/or implicitly by the auditee with regard to the accounting information presented to the auditor, for example, the auditee has valued inventories at the lower of cost or market value. Based on the evidence gathered, the auditor forms an opinion as to the closeness with which the auditee's assertions comply with established standards and polices, for example, generally accepted accounting principles (GAAP) and other statutory rules and regulations. The auditor communicates the degree of correspondence between the auditee's assertions and established criteria in the form of an audit report to interested parties that include stockholders, lenders and creditors. The Demand for Auditing The definition of auditing can further be discussed in terms of a principal-agent framework that explains the demand for auditing. See Figure 1-1 below for the relationships. First, stockholders (referred to as principals) of a corporation appoint a board of directors who in turn hires a professional management team (referred to as agents) to run the corporation. Second, both the stockholders and management seek to maximize their self-interest. Their goals/activities are not necessarily congruent. Third, the stockholders appoint an outside independent party (an external auditor) to monitor and report the goals/activities of the management. The auditor provides a form of attestation service, an auditing service, to the stockholders. Fourth, the external auditor gathers and evaluates evidence concerning the explicit and implicit assertions made by the management (auditee’s assertions) in the financial statements and reports to the stockholders about the fairness of the financial statements presentation in the form of an audit opinion report. If the management’s financial statements are presented fairly, the auditor issues an unqualified opinion report. On the other hand, if the management’s financial statements are not presented fairly, the auditor issues a qualified opinion report. See Table 1-2 for a brief description of the various types of audit opinion report. A qualified audit opinion usually means that the management’s financial statements contain material misstatements. Misstatements may be in the form of errors, unintentional mistakes, or frauds, intentional misrepresentations. Two common types of intentional misrepresentations are misappropriation of assets, also known as employee fraud, and fraudulent financial reporting, also known as management fraud. Table 1-2 Types of Audit Opinion Report Types of Audit Opinion Report Unqualified Opinion, Standard Report Unqualified Opinion, Explanatory paragraph Added Qualified Opinion Brief Description This report is issued when the auditor judges that the client’s financial statements fairly present, in all material respects, the financial position, results of operations, and cash flows in conformity with GAAP. This report is issued when the auditor judges that it is necessary to add a paragraph to explain certain accounting related matters in a standard unqualified opinion report. This report is issued when the auditor judges that the client’s financial statements fairly present, in Financial and Integrated Audits - Frederick Choo Types of Audit Opinion Report Brief Description all material respects, the financial position, results of operations, and cash flows in conformity with GAAP “except for” the material effect of certain accounting related matters to which the qualification relates. This report is issued when the auditor judges that the client’s financial statements, taken as a whole, do not fairly present the financial position, results of operations, and cash flows in conformity with GAAP. This report is issued when the auditor does not express an opinion on the client’s financial statements. Adverse Opinion Disclaimer of Opinion Figure 1-1 The Demand for Auditing in a Principal-Agent Framework XYZ Company Stockholders Board of Directors XYZ Co. Management (Accountant) Independent Auditor (External) Audit Report (Opinion) Unqualified Qualified Attestation Service (Audit) Financial Statements containing Management’s Implicit/Explicit Assertions Misstatement Error Fraud Unintentional Intentional mistake misrepresentation Misappropriation of assets (Employee fraud) Fraudulent financial reporting (Management fraud) The Demand of Other Users The principal-agent framework above focuses on the stockholders as a primary party demanding audited financial statements. Besides the stockholders, there are a diversity of other users (other 3 rd parties) of the audited financial statements. Table 1-3 describes other users of the audited financial statements. Table 1-3 Other Users of Audited Financial Statements User Bondholders Court System Economists Use of Audited Financial Statements Assess the ability of a company to repay indebtedness. Assess the financial position of a company in litigation. Assess the effects of economic policies and the implications for public policy decisions. 5 6 1 Financial and Integrated Audits User Use of Audited Financial Statements Financial Institutions Labor Unions Management Potential investors Regulatory Agencies Taxing Authorities Determine whether to make a loan to a company. Assess the profitability of a company and the potential for future wages or profit sharing contracts. Review performance and make decisions affecting future directions of a company. Determine whether to invest in a company. Determine whether regulatory action is necessary to protect the public. Determine taxable income and tax due. Type of Services CPA firms provide five broad types of services as shown in Table 1-4. Table 1-4 Five Broad Types of Services Type of Service Attestation services Tax services Management advisory (consulting) services Accounting services Assurance services Nature of Service Attestation services are any professional services in which a CPA firm issues a written report that expresses an opinion or conclusion about the reliability of a written assertion that is the responsibility of another party. Attestation services include financial audit of private (non-publicly traded) companies and integrated audit of public (publicly traded) companies; report on a client's internal control structure; review of private companies' financial statements; examination of prospective financial statements, and application of agreedupon procedures on specific elements, accounts, or items of a financial statement. The AICPA’s Auditing Standard Board issues Statements on Auditing Standards (AUs), which provide guidance for CPAs who perform financial audit for private companies. On the other hand, the SEC’s Public Company Accounting Oversight Board (PCAOB) issues Auditing Standards (ASs), which provide guidance for CPAs who perform integrated audit for public companies. Table 1-5 describes four broad types of attestation services. See Appendix A for a list of the AUs and see Appendix B for a list of the ASs. Tax services include preparation of tax returns, assistant in tax planning, and engagement in tax litigation. The AICPA's Federal Taxation Executive Committee issues Statements on Responsibilities in Tax Practice (SRTPs), which provide guidance for CPAs who perform tax services. Management consulting services include design of accounting information systems, and engagement in marketing study, and executive recruiting. The AICPA's Management Advisory Service Executive Committee issues Statements on Standards for Management Advisory Services (SSMASs) , which provide guidance for CPAs who perform management advisory services. Accounting services include preparation of financial statements and compilation of financial statements. The AICPA's Accounting and Review Services Committee issues Statements on Standards for Accounting and Review Services (ARs), which provide guidance for CPAs who perform accounting services. See Appendix D for a list of the ARs. Assurance services are independent professional services that improve the quality of information, or its context, for decision-makers. By this broad definition, assurance services include attestation services in that they improve the quality of information for decision-makers by issuing a written report about the reliability of certain written assertions of another party. Assurance services also encompass compilation services in that they improve the quality of information for decision-makers by presenting (compiling) them as financial statements in accordance with GAAP. However, assurance services do not include consulting services although they often deliver a similar body of knowledge and skills. A key difference between assurance and consulting services is the objective of the engagement. Assurance services are designed to optimize the client’s decision making whereas consulting services are designed to improve the client’s outcomes or conditions. The AICPA's Auditing Standards Board issues Statements on Standards for Attestation Engagements (ATs), which provide guidance for CPAs who perform accounting services. Table 1-6 describes six common types of assurance services. See Appendix C for a list of the ATs. CPA firms provide four broad types of attestation services that are described in Table 1-5. Table 1-5 Four Broad Types of Attestation services Financial Audit (private company) Integrated Audit (public company) Four Broad Types of Attestation services This type of service involves obtaining and evaluating evidence about a client’s financial statements. The AICPA’s GAAP and Auditing Standard Board’s Auditing Standard AU 700 require that auditors of private companies in the United States to provide an opinion on the company’s financial statements. Based on this financial audit, the auditor issues a “positive” (means certain or confident) expression of opinion on whether the financial statements are presented fairly in conformity with the GAAP and Auditing Standards. Figure 1-3 presents an overview of the financial audit. This type of service involves obtaining and evaluating evidence about a client’s internal control over financial reporting (ICFR) and its financial statements. The Sarbanes-Oxley Act Section 404(b) and PCAOB’s Auditing Standard AS 5 require that auditors of public companies in the United States to provide an opinion on the effectiveness Financial and Integrated Audits - Frederick Choo Four Broad Types of Attestation services Examination Review Agreed-upon procedures of the company’s ICFR and an opinion on the company’s financial statements. Based on this integrated audit, the auditor issues an opinion on the effectiveness of the client’s ICFR and an opinion on the fair presentation of the financial statement in accordance with the standards of the PCAOB. Figure 1-4 presents an overview of the integrated audit. This type of service involves obtaining and evaluating evidence about a variety of situations which contain assertions made by another party. The auditor performing this type of service normally follows the AICPA’s Statements on Standards for Attestation Engagements (ATs). Based on the examination, the auditor issues a “positive” expression of opinion on whether the other party’s assertion conforms to certain applicable criteria. Examples of examination services include (1) prospective (rather than historical) financial statements, (2) management’s assertions about the effectiveness of a client’s internal control structure, and (3) a client’s compliance with specified laws and regulations. This type of service involves inquiries of an audit client’s management and comparative analyses of financial information. The scope of this service is significantly less than that of an audit or examination in that it usually does not involve obtaining and evaluating evidence. The auditor performing this type of service normally follows the AICPA’s Statements on Standards for Accounting and Review Services (ARs). Based on the review, the auditor issues a “negative” (means uncertain or unconfident) expression of opinion on whether the financial statements are presented fairly in conformity with established criteria such as GAAP. Thus, instead of stating a “positive” opinion that “the financial statements are presented fairly in conformity with GAAP”, a “negative” opinion is usually stated as that “ we are not aware of any material modifications that should be made to the statements in order for them to be in conformity with GAAP.” Examples of review services include (1) review of interim financial statements of public companies and (2) review of annual financial statement of non-public companies. This type of service involves the auditor, the client, and the intended users to agree on certain procedures to be performed on specified financial statement/non-financial statement matters. The auditor performing this type of service normally follows the AICPA’s Statements on Standards for Attestation Engagements (ATs) for financial matters (e.g., gross sales account for a lease agreement) and non-financial statement matters (e.g., compliance with federal affirmative action laws). Based on the agreed-upon procedures, the auditor issues a “summary of findings” report, which does not include an opinion. Figure 1-3 An Overview of the Financial Audit (Private Company) Management Financial Audit Implements internal controls Conducts transactions Attests to management’s internal controls Accumulates transactions into account balances Prepares financial statements Issues financial statements Attests to management’s financial statements Issues audit report: 1. An opinion on the fair presentation of the financial statements 7 8 1 Financial and Integrated Audits Figure 1-4 An Overview of the Integrated Audit (Public Company) Management Integrated Audit Reports on ICFR Attests to management’s report on ICFR Management Report on ICFR contains an explicit statement on whether management’s assessment of ICFR is effective as of the end of the period reported on Issues audit report: 1. An opinion on the effectiveness of the company’s ICFR Attests management’s financial statements Prepares financial statements Issues audit report: 2. An opinion on the fair presentation of the financial statements Issues financial statements ICFR = Internal Control Over Financial Reporting CPA firms offer a wide variety of “other” assurance services. The six common “other” assurance service are shown in Table 1- 6. Chapter 21, Other Audit Engagements, provides more discussion on some “other” assurance services and attestation services of the assurance services. Table 1-6 Six Common “Other” Assurance Services Type Risk Assessment Business Performance Measurement Information Systems Reliability Electronic Commerce Healthcare Performance Function This assurance service identifies a client’s profile of business risks and assesses whether the client has appropriate systems in place to effectively manage those risks. This assurance service evaluates whether a client’s performance measurement system contains relevant and reliable measures for assessing the degree to which the client’s goals and objectives are achieved or how its performance compares to its competitors. This assurance service assesses whether a client’s internal information systems (financial and non-financial) provide reliable information for operating and financial decisions. This service assesses whether systems and tools used in electronic commerce provide data integrity, security, privacy, and reliability. See Figure 21-15 in Chapter 21 for an example of a WebTrust report. This assurance service assesses and reports on the quality of care delivered by health care Financial and Integrated Audits - Frederick Choo Type Function Measurement systems, and to provide comparative analyses on costs and delivery systems. This assurance service provides assistance to elderly people and their family members by offering financial advice and measuring how effectively health care providers meet the needs of the elderly and their families. Elder Care A diagrammatic representation of the relationship among the professional services is shown in Figure 1-2. Figure 1-2 Relationships among Professional Services Assurance Services Nonassurance Services Attestation services Examination Review Financial Audit Integrated Audit Certain Management Consulting Services E.g., Fraud Investigation Management Consulting Services Tax Services Agreed-Upon Procedures Accounting Services Compilation Risk Assessment Web/SysTrust XBRL ElderCare Plus Health Care Performance Measurement Source: Adapted from the Elliott Committee Report (AICPA, 1997) The five broad types of services shown in Table 1-4 above fall into four categories of audit (see Table 1-7) and they are usually conducted by several types of auditor (see Table 1-8). Table 1- 7 Four Categories of Audit Category of Audit Financial audit Integrated audit Compliance audit Operational audit Nature of Work This type of service involves obtaining and evaluating evidence about a client’s financial statements. The AICPA’s GAAP and Auditing Standard Board’s Auditing Standard AU 700 require that auditors of private companies in the United States to provide an opinion on the company’s financial statements. Based on this financial audit, the auditor issues a “positive” (means certain or confident) exp...
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