Auditing

1

• Auditing
• Attestation
• Assurance
• Fraud

2
Truisms

• In God We Trust, All Others We Audit
• Trust but verify
• Be not suspicious but be darn skeptical
• When all else fails, use common sense
• Use common sense before you use anything else

3
Introduction

• What is an Assurance service?
• What is an Attestation service?
• What is Auditing?
• What is the difference between Accounting and
  auditing?

4
What do the following scenarios have in common?

• Making a valuation statement about the accuracy
  and validity of someones decisions/assertions
• An auto mechanic tells you that your alternator
  is defective?
• A stereo salesman suggests that a certain brand
  of CD player is the best value for the money.
• A cellular phone company claims to have the best
  rates in the area.

5
What do the following scenarios have in common?

• A dentist urges you to put a crown on a tooth.
• Your friends tell you to take Route 1 instead of
  Route 95 to get to your destination.
• A recruiter pushes his companys employee
  benefits program during an interview.
• Management releases reports showing a 20 percent
  growth in revenue and profits.Aunt Edna tells
  you to put a cold compress on your tooth?

6
Common Themes

• Relevance
• Reliability
• Users expectations of auditors behavior

7
Methods to encourage appropriate behavior

• GAAS
• SEC
• Legal Liability
• Code of Conduct
• Peer Reviews

8
Is fraud present?

• Definition of fraud
• Managements responsibility
• Auditors responsibility

9
Overview of Auditing

• Why study auditing?

10
What is an Audit and what value does it have?

• Agent/Principal, Asymmetry of Information, and
  self-protection.
• Value Added--banks,creditors, government
• formal definition--systematic process of
  objectively obtaining and evaluating evidence
  regarding assertions about economic transactions
  and events to ascertain the degree of
  correspondence between assertions and established
  criteria and communicate the results to users of
  financial statements.

11
Types of auditors?

• The good, the bad, the ugly, and the untouchable.
• formal definition--an independent party that
  obtains and evaluates evidence to determine
  agreement between managements assertions and
  established criteria. Must plan and perform the
  audit to obtain reasonable assurance that the f/s
  are free from material misstatements.

12
Auditors Responsibility

• Financial statements (assertions) are the
  responsibility of management.
• Auditors responsibility is to opine that the f/s
  are, or are not, free of material misstatements
  (errors, irregularities, fraud) based on evidence
  obtained (GAAS).

13
Types of Audits

• Financial
• Compliance
• Operational
• Forensic
• F/S fraud
• Insurance fraud
• Embezzlement
• Money laundering
• Matrimonial disputes

14
Types of fraud (against and on behalf of)

• Misappropriation of assets vs fraudulent
  financial reporting

15
Why do frauds occur?

• Perceived pressure
• Perceived opportunity
• Ability to rationalize

16
Auditing vs attestation vs assurance

• Examinations-expresses written opinion

17
Auditing vs attestation vs assurance

• Attestations engagements--expresses written
  conclusion. .

18
Auditing vs attestation vs assurance

• Assurance services--improves the quality of
  information. care services, TAMU vs UT,

19
Generally Accepted Auditing Standards

• General Standards-TIP
• Field Work Standards - PIE
• Reporting Standards - DOGC / GCDO

20
Professional Code of Conduct

• General stds of ideal conduct with rules and
  examples of misconduct.
• Four parts to the AICPA code of conduct.
• Principles
• Rules of Conduct
• Interpretations
• Rulings

21
Rules of Conduct

• independence, intergrity and objectivity, general
  stds, compliance w/stds, acctg principles,
  confidential info, acts discreditable,
  advertising, commissions, and forms of practice.

22
Ethical behavior

• Conduct that differs from what is considered
  appropriate under the circumstances
• Core valuesTrustworthiness, respect.
• Ethical dilemmas

23
Independence

• Independence in Fact and Independence in
  Appearance
• Advocateto be or not to be.
• Unbiased in the performance of tests, evaluation
  of those tests, and in issuance of the report

24
Independence

• Questions of What if

25
Independence

• Direct financial interest
• Covered members(ability to influence engagement)
• Members on ET and their spouses/immediate family
• Certain Partners
• Timing
• Materiality
• Participate
• Do not participate

26
Independence

• Indirect financial interest
• Mutual funds
• Nondependent/close relatives
• Timing
• Covered members(ability to influence engagement)
• Members on ET and their spouses/immediate family
• Certain Partners
• Participate
• Materiality
• Aware
• Do not participate
• Materiality
• Aware

27
Independence

• Direct managerial interest
• Auditor and dependent/close relatives
• Timing
• Positions
• Audit sensitive
• Significant influence
• Participate
• Do not participate

28
Independence

• Indirect managerial interest
• Positions
• Audit sensitive
• Significant influence
• Nondependent/close relatives
• Covered members(ability to influence engagement)
• Members on ET and their spouses/immediate family
• Certain Partners
• Timing
• Participate
• Do not participate

29
Auditors Reports

• Attestation/GAAS
• Examinations, reviews, and agreed upon procedures
• Reporting Stds
• Objective of reporting stds

30
NO Qualifications

• Unqualified report
• Std three par report pg 17-2
• f/s present fairly

31
Modifications without qualifying

• Uncertainties (litigation)
• Going Concerns

32
Modifications without qualifying

• Departures from promulgated GAAP
• reliance on other auditors
• External (sharingpredecessor/successor)
• Internal

33
Qualified for Scope limitations--pg 17-6

• Reasons to qualify (except for) for scope
  limitations

34
Qualified for Disclosure problems--pg 17-14

• Reasons to qualify (except for) for disclosure
  problems

35
Qualified (maybe) for Changes in GAAP or
departures from GAAP

• Determining afffect on opinion depends on the
  answers to the following
• Changing from GAAP to GAAP?
• Is the method of change GAAP?
• Is there adequate justification?
• Yes
• No

36
Adverse pg 17-13

• F/S as a whole are/are not misleading.
• Reasons for giving an adverse?

37
Disclaimer pg 17-8

• What happens to the scope paragraph?
• Reasons for giving a disclaimer?

38
Other Reporting Issues

• No piecemeal opinions
• Use of a specialist
• Updating the report (same) (17-21)
• Updating the report (17-22)
• Changing prior opinion
• Different (qualified vs unqualified)
• Dual dating

39
Attestation stds vs GAAS

• Similarites in TIP PIE GCDO
• Differences in TIP PIE GCDO

40
Reporting on other information and special reports

• Other information (not required) presented with
  F/S
• Other information (required)--segments
• Other information(required)--supplementary
  information
• Other information(not required)--schedules

41
Special reports

• OCBOA pg18-8
• Specified elements pg18-10
• Agreed upon procedures pg18-11

42
Special reports

• Compliance with contractual agreements (loan
  covenant reviews) pg18-13
• Special purpose financial statements pg 18-13
• Prescribed forms pg18-14

43
Deficient Report

• Problem 16-41

44
Summary and Examples

• Sharing responsibility
• Emphasis of a matter
• Departure from GAAP
• Inconsistency in GAAP (justified or not
  justified)
• Uncertainty
• Going Concern

45
Summary and Examples

• Billing rates-Proof Positive
• QC4
• Reporting on I/C

46
Overview of audit process

• Obtain client
• Understand client
• Standard
• Strategic processes
• Formulate audit plan
• Determine level of risks
• Evaluate I/C
• Test I/C if warranted
• Perform substantive tests

47
Audit Time Line

• Strategy and budgets---April/May
• Analytical Reviews and draft of
  program---July/August
• Obtain/document understanding of I/C
• Perform testEvaulate resultsAssess
  risks-----Sept/Oct
• Substantive tests Subsequent events Rep letter
  Report---Dec/Feb

48
Obtaining the client

• CHANGING AUDITORS
• WALK INS
• REFERRALS (STAFF AND CLIENTS)
• BIDS (PROPOSAL LETTER)
• ADVERTISING

49
Accepting Client

• CREDIT CHECKS
• PRIOR F/S
• PRIOR AUDITORS
• INQUIRE OF THIRD PARTIES (SMALL CLIENTS)--MAGNUM
  PI
• DESIRED INFORMATION

50
Engagement letters

• Contractual relationship
• Explains responsibilities
• New and continuing clients
• 1136 Tenants Case

51
Understanding industry and economic conditions

• Organization structure
• Production lines
• Capital structure

52
Understanding industry and economic conditions

• Operational structure, locations of subs
• related parties SAS 57
• how to identify?
• Distribution methods
• Compensation policies
• Control structure

53
Understanding industry and economic conditions

• Control environment
• Risk assessment
• Control activities
• Information and communication
• Monitoring
• acctg principles
• risk areas
• risk factors of significance
• red flags-danger signals to auditors

54
Sources of industry and economic information

• Touring facilities
• Transaction reviews
• Trade publications and business periodicals
• SEC filings
• prior year wps
• Audit guides

55
Formulate audit plan

• Perform Analytical reviews
• Determine audit strategy
• materiality
• Assess audit risk
• ARIR CR DR
• Assess risk of fraud
• Types
• Responsibility
• Reasons
• Risk factors

56
Formulate audit plan

• audit program--road map
• EDP
• Staffing
• Specialist
• Use of internal auditors

57
Types of fraud

• Financial reporting (mgmt)
• Misappropriation of assets (employees/customers)

58
Reasons frauds occur

• Pressure
• Opportunity
• Ability to rationalize

59
Responsibility for detection

• Management
• Auditor
• SAS no. 1 The auditor has a responsibility to
  plan and perform the audit to obtain reasonable
  assurance about whether the financial statements
  are free of material misstatement, whether caused
  by error or fraud.

60
Risk Factors associated with

• Fraudulent financial reporting
• Misappropriation of assets

61
Common techniques used in fraudulent financial
reporting

• Usually involves accounts receivables, inventory,
  expenses, revenues

62
Purpose of ICS

• is to provide reasonable assurance that
  managements objectives will be met. Safeguard
  assets, provide reliable data (safeg
  authorsegrdocu indep rev), promote operating
  efficiency (indep revmonitoringsafegbudget
  rev), and compliance with applicable laws.

63
The Internal Control Structure

• Why test I/C procedures?
• Questions to ponder
• 45M in billings were placed in a drawer and
  forgotten when the accountant was out sick.
• customer did not pay 15m for shipped merch.
  because their purchasing mgr was out of town.
• client has several cking acctscks are not
  prenumberedvoids cks are discarded and the
  number reused How would you determine that all
  disbursements were recorded and were appropriate.

64
The Internal Control Structure

• Questions to ponder
• client ordered chemicals for resale from
  different supplier because of cheaper price.
  chemicals were unstable and contaminated
  customers supply. client lost customer and is
  facing a lawsuit.
• are 94 sales included with 95 sales are 95
  expenses included with 96 expenses are all
  liabilities recorded
• how do you know that cash exist complete
  accuratein the proper periodproperly
  valuedpresented and disclosed properlybelongs
  to the company.

65
Components of I/C S

• control environment
• risk assessment
• control activities
• information communication
• monitoring

66
Control environment

• overall attitude--inherent risk factors (no board
  of dir/audit committee no I/A dept lacks
  integrity)--Tone at the top

67
control environment

• embezzelment computer down time
• aggressive in taking bus risks
• monitors operations--owner/mgr...
• pressures to achieve unrealistic
  goals--Managements philosophy
• methods of assigning authority

68
control environment

• use of budgets, forecasts
• hiring , training, promotions, compensation
• involvement of directors and audit committee
• regulatory agencies

69
Risk assessment

• What are the risks associated with achieving
  control objectives?
• What are the risks associated with providing
  reliable data?
• What are the risks that data is incomplete, does
  not exist, not accuarate, not properly valued?

70
Control activities

• Performance reviews
• Information processing
• Safeguarding assets
• Segregation of duties

71
Information Communication (Accounting system)

• documents, journals, ledgers
• identify, classify, record, report all valid
  transitions (consistent with magmata objectives)
  on a timely basis, in the proper period, and for
  the proper amount.

72
Auditor must know (information and communication)

• all classes of transactions,
• how transactions originatehow a sale is made
  revenue recognition policies how a liability is
  incurred
• all files and records, flow of the documents
• computer interface, normal and abnormal
  transactions
• how accruals and estimates are made

73
Monitoring

• Typical supervisory and/or managerial functions
  to track the effectiveness of I/C

74
Different systems for different companies

• size, industry,regulatory requirements,complexity
• cost of implementing system (concept of
  reasonable assurance)
• computer Vs no computer, integrity of personnel,
  degree of seg. of duties
• internal auditors, easy access to assets.

75
Limitations

• errors
• collusion
• management override

76
Auditor considers I/C S in determining the N,T,
E of Sub Test

• Test of I/C procedures vs sub test
• test of i/c are employees performing their
  duties. test that are directed toward the design
  or operation of an internal control structured
  procedure to assess its effectiveness in
  preventing or detecting material misstatements in
  a f/s assertion.
• standard audit procedures--I I O C R

77
Sub test

• provides evidence of likely monetary error
• test of details and analytical procedures to
  detect material misstatements in the account
  balance, transaction or f/s assertion.
• standard audit procedures--I I O C R

78
Assessment of I/C risk

• Must decide the degree of risk that the control
  structure does or does not provide some
  predetermined level of assurance that
  managements assertions are free of material
  misstatements.

79
Assessment of I/C risk

• obtain and document understanding of how the
  systems should work.
• inquiry, inspection, observation, prior
  experience
• origination and disposition of transaction,
  documents used, depts and personnel
• more detailed if reliance approach used vs subst
  approach
• auditable? identify I/R?

80
Preliminary assess--

• C/R at maximum if no reliance is planned or it is
  not cost beneficial to perform I/C tests--small
  clientprepaidsaccrualsintangibles--limited
  number of transactions--subst approach

81
Preliminary assess ---

• C/R at less than a maximum if reliance is planned
  and auditor can identify controls he/she wants to
  place on--reliance approach

82
Test controls and evaluate results

• (increase/decrease preliminary assessment of C/R)
  to
• determine the N,T, E of sub tests (interim tests)

83
Timing and situational risk factors--

• even if results appear positive
• sampling risk
• observational risk
• incompetence

84
The assessment of C/R

• should be done for each acct and for each audit
  objective(assertion).
• Keep in mind the type of misstatements that would
  occur (over/under)

85
Verify mgmts assertions

• E C C A V PD RO

86
Existence

• from g/l to document
• tests for overstatement
• based on your direct knowledge or
  interrelationships
• sales represents goods shipped or services
  rendered. A/R are for amounts owned by
  non-fictitious customers at the b/s date.

87
Completeness

• from document to g/l
• tests for understatement
• based on direct knowledge or interrelationships
• all credit and cash transactions were properly
  recorded (inputted and processed)

88
Accuracy

• transactions, journals are accurate (reconciled,
  footed, extensions)--princes and
  quantitiesdebits and credits
• based on review and resolution of errors
  identified in edit runs and exception reports

89
Nature of evidence gathered to verify assertions

• Underlying accounting data
• Corroborating information
• physical,external,internal,analytical,reperformanc
  e
• canceled cks,invoices, contracts, minutes, client
  rep letter, atty letter, confirmations

90
Evidence must be evaluated for its competency and
sufficiency

• competent--persuasive not convincing evidence
• valid and relevant (reliable and
  useful)--persuasive

91
sufficiency

• depends on audit risk and materiality
• Audit risk (ARIRX CR X DR)
• present fairly in all material ....
• the risk that a material error /irreg. showing up
  in the f/s
• the risk that the wrong opinion was issued
• level of audit risk should be low

92
IR--

• nature and characteristic of the account. Depends
  on industry, regulation, economy, number of
  transactions

93
CR--

• based on assessment of internal control procedures

94
DR--

• level of sub test---quality control

95
Materiality

• how much error can you live with
• defined during planning and revised during the
  audit
• allowance for undetected errors

96
Materiality

• b/s, i/s
• score sheet
• Number of items examined depends on sampling,
  judgment, costs of reperformance,etc.

97
Revenue/accounts receivable/cash receipts

• Control functions
• sales order control
• execution of order control
• invoicing control
• recording
• cash receipts

98
Management assertions and control activities

• Existence/completeness/accuracy?
• Safeguard
• Segregation of duties
• Independent reviews
• Proper documents
• Proper authorization

99
sales order control (phys, seg, indp, doc,
auth)ltgt (E,C,C,A,V,RO,PD)

• credit department receives and approves customer
  order.
• prepares sales order for shipping, billing, and
  customer

100
execution of order control (phys, seg, indp, doc,
auth)ltgt (E,C,C,A,V,RO,PD)

• shipping /stores prepares shipping documents for
  billing and customer.
• updates perpetual records

101
invoicing control (billing) (phys, seg, indp,
doc, auth)ltgt (E,C,C,A,V,RO,PD)

• prepares invoice based on s/o and shp/d for
  customer and accts/rec
• enters transaction in the sales register

102
recording control (accts rec) (phys, seg, indp,
doc, auth)ltgt (E,C,C,A,V,RO,PD)

• updates sub ledger
• prepares COGS entry

103
cash receipts (phys, seg, indp, doc, auth)ltgt
(E,C,C,A,V,RO,PD)

• lock box
• listing--names and amounts--gt to accts rec for
  posting
• remittances endorsed immediately for deposit only

104
cash receipts (phys, seg, indp, doc, auth)ltgt
(E,C,C,A,V,RO,PD)

• cashier deposits remittances daily--gtdeposit slip
  sent to accts rec for posting
• total cash receipts (daily) posted to CR journal
  and reconciled with listing and control accts.
• establish control over post dated or incorrect
  cks

105
Cash receipts (phys, seg, indp, doc, auth)ltgt
(E,C,C,A,V,RO,PD)

• returned cks (customer NSF ck)
• should be controlled by employee not involved
  with making the deposits or recording the entries

106
Testing control procedures---pgs 10-12 10-13

• Authorization
• Proper doc
• Safeguarding assets/accuracy
• Indp reviews
• Seg. of duties

107
Expenses/accts pay/cash disb

• Control functions
• requisition
• purchasing
• receiving
• recording
• cash disb

108
Requisition (phys, seg, indp, doc, auth)ltgt
(E,C,C,A,V,RO,PD)

• prepares purchase requisition
• examines merch for validity
• updates perpetuals

109
Purchasing (phys, seg, indp, doc, auth)ltgt
(E,C,C,A,V,RO,PD)

• based on requisition approves purchase (prepares
  PO) and selects vendor.

110
Receiving (phys, seg, indp, doc, auth)ltgt
(E,C,C,A,V,RO,PD)

• receives merch and prepares receiving doc
• distributes merch

111
Recording (phys, seg, indp, doc, auth)ltgt
(E,C,C,A,V,RO,PD)

• based on RO,PO, RD,Inv, prepares voucher
• updates voucher register and a/p sub ledger

112
cash disb (phys, seg, indp, doc, auth)ltgt
(E,C,C,A,V,RO,PD)

• validity of supporting doc
• signer of cks indep of CR and CD functions
• signer cancels docs

113
cash disb (phys, seg, indp, doc, auth)ltgt
(E,C,C,A,V,RO,PD)

• cks are pre-numbered
• cks are mailed by signer and not the preparer
• cks not made to cash or bearer

114
cash disb (phys, seg, indp, doc, auth)ltgt
(E,C,C,A,V,RO,PD)

• cks not signed in advance
• unsigned cks and blank cks properly safeguarded
• petty cash used for small , miscellaneous
  disbursements

115
Testing control procedures--pgs 12-12 , 12-13

• Authorization
• Seg. of duties
• Proper doc
• Indp reviews
• Safeguarding assets

116
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117
Summary

• Preliminary review
• obtain and document understanding
• Develop plan based on preliminary assessement
• Reliance planned
• Substantive test

118
Review--test I/C for A/R Rev

• Which cycle? Which account? (RevenuePayments
  SalesA/RInventory COGS)
• Which assertion/objective? (AccuracyCompleteness
  Existence)
• Which control procedure?---Testing
  authorization....
• Which control function? (Sales order Execution
  of order )
• Which files? Which documents?

119
Review--test I/C for A/R Rev

• Which audit procedures?
• inspect doc for signatures
• inspect doc for proof of math accuracy (recompute
  extensions--PxQ)
• inquire about credit granting policies

120
Review--test I/C for A/R Rev

• Which audit procedures?
• inspect/observe posting and authorization for
  postings (any intentional under/over footings
• inspect/observe proof of authorizations for
  correcting entries (from exception reports) and
  clients review of numerical control
• inspect/observe proof of authorization for
  shipping (all docs)

121
Substantive tests--Accts Rec

• Purpose of sub tests
• Control functions
• Control procedures
• Audit objectives

122
Substantive tests--Accts Rec

• Completeness, Accuracy, and Cutoff
• test math accuracy
• cutoff tests
• unmatched items
• test numerical sequence--if not prenumbered

123
Substantive tests--Accts Rec

• Existence Rights and Obligations
• confirmations
• confirmation procedures
• population
• reconcile with sub
• select sample (unusal balances)
• positive
• negative

124
Substantive tests--Accts Rec

• confirmation exceptions
• unable to locate
• timing diff
• true exceptions

125
Substantive tests--Accts Rec

• If you cannot send confirmations
• sales orders
• contracts
• shipping doc
• cash receipts and remittance advice
• postings

126
Substantive tests--Accts Rec

• Lapping
• lockboxsegregationvacationmonthly statements
• Tests for collectability
• review and test aging schedule
• review problem accts

127
Other substantive tests

• test math accuracy of ledgers
• examine credits and returns after year-end
• examine write-offs before and after year-end
• examine contingent sales agreements
• examine related party sales

128
Substantive tests--Cash

• Types
• Confirmation
• bank reconciliation
• transfer tests
• cash counts
• proof of cash

129
Confirmation

• Standard
• Normally done at year-end and interim
• Also request a cutoff statement
• confirm all accounts open during the year
• other information--LTD

130
Bank reconciliation

• Standard --
• May review over a given period.

131
Bank transfer test--

• provides reasonable assurance that kiting has not
  occurred
• compare dates that disb and receipts were
  recorded in g/l with date disb and receipts
  recorded by the bank

132
Proof of cash
133
General

• review cash transactions until field work ends
  for unusual payments to officers, temporary
  reduction in N/P, or payments to unrecognized
  vendors.
• any restrictions

134
Inventory--Substantive tests

• Mckesson Robbins
• Required by GAAS

135
Planning

• Client has primary responsibility
• Review clients instructions

136
Observation

• s/b well informed regarding industry---may need a
  specialist
• inventory s/b well arranged to detect
  consignments, age and neglect, movements,
  shipments, receipts, awaiting repair or delivery.

137
Observation-test counts

• confirm accuracy
• corroborate existence
• records info from tag numbers for later tracing
  to summerization
• how many depends on judgement, error rate, type
  of inventory, client request

138
Observation-tag/sheet control

• Final summerization

139
Other tests

• LCM
• Cutoff

140
Difficult inventories

• logs in river
• piles of coal/scrap metal
• vats of chemicals
• cattle ranch

141
If inventory not observed

• alternative procedures on beginning or ending
  inventoy
• over slept

142
Variable sampling

• Classicial
• MPU
• Difference estimation
• Ratio estimation
• PPS
• Use for testing overstatements

143
Sampling risk

• compliment of confidence level
• incorrect acceptance (overreliance)
• incorrect rejection (underreliance)

144
Precisionmaterialitytolerable rate

• Precision intervalAVPrecision
• Sample size
• based on planned precision n(_at_/PP)
• planned precision is an adjusted TR determined by
  IA, IR.

145
SS does not determine IA, IR, nor TR

• as PP increasesgtSS decreases
• as CL decreasesgtcauses IA IR to increase
  (allowed to go up)gtincrease in PPgtSS
  decreases

146
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147
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148
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149
Common law

• based on prior legal decisions
• varies by state
• burden of proof on plaintiff

150
Liabilitiy to client and subrogee under common law

• Can sue for ordinary negligence, gross
  negligence, fraud
• Breach of contract
• Lack of confidentiality (special breach)
• Defalcation by employee not detected by CPA
  (because did not follow gaas)

151
Plaintiffs must show

• loss
• cpa had a duty to perform (privity)
• loss resulted from nonperformance of duty (breach)

152
CPA can show

• not negligent
• followed GAAS
• causation defense
• contributory negligence

153
Liability to third parties under common law

• Can only sue for gross negl and fraud unless
• Identified
• Forseen third parties (ord., gross, and fraud)
• Forseeable third parites (ord., gross, and fraud)

154
Liability under statutory law

• 1933 act
• burden of proof on CPA
• any buyer of shares can sue for ord. gross or
  fraud
• cpa must prove due diligence

155
1934 act

• cpa liable for loss to buyer and seller for
  false or misleading stmt
• burden of proof on plaintiff

156
1934 act

• cpa must proove due diligence (18a only) and no
  knowledge of false or misleading stmt.
• Rule 10b-5