AUDITING CHAPTER 7

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AUDITINGCHAPTER 7

• Audit Process Detecting Fraud
• By
• David N. Ricchiute

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TOPICS

• Audit process
• Client acceptance, client strategies, planning,
  interim year end work
• Auditors responsibility to detect, report fraud

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PRELIMINARY STEPS IN AUDIT PROCESS

• Communication with audit committee
• Accepting, continuing engagements
• Understand clients business strategies
• Planning
• Interim, year-end audit work

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AUDIT COMMITTEESHistory

• 1940 SEC ASR 19 encouraged
• 1978 required by NYSE
• 1999 recommendations from Blue Ribbon on audit
  committee effectiveness
• Consistency of accounting principles
• Clarity, completeness of financial statements

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SEC SARBANES-OXLEY RULES Post 2000

• Mandates
• Reviews of public company financial statement
  interim reports
• Disclosure in proxy statements whether audit
  committee discussed
• Financial statements with management
• Estimates, uncertainties, unusual transactions,
  new accounting principles, independence with
  auditor

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QUALITY OF EARNINGS

• Auditor must discuss quality not just
  acceptability of accounting principles earnings
  with Audit committee (SAS 89)
• Consistency in use of accounting principles
• Clarity, completeness of financial statements

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ACCEPTING, CONTINUING ENGAGEMENTS

• Establish policies, procedures to accept,
  continue clients (Stmt. Quality Control Stds. No.
  1 )
• For new client
• Evaluate ability to service client
• Review financial statements
• Inquire about reputation, bankruptcy
• Investigate key managers

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COMMUNICATIONS WITH PREDECESSOR

• Successor auditor initiates communication
• Predecessor auditor obtains permission to
  disclose confidential information (Rule 301)
• Is prior auditors resignation, replacement
  linked to (SAS 84)
• Disagreement with management?
• Management integrity?
• Other reasons?

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UNDERSTANDING WITH CLIENT

• Objectives limitations of engagement
• Managements responsibilities
• Example financial statement audit
• Objective express opinion whether statements
• Present fairly
• In all material respects
• In conformity with GAAP
• SAS 83 SSAE 7

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MANAGEMENTS RESPONSIBILITIES

• Financial statements
• Establishing, maintaining effective internal over
  financial reporting
• Assuring compliance with laws regulations
• Making records, information available
• Confirming representations made during engagement

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ENGAGEMENT LETTERS

• Drafted by auditor for CEOs signature
• Written agreement to state purpose of engagement
  role of auditor
• Optional but recommended by SAS 84 which requires
  some form of written understanding in work papers

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PROPOSED ADJUSTING JOURNAL ENTRIES (AJE)

• SAS 88 Audit Adjustments
• Managements responsibility to record material
  proposed adjustments
• Management must confirm responsibility for
  adjustments at year end in representation letter
• Auditor informs audit committee of managements
  responsibilities for adjustments

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UNDERSTANDING CLIENTS BUSINESS

• Auditor considers effects of client business
  strategies on
• Risks
• Strategies to overcome risk
• Transactions, events as products of managements
  strategies

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CLIENT STRATEGY TEMPLATE-Strategies

• Growth strategy
• Financial goals operating priorities

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CLIENT STRATEGY TEMPLATE-Characteristics

• Characteristics of business
• Major business units
• Markets
• Products
• Customers
• Competitors
• Strategic alliances joint ventures
• Potential adverse influences

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BUSINESS Units, Markets, Products, Customers

• Demonstrate value of product
• RD to develop new products

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FINANCIAL GOALS, OPERATING PRIORITIES Merck

• Remain in top quartile
• Maximize revenue growth
• Preserve profitability of core business
• Achieve full potential

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ERRORS VS. FRAUD

• Errors
• Unintentional misstatements or omissions in
  financial statements
• Fraud
• Fraudulent financial reporting intentional
  misstatement or omission
• Misappropriation of assets theft

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PLANNING

• Risk of misstatement from fraud
• First quarter planning
• Second quarter planning

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RISK OF FRAUD Auditors Responsibility

• Discuss risk with staff
• Obtain pertinent information
• Identify assess risks
• Plan according to assessment
• Evaluate evidence

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RISK OF FRAUD Other Aspects

• Professional skepticism
• No presumption of dishonesty balanced with
  possibility of misstatement due to fraud
• Fraud screens
• Some financial ratios help
• Asset quality
• Total accruals to total assets
• Days sales in receivables

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IDENTIFYING, ASSESSING RISK OF FRAUD

• Fraud triangle
• Incentives, pressures to commit fraud
• Opportunities to commit fraud
• Managements rationalizations for committing fraud

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FIRST-QUARTER PLANNING

• Review prior-year audit work
• Review 1st quarter results
• Prepare preliminary audit time budget
• Consider adverse influences

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SECOND-QUARTER PLANNING

• Review 2nd quarter results
• Finalize budget
• Perform analytical procedures
• Prepare preliminary planning memo
• Coordinate staff with client
• Prepare interim audit programs

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INTERIM AUDIT WORK Controls Programs

• Understand internal control
• Perform tests of controls
• Assess control risk
• Prepare preliminary audit programs

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YEAR-END AUDIT WORK

• Coordinate with client
• Finalize audit program
• Perform substantive tests, analytical procedures
• Evaluate audit test results
• Material errors, fraud
• Subsequent events

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YEAR-END AUDIT DOCUMENTATION

• Management, legal representations
• Audit documentation review
• Staff work reviewed
• Audit reports