AUDITING: A RISK ANALYSIS APPROACH

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AUDITING A RISK ANALYSIS APPROACH
5th edition
Larry F. Konrath
Electronic Presentation
by Harold O. Wilson
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CHAPTER 13
SUBSTATIVE AUDIT TESTING
Financing Investing Cycle Completing the Audit
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Financing Investing Cycle

• Investing transactions marketable securities,
  bonds, real estate
• Borrowing transactions bonds, mortgages,
  financing leases
• Stockholders equity transactions dividends,
  earnings,
• stock issuance
• retirement, treasury
• stock

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INVESTING TRANSACTIONS

• Audit risk relates to existence, ownership,
  valuation of securities.
• Securities may be collateral for loans
  (disclosure required).

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And, how are securities classified?
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Valuations of Securities

• GAAP requires classifications
• Trading Securities.
• Available-for-Sale Securities.
• Held-to-Maturity Securities.
• Intent, Motive! and ability, and paper
  gains losses must be scrutinized under current
  GAAP as part of the audit.

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FAQ?
Investments must be properly accounted for under
GAAP what criteria supports presenting
securities under current assets?
BOTH marketability and management intent!
Valuation principles, pledging, and losses/gains
must follow GAAP!
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SUMMARIZED AUDIT PROGRAM Investments

• Confirm transactions/balances with
  trustee or transfer agent.
• Inspect securities held by client, noting
  changes in serial numbers from prior
  year(s).
• Verify cutoff procedures, consistency
  with recorded details.
• Verify incomes earned, accrued.
• Trace information through records
  (documents through General Ledger)
  

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SUMMARIZED AUDIT PROGRAM Investments

• Verify losses/gains (both realized unrealized
  disclosure of same.
• Compare records with records of all related
  parties affiliates records, to verify form vs.
  substance issues.
• Scrutinize authorizations and prove mathematics
  for changes, fair values compare data to trends,
  etc.

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Borrowing TransactionsAudit Objectives

• Existence completeness
• Errors of omissions
• Valuation
• Long-term liabilities
• Troubled debt restructuring
• Presentation disclosure
• Current v. noncurrent
• Details of pensions, leases, bonds, mortgages

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SUMMARIZED AUDIT PROGRAM Long-Term Debt

• Confirm transactions/balances with
  creditors/bondholders,
  lessors..
• Examine agreements/indentures, note
  covenants, compliance, pledges, etc.
• Verify cutoff procedures, consistency
  with recorded/unissued details.
• Verify expenses incurred, accrued.
  

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STOCKHOLDERS EQUITY Objectives

• Disclosure classification of paid-in capital v.
  retained earnings
• Earnings per share
• Ordinary v. fully diluted

Valuation typically not a major concern.
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FAQ?

• After all assets and liabilities other
  stockholders equity accounts are audited, what
  is done to verify Retained Earnings, per se,
  since it is intangible?

R.E., is a plug however, the known debits
credits should include net income and dividends!
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SUMMARIZED AUDIT PROGRAM Capital Stock

• Confirm transactions/balances with
  owners and/or transfer agents.
• Analyze verify all changes in all
  stock accounts (e.g., dividends, splits,
  options, treasury shares).
• Verify cutoff procedures, consistency
  with recorded/unissued details.

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SUMMARIZED AUDIT PROGRAM Capital Stock

• Verify dividend approvals, payments.
• Investigate any property dividends.
• Review minutes applications of GAAP, and math
  for above dealings.
• Verify EPS propriety, math, disclosure.

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RISK ANALYSIS SOURCES

• Although evidence and clues emerge as the audit
  progresses, sources of inputs for audit attention
  are ever-present, such as
• Management inquiry
• Auditors current and prior workpapers
• Permanent files
• Predecessor audit correspondence, contact
• Analytical procedures
• Industry guides/GAAP

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AUDIT RISK ANALYSIS Related Party
Transactions

• Form vs. substance
• Conflicts of interests Refunding of loans
• Excessively risky investments
• Complex practices, policies, structures (e.g.,
  transfers of problem loans)
• Inadequate loss reserves
• Unusual, excessive dealings with affiliates,
  especially near FYE

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AUDIT RISK ANALYSIS Potential debt
defaults

• Meeting agreements, requirements
• Potential restructurings
• Ability to continue as a going concern
• Derivatives, per se (undue speculation)
• Disposals of segments (GAAP)

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SUMMARIZED AUDIT PROGRAM Valuations

• Investments Examine brokers advices compare to
  current market quotations.
• Long-Term Debt Confirmations provide valuations
  calculate premium/discounts.
• Capital Stock Verify to Board minutes, issuance
  documents, etc.
• Verify consistency of all with GAAP
  and disclosure guidelines.

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Completing the Audit Analytical Procedures
include ...

• Compare current transactions with
  prior year incomes, expenses.
• Compare percentages for balances,
• incomes, ROI, etc., to trends.
• Compare prior disclosures footnotes with
  current plans.
• Scan for clues to misstatements, aggregate
  materiality, etc.

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Completing the Audit Subsequent Events

• Type I Events that provide additional evidence
  with respect to conditions that existed at FYE,
  and affect estimates inherent in financial
  statements. AJEs likely!
• Type II Events that provide evidence with
  respect to conditions that did not exist at FYE,
  but arose after FYE. Footnotes
  likely!

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Completing the Audit Subsequent Events Clues

• Interim financial statements
• Inquire of management
• Contingent liabilities or commitments
• Significant change in stock, debt, or working
  capital
• Current status of open items
• Unusual adjustments made after year end
• Minutes of executive committees
• Representation Letters
• Communication with legal counsel

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CLOSING CONSIDERATIONS

• Cash Flow analysis, etc.
• Workpaper review (complete, indexed tied in,
  no pending matters or open items, etc.)
• All exceptions cleared!
• Auditor/Client conference (discussion of
  adjustments, draft of Audit Report/opinion,
  and draft of Management Letter contents)

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NEITHER CLIENTS NOR AUDITORS LIKE SRPRISES!
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CLOSING CONSIDERATIONS

• Audit Committee communications
• GAAS, auditor responsibility
• Nature of an audit
• Accounting policies, adjustments
• Managements responsibilities
• Compromises, difficulties encountered

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CLOSING CONSIDERATIONS

• Client Representation Letter (if refused, it
  becomes a scope limitation)
• Confirms oral and written understandings
• Some assurance of auditor-client cooperation
• Psychological pressure on client

NO RELIEF OF AUDITOR RESPONSIBILITY!
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COMMUNICATIONS Representation Letter Contents

• Financial Statements management beliefs,
  assurances
• Completeness of information, availability
• Accounting principles (recognition,
  measurements, disclosures)
• Internal controls
• Subsequent events
• Cooperation!

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COMMUNICATIONS Reportable Conditions Letter

• Material internal control concerns of the
  auditor
• Addressed to the Audit Committee (copy to each
  member, separately mailed) with restricted
  distribution indication
• Discussion of objectives of audits
• Defines and listsReportable conditions
• Some auditor protection!

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COMMUNICATIONS Management Letters
Management Letter comments to improve controls
and/or surveillance.
Reportable conditions include weaknesses AND
potential for improper activities and for
fraud.
Complex transactions challenge auditors and
management-- as both are under pressure!
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End of Chapter 13