CHAPTER 5CHAPTER 5OVERVIEW OF THE AUDIT PROCESSOVERVIEW OF THE AUDIT PROCESS

FallFall 2007 2007

CHAPTER 5CHAPTER 5OVERVIEW OF THE AUDIT PROCESSOVERVIEW OF THE AUDIT PROCESS

FallFall 2007 2007

Overview of the Audit Process Assessing Audit Risk Audit Objectives Materiality Audit Procedures Audit Risk Model

Overview of the Audit Process

Overview of the Audit Process

1. Understand entity & environment2. Anticipate where misstatement most

likely to occur3. Plan audit strategy

– Nature– Timing– Extent– Staffing

4. Perform field work5. Issue audit report & other communications

Understand the Entity and Its Environment

Understand the Entity and Its Environment

Obtain an understanding of:1. Industry, regulatory and other external factors2. Nature of the entity including application of

accounting policies3. Objectives & strategies and the related

business risks4. Internal control5. Measurement and review of the entity’s

financial performance

Why do we care about this???

Anticipate Misstatements and Fraud

Anticipate Misstatements and Fraud

Fundamental Questions:• Which accounts are most likely to be

misstated?• How are they likely to be misstated?• Intuitively we should “do more auditing” on

those accounts.

New SAS’s (No’s 104-111) on linking risks with financial statement assertions with procedures

Anticipate Misstatements and Fraud

Anticipate Misstatements and Fraud

Management Assertions:• Management has asserted the financial

statements are “right”• How the financial statements are “right”

– Transactions– Balances– Disclosures

• Think about where are they likely to be “wrong”

Transaction Audit ObjectivesTransaction Audit Objectives

For each recorded transaction:• Occurrence• Completeness • Cutoff• Accuracy• Classification

Balance Audit ObjectivesBalance Audit Objectives

For each balance (on the B/S)

• Existence

• Completeness

• Rights & Obligations

• Valuation & Allocation

Disclosure Audit ObjectivesDisclosure Audit Objectives

For each footnote:

• Occurrence and Rights & Obligations

• Completeness

• Classification & Understandability

• Accuracy & Valuation

Plan Audit: Nature of TestsPlan Audit: Nature of Tests

• Procedures to Obtain an Understanding• Tests of Controls• Substantive Tests

– Analytical Procedures– Transactions & Balances

• Estimates

– Footnotes

Analytical ProceduresAnalytical Procedures

• What are they?• Underlying Assumption: We assume

conditions will persist in absence of information to the contrary.

• When are they used/required?– Planning: decide where problems might

be– Field Work: test numbers– Completion: “sanity check”

Plan Audit: Timing of TestsPlan Audit: Timing of Tests

• Interim vs/ Year end• Surprise vs. planned

Plan Audit: Extent of TestsPlan Audit: Extent of Tests

• Extent of testing related to materiality• Materiality defined: Influence on the

judgment of a reasonable person relying on the financial statements (FAS2)

• Influences the audit process

– Planning: How much work to do.

– During the audit: Evaluate the significance of findings.

• Considers quantitative and qualitative factors

Plan Audit: Staffing of TestsPlan Audit: Staffing of Tests

• Generally a more experienced person yields higher quality evidence

Plan Audit: The Audit Risk Model

Plan Audit: The Audit Risk Model

• Once we figure out what might cause the f/s to be misstated, we need to determine how our audit can be most efficiently and effectively tailored to address our concerns.

• The Audit Risk Model is our tool to do this.

The Audit Risk ModelThe Audit Risk Model

AR = IR x CR x DR

AR: Risk that auditor issues incorrect reportIR: Risk of misstatement, assuming no internal controlsCR: Risk that misstatements will not be prevented or

detected by the IC systemDR: Risk that the auditor will not detect a material

misstatementFR: Risk of fraud that is considered as part of IR & CR

Each of these must be assessed for each class of transactions, account, and objective.

The Audit Risk ModelThe Audit Risk Model

AR = IR x CR x DR

How does this relate to types of tests?• Procedures to Obtain an Understanding• Tests of Controls• Substantive Tests

– Analytical Procedures– Transactions & Balances

• Estimates

– Footnotes

Risk Analysis: Example 1Risk Analysis: Example 1

You have been engaged to audit Apparel Inc., an upscale trendy clothing manufacturer that sells to small independently owned boutiques. Apparel must obtain an audit as a condition of its bank loan, which is up for renewal. Lately Apparel’s customers have been experiencing declining sales in part due to their inability to compete with large mall-chain stores. Apparel’s credit manager position has been vacant for the last 6 months and those duties have been taken over by an accounts receivable clerk with little experience. AR is a significant portion of company assets. Controls over sales transactions at the time of sale are strong.

With respect to the occurrence of Accounts Receivable transactions….

AR = IR x CR x DR

With respect to the valuation of Accounts Receivable balance …..AR = IR x CR x DR

Risk Analysis: Example 2Risk Analysis: Example 2

Your firm has been engaged to audit Stationary Inc., a family owned business currently seeking new bank financing. Because of increasing use of email, demand for their product has been decreasing dramatically. However, their controller, a CPA, has implemented numerous procedures to ensure that inventory levels are monitored and inventory cost is conservative. There are also strict security procedures in the warehouse.

With respect to the existence of inventory balance …..AR = IR x CR x DR

With respect to the valuation of inventory balance …..AR = IR x CR x DR