AUDITING CHAPTER 2

1
AUDITINGCHAPTER 2

• Standards, Materiality, Risk
• By
• David N. Ricchiute

2
TOPICS

• Audit Attestation standards
• Auditing concepts
• Audit risk
• Materiality in financial statement audit

3
EARLY DEVELOPMENT OF STANDARDS

• 1941 Accounting Series Release (ASR)21
• SEC requires audit report
• Audit conducted in accordance with generally
  accepted standards
• 1948 AICPA approves generally accepted auditing
  standards (GAAS)

4
RECENT DEVELOPMENT OF STANDARDS

• 1970s practitioners criticized GAAS as not
  sufficiently specific
• 1986 Attestation standards developed
• Umbrella for engagement standards
• GAAS applies exclusively to financial statement
  audits

5
COMPARING GAAS ATTESTATION

• Attestation GAAS

Broad range of engagements including audit Financial statement audit
Umbrella for all attest services Audit one of many attest engagements
6
GENERAL STANDARDS

• Attestation GAAS

Adequate technical training Adequate technical training
Adequate knowledge Assertion can be evaluated by reasonable criteria consistently measured or estimated
Independence in mental attitude Independence in mental attitude
Due professional care Due professional care

7
FIELDWORK STANDARDS

• Attestation GAAS

Adequately planned supervised Adequately planned supervised
Understanding internal control
Sufficient evidence Sufficient competent evidential matter
8
REPORTING STANDARDS

• Attestation GAAS

Assertion identified
Conclusion about conformity with established criteria State significant reservations Conclusion about conformity with GAAP Consistent use of GAAP Adequate informative disclosures
Limited use to parties agreeing on procedures Opinion on statements as a whole
9
STANDARDS FOR PUBLIC COMPANY ENGAGEMENTS

• Sarbanes-Oxley Act of 2002
• Creates Public Company Accounting Oversight Board
  (PCAOB)
• Delegates authority to PCAOB to
• Oversee, regulate accounting and auditing
  professions
• Develop accounting, auditing standards or
• Accept accounting standards from FASB
• Accept auditing standards from AICPA

10
AUDITING CONCEPTS

• Independence
• Due care
• Evidence
• Reporting

11
INDEPENDENCE EXPLAINED

• In fact
• State of mind
• Attitude of impartiality
• In appearance
• Free of overt interest in client

12
CONSULTING PUBLIC COMPANY ENGAGEMENTS 2000

• consulting other services may shorten the
  distance between the auditor management.
  Independenceif not in fact, then certainly in
  appearancebecomes a more elusive proposition.
  In this dual role, the auditor, who guards the
  integrity of the numbers, now both oversees
  answers to management.
• Arthur Levitt, Jr., Renewing the Covenant with
  Investors Speech at NYU Center for Law
  Business, 5/10/00.

13
SEC PUBLIC COMPANIES INDEPENDENCE REFORMS 2000

• Engagement team model of independence
• Team immediate family prohibited from
  investments in clients
• Increased restrictions for IT and internal audit
  consulting
• Required disclosure audit/nonaudit fees in proxy
  statement

14
SARBANES-OXLEY, INDEPENDENCE 2002

• Establishes PCAOB
• Addresses accountability for corporate criminal
  fraud
• Limits audit firms consulting services to public
  company clients
• Client board of directors to approve consulting
  services provided by auditor

15
SERVICES PROHIBITED BY SARBANES-OXLEY

• For public companies
• Bookkeeping, other accounting services
• Information systems design, implementation
• Valuation or appraisal services
• Actuarial services
• Internal audit outsourcing services
• Management functions, human resources
• Broker, dealer, investment advisor
• Legal, expert services
• Other services to be determined

16
SEC, INDEPENDENCE, PUBLIC COMPANIES 2003

• Further independence regulations
• Rotate engagement partner 5-7 years
• Restrict firms independence for 1 year when
  client hires member of audit team
• Violates independence if auditors compensation
  based on selling service other than attest
• Require auditor report certain matters to
  clients audit committee
• Critical accounting policies

17
DUE CARE EXPLAINED

• Care when providing professional services
• Adequate training for professional services

18
DUE CARE IN LAW

• Every man who offers his service to another is
  employed assumes the duty to exercise such skill
  as he possesses with reasonable care diligence.
  if one offers his service, he is understood as
  holding himself out to the public as possessing
  the degree of skill commonly possessed by others
  in the same employment if his pretensions are
  unfounded, he commits a species of fraud upon
  every man who employs him . . .
• Cooley on Torts

19
DUE CARE WORLDCOM 2002

• 2nd largest long-distance carrier restated
  financial statements for 5 quarters
• Network access fees capitalized instead of
  expensed
• Overstated net income by 11 billion
• Overstated balance sheet by 75 billion
• Not GAAP
• Auditor knew but did not challenge

20
DUE CARE PRUDENT PRACTITIONER

• Foresee unreasonable risk to others
• Attend to extra risks
• Consider unusual circumstances or relationships
• Identify unfamiliar situation take precautions
• Resolve doubt
• Keep current
• Review work of assistants

21
DUE CARE OPERATIONALIZED

• Auditor obtains knowledge of business to
  understand events, transactions, practices with
  significant effect on financial statements
• Plan audit to limit audit risk to low level
• Assess possible errors on balance sheet

22
EVIDENCE EXPLAINED

• Underlying accounting data
• Journals, ledgers, reconciliations, accounting
  manuals
• Corroborating information
• Receiving reports, invoices, contracts,
  representations from 3rd parties

23
EVIDENCE

• Basis for all decisions
• Evidential matter
• Planning supervision
• Internal control

24
EVIDENCE SUFFICIENCY COMPETENCE

• Sufficiency
• Quantity useful evidence collected at reasonable
  cost
• Competence
• Validity varies with source
• Relevance related to assertion

25
EVIDENCE HIERARCHY

• Independent sources more reliable than management
• Banks, debtors
• Evidence obtained directly more persuasive than
  indirect evidence from management
• Physical examination, observation, computation,
  inspection
• Effective internal control systems produce more
  reliable evidence

26
PLANNING SUPERVISION EXPLAINED

• Planning
• Developing objectives strategy
• Supervision
• Directing assistants toward
• objectives
• Determining when objectives
• are met

27
INTERNAL CONTROL

• Policies procedures of management board of
  directors
• Provides reasonable assurance their objectives
  will be achieved
• Auditor must understand clients internal
  controls
• To plan audit
• To design audit tests

28
REPORTING EXPLAINED

• Report states conclusion
• Attestation report
• Whether managements assertion conforms with
  stated criteria
• Audit report
• Whether financial statements conform to GAAP

29
AUDIT REPORT CONCLUSION

• In our opinion, the financial statements referred
  to above present fairly, in all material
  respects, the financial position of the company .
  . ., the results of its operations and its cash
  flows . . ., in conformity with generally
  accepted accounting principles.

30
STRATEGY FOR RISK

• Risk of omissions or misstatements
• Design engagement to control material omissions
  or misstatements
• Provide reasonable not absolute assurance of
  detecting omissions or misstatements

31
ATTESTATION RISK

• Probability that attester may unknowingly fail to
  modify a written conclusion about an assertion
  that is materially misstated
• D. N. Ricchiute, Auditing, 8th ed.

32
AUDIT RISK

• Probability that auditor may unknowingly fail to
  modify opinion on financial statements that are
  materially misstated
• D. N. Ricchiute, Auditing, 8th ed.

33
COMPONENTS OF AUDIT RISK

• Client sources of risk
• Inherent risk
• Control risk
• Auditor source of risk
• Detection risk

34
COMPONENTS OF AUDIT RISK DEFINED

• Inherent risk
• Risk that errors will occur
• Control risk
• Risk that internal controls wont prevent,
  detect, correct errors
• Detection risk
• Risk that audit procedures wont find errors

35
INHERENT RISK SOURCES

• Risk that errors will occur
• Business
• Industry
• Managements predisposition to manage earnings
• Aggressive use of GAAP
• Specific accounts
• Liquid assets vs. nonliquid assets

36
CONTROL RISK SOURCES

• Risk that internal controls wont prevent,
  detect, correct errors
• Outdated technology
• Outdated software
• Lack of respect for controls by top management

37
DETECTION RISK SOURCES

• Likelihood that errors could occur and not be
  detected by audit procedures
• Nature of audit procedures
• Extent of audit procedures
• Timing of audit procedures
• Auditors judgment

38
AUDIT RISK MODELSAS No. 47

• AR IR x CR x DR
• DR AR
• IR x CR

39
AUDITORS BUSINESS RISK

• The probability that a practitioner might incur
  damages despite issuing an appropriate report
• Ex. litigation
• Factors affecting auditors business risk
• Aggressive financial reporting
• Management integrity or reputation
• Conflicts of interest regulatory problems
• Industry characteristics

40
AUDITORS RESPONSE TO BUSINESS RISK

• If business risk is higher, adjust audit risk
  assessment
• Set audit risk lower
• Decrease acceptable level of detection risk
• Increase evidence
• Drop client
• If assurance levels all same, do not adjust audit
  risk

41
AUDIT FAILURE DEFINED

• Failing to perform procedures that would reduce
  audit risk to a relatively low level
• Ex. Sunbeam
• Sunbeams auditor a) identified reserves not in
  compliance with GAAP b) proposed adjustments
  which management rejected c) accepted reserves
  as stated after incorrectly applying materiality
  analysis

42
MATERIALITY

• The magnitude or an omission or misstatement of
  accounting information that, in the judgment of a
  reasonable person relying on the information,
  would have been changed or influenced by the
  omission or misstatement.1
• Statement of Financial Accounting Standards No.
  2, Qualitative Characteristics of Accounting
  Information, Stamford FASB, 1980, par 132.

43
MATERIALITY IN PRACTICE

• Preliminary estimate of materiality for planning
  guides audit effort, evidence collection
• SAS No. 22, Planning Supervision

44
AUDIT RISK, MATERIALITY, AUDIT EFFORT

• Inverse relationship between audit risk and
  materiality
• Low audit risk suggests it would take larger
  amounts to be material
• Inverse relationship between materiality and
  audit effort (hours worked)
• Higher materiality threshold suggests less audit
  effort

45
QUANTITATIVE MATERIALITY CRITERIA

• Effect on
• Net income
• Total assets
• Total revenue

46
SAS 99 ON MATERIALITY

• Auditors should
• Not rely solely on quantitative materiality
  criteria
• Judge materiality of misstatements both
  individually in aggregate
• Recognize that intentional but immaterial
  misstatements are inappropriate may be unlawful

47
QUALITATIVE MATERIALITY CONSIDERATIONS

• Misstatement may not be immaterial if
• Affects debt compliance requirements
• Masks change in earnings
• Conceals unlawful transaction
• Prompts undue expectations
• Hides failure to meet analysts expectations
• Associated with an estimate
• Affects managements compensation

48
ALLOCATING PRELIMINARY MATERIALITY ESTIMATES

• On the basis of
• Relative magnitude of financial statement
  accounts
• Relative variability of financial statement
  accounts
• Professional judgment