AUDITINGCHAPTER 2Standards, Materiality, & RiskByDavid N. Ricchiute

GBW Ch. 2 8th ed2

TOPICS

Audit & Attestation standardsAuditing conceptsAudit riskMateriality in financial statement audit

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EARLY DEVELOPMENT OF STANDARDS

1941 Accounting Series Release (ASR)#21 SEC requires audit report Audit conducted in accordance with

generally accepted standards1948 AICPA approves generally accepted auditing standards (GAAS)

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RECENT DEVELOPMENT OF STANDARDS

1970s practitioners criticized GAAS as not sufficiently specific1986 Attestation standards developed Umbrella for engagement standards GAAS applies exclusively to financial

statement audits

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COMPARING GAAS & ATTESTATIONAttestation GAASBroad range of engagementsincluding audit

Financial statement audit

Umbrella for all attest services

Audit one of many attest engagements

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GENERAL STANDARDSAttestation GAAS

Adequate technical training Adequate technical training

Adequate knowledgeAssertion can be evaluated by reasonable criteria & consistently measured or estimatedIndependence in mental attitude

Independence in mental attitude

Due professional care Due professional care

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FIELDWORK STANDARDSAttestation GAAS

Adequately planned & supervised

Adequately planned & supervisedUnderstanding internal control

Sufficient evidence Sufficient competent evidential matter

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REPORTING STANDARDSAttestation GAAS

Assertion identifiedConclusion about conformity with established criteriaState significant reservations

Conclusion about conformity with GAAPConsistent use of GAAPAdequate informative disclosures

Limited use to parties agreeing on procedures

Opinion on statements as a whole

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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

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AUDITING CONCEPTSIndependenceDue careEvidenceReporting

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INDEPENDENCE EXPLAINED

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

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CONSULTING & PUBLIC COMPANY ENGAGEMENTS 2000

… consulting & other services may shorten the distance between the auditor & management. Independence—if not in fact, then certainly in appearance—becomes 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.

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SEC PUBLIC COMPANIES INDEPENDENCE REFORMS 2000

Engagement team model of independence Team & immediate family prohibited from

investments in clientsIncreased restrictions for IT and internal audit consultingRequired disclosure audit/nonaudit fees in proxy statement

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SARBANES-OXLEY, & INDEPENDENCE 2002

Establishes PCAOBAddresses accountability for corporate & criminal fraudLimits audit firm’s consulting services to public company clientsClient board of directors to approve consulting services provided by auditor

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SERVICES PROHIBITED BY SARBANES-OXLEY

For public companies:Bookkeeping, other accounting servicesInformation systems design, implementationValuation or appraisal servicesActuarial servicesInternal audit outsourcing servicesManagement functions, human resourcesBroker, dealer, investment advisorLegal, expert servicesOther services to be determined

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SEC, INDEPENDENCE, & PUBLIC COMPANIES 2003

Further independence regulations Rotate engagement partner 5-7 years Restrict firm’s independence for 1 year

when client hires member of audit team Violates independence if auditor’s

compensation based on selling service other than attest

Require auditor report certain matters to client’s audit committee Critical accounting policies

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DUE CARE EXPLAINED

Care when providing professional servicesAdequate training for professional services

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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

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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 GAAPAuditor knew but did not challenge

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DUE CARE &PRUDENT PRACTITIONER

Foresee unreasonable risk to othersAttend to extra risksConsider unusual circumstances or relationshipsIdentify unfamiliar situation & take precautionsResolve doubtKeep currentReview work of assistants

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DUE CARE OPERATIONALIZED

Auditor obtains knowledge of business to understand events, transactions, practices with significant effect on financial statementsPlan audit to limit audit risk to low levelAssess possible errors on balance sheet

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EVIDENCE EXPLAINED

Underlying accounting data Journals, ledgers,

reconciliations, accounting manuals

Corroborating information Receiving reports, invoices,

contracts, representations from 3rd parties

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EVIDENCE

Basis for all decisions Evidential matter Planning & supervision Internal control

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EVIDENCE: SUFFICIENCY & COMPETENCE

Sufficiency Quantity useful evidence collected at

reasonable costCompetence Validity: varies with source Relevance: related to assertion

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EVIDENCE HIERARCHY

Independent sources more reliable than management

Banks, debtorsEvidence obtained directly more persuasive than indirect evidence from management

Physical examination, observation, computation, inspection

Effective internal control systems produce more reliable evidence

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PLANNING & SUPERVISION EXPLAINED

Planning Developing objectives & strategySupervision Directing assistants toward objectives Determining when objectives are met

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INTERNAL CONTROL

Policies & procedures of management & board of directorsProvides reasonable assurance their objectives will be achievedAuditor must understand client’s internal controls To plan audit To design audit tests

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REPORTING EXPLAINED

Report states conclusion Attestation report

Whether management’s assertion conforms with stated criteria

Audit report Whether financial statements conform

to GAAP

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AUDIT REPORT CONCLUSIONIn 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.

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STRATEGY FOR RISK

Risk of omissions or misstatementsDesign engagement to control material omissions or misstatementsProvide reasonable not absolute assurance of detecting omissions or misstatements

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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.

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AUDIT RISK

Probability that auditor may unknowingly fail to modify opinion on financial statements that are materially misstated

D. N. Ricchiute, Auditing, 8th ed.

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COMPONENTS OF AUDIT RISK

Client sources of risk Inherent risk Control riskAuditor source of risk Detection risk

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COMPONENTS OF AUDIT RISK DEFINED

Inherent risk Risk that errors will occur

Control risk Risk that internal controls won’t prevent,

detect, correct errorsDetection risk Risk that audit procedures won’t find

errors

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INHERENT RISK SOURCESRisk that errors will occur

BusinessIndustryManagement’s predisposition to manage earningsAggressive use of GAAPSpecific accounts Liquid assets vs. nonliquid assets

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CONTROL RISK SOURCES

Risk that internal controls won’t prevent, detect, correct errorsOutdated technologyOutdated softwareLack of respect for controls by top management

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DETECTION RISK SOURCESLikelihood that errors could occur

and not be detected by audit proceduresNature of audit proceduresExtent of audit proceduresTiming of audit proceduresAuditor’s judgment

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AUDIT RISK MODEL:SAS No. 47

AR = IR x CR x DR

DR = AR IR x CR

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AUDITOR’S BUSINESS RISKThe probability that a practitioner

might incur damages despite issuing an appropriate report Ex.: litigation

Factors affecting auditor’s business risk Aggressive financial reporting Management integrity or reputation Conflicts of interest & regulatory

problems Industry characteristics

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AUDITOR’S 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

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AUDIT FAILURE DEFINED

Failing to perform procedures that would reduce audit risk to a relatively low level Ex.: SunbeamSunbeam’s 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

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MATERIALITYThe 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.

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MATERIALITY IN PRACTICE

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

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AUDIT RISK, MATERIALITY, AUDIT EFFORT

Inverse relationship between audit risk and materiality Low audit risk suggests it would take

larger amounts to be materialInverse relationship between materiality and audit effort (hours worked) Higher materiality threshold suggests less

audit effort

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QUANTITATIVE MATERIALITY CRITERIA

Effect on Net income Total assets Total revenue

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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

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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 management’s compensation

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ALLOCATING PRELIMINARY MATERIALITY ESTIMATES

On the basis of Relative magnitude of financial

statement accounts Relative variability of financial

statement accounts Professional judgment