johnstone 9e auditing chapter5 pptfinal

A U D I T I N GA RISK-BASED APPROACH TO

CONDUCTING A QUALITY AUDIT

9th Edition

Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg

Copyright © 2014 South-Western/Cengage Learning

Chapter 5Professional Auditing Standards and the Audit

Opinion Formulation Process

Copyright © 2014 South-Western/Cengage Learning 5-2

Learning Objectives

1. Identify and compare the various auditing standards that provide guidance on the audit opinion formulation process

2. List and discuss the foundational principles underlying the auditing standards

3. List the phases and related activities in the audit opinion formulation process

4. Explain the concept of accounting cycles and discuss their importance to the audit opinion formulation process


Learning Objectives

5. Describe the assertions that are inherent to financial statements and explain their importance to the audit opinion formulation process

6. Define audit evidence and describe the purpose and types of audit procedures used to obtain audit evidence

7. Discuss the importance of audit documentation and provide examples

8. Discuss audit activities in Phase I of the audit opinion formulation process


Learning Objectives

9. Discuss audit activities in Phase II of the audit opinion formulation process

10. Discuss audit activities in Phase III of the audit opinion formulation process

11. Discuss audit activities in Phase IV of the audit opinion formulation process

12. Discuss audit activities in Phase V of the audit opinion formulation process


Learning Objectives

13. Apply the concepts related to the auditor’s assessment of internal control design effectiveness, implementation, and operating effectiveness

14. Apply the frameworks for professional decision making and ethical decision making to issues involving conducting an audit


THE AUDIT OPINION FORMULATION PROCESS


PROFESSIONAL JUDGMENT IN CONTEXT - Importance of Adhering to Professional Auditing Standards

• Adhering to the professional auditing standards is viewed as conducting a quality audit• Lack of adherence heightens the risk of issuing an

unqualified audit opinion on financial statements that are materially misstated• Highlighted in the 2004-2006 audits of Thornton

Precision Components, Limited (TPC) performed by Ernst & Young, LLP UK (E&Y UK)



• What is the role of auditing standards and their underlying principles in promoting a quality audit? (LO 1, 2)• How does the fundamental concept of professional

skepticism relate to audit quality? (LO 2)• What audit evidence is necessary for opining on a

client’s financial statements? (LO 6)• How does audit documentation provide evidence

related to audit quality? (LO 7)



• What audit activities are conducted during the audit opinion formulation process to provide reasonable assurance about a client’s financial statements? (LO 8, 9, 10, 11, 12)• How does professional judgment and ethical decision

making contribute to audit quality? (LO 14)


Identify and Compare the Various Auditing Standards that Provide Guidance on the Audit

Opinion Formulation Process

Learning Objective 1


Professional Auditing Standards

• Auditors in the United States follow auditing guidance issued by:• American Institute of Certified Public Accountants

(AICPA) • Public Company Accounting Oversight Board (PCAOB) • International Auditing and Assurance Standards Board

(IAASB)• Common objective - Provide assurance to public that

audits are conducted in a quality manner


Professional Auditing Standards

• Require auditors to develop and communicate:• Opinion on financial statements• Client’s internal control over financial reporting

• Vary according to the nature of organization audited• Audit compliance depends on:• Domicile of the organization• Where its stock is publicly traded


AICPA’S AUDITING STANDARDS BOARD - CLARITY PROJECT

• Made standards easier to read, understand, and apply• Converged its standards with the International

Standards on Auditing (ISAs), issued by the IAASB• Standards were written using drafting convention

called the clarity format• Issued the clarified standards in a single Statement

on Auditing Standard (SAS No. 122) in 2012


Each standard of Clarity format presented in following sections

•Purpose and scope of the standardIntroduction

•Context in which the requirements are setObjective

•Relevant meanings of terms in standardsDefinitions

•Actions required to achieve objective of the standard

Requirements

•Cross-references to the requirements•Guidance for applying requirements of standard

Application and other explanatory material


Auditing Standards Issued by the IAASB

• Objectives• Set auditing, assurance, and other related standards• Facilitate convergence of international and national

auditing and assurance standards• Enhance quality and consistency of practice throughout

the world• Strengthen public confidence in the global auditing and

assurance profession


Auditing Standards Issued by the IAASB

• Standards should to be understandable, clear, and consistent• Launched a program in 2004 to enhance clarity of its

ISAs• Clarity Project was completed in 2009• As of 2013, a set of its clarified standards comprises

of:• 36 ISAs • 1 International Standard on Quality Control (ISQC)


Each standard of Clarity format presented in following sections

•Purpose and scope of subject matter of ISAIntroduction

•Clear statement of the objective of the auditor

Objective

•For applicable terms includedDefinitions

• For each objective are provided

Requirements

•Explains what a requirement means or intends to cover

Application and other explanatory material


Auditing Standards Issued by the PCAOB

• Apply to auditors of U.S. public companies• Issued sixteen Auditing Standards (ASs) as of 2013• PCAOB interim standards - Standards adopted from

AICPA • Requirement for public company auditors, unless

superseded by a PCAOB standard• Standards issued by AICPA after April 16, 2003, not

included


Exhibit 5.1 - Comparison of U.S. and International Auditing Standards


List and Discuss the Foundational Principles Underlying the Auditing Standards



PCAOB Guidance - General standards

• Require• Audit to be performed by individuals having adequate

technical training and proficiency as an auditor• Auditors to be independent: • In fact, i.e., in reality in terms of mental attitude and• In appearance, i.e., in how the auditor is perceived by

users• Audit to be conducted with professional care expected

of a prudent auditor


PCAOB Guidance - Fieldwork standards

• Applicable to conduct of the audit• Require auditors to:• Properly plan and supervise the audit• Develop an understanding of client’s controls • Prerequisite for developing audit tests

• Obtain audit evidence by performing audit procedures


PCAOB Guidance - Reporting standards

• Applicable to communicating auditor’s opinion• Require auditors to:• State whether financial statements are presented in

accordance with the applicable financial reporting framework (i.e., GAAP or IFRS)

• Identify conditions where accounting principles are not consistently observed

• Review disclosures for adequacy and state in the report if disclosures are not reasonably adequate

• Express an opinion on financial statements as a whole or state that an opinion cannot be expressed


AICPA Guidance - Purpose and premise of audit

• Purpose - Enhance degree of confidence that users can place in financial statement• Premise - Management has responsibility to:• Prepare financial statements• Maintain internal control over financial reporting• Provide auditor with relevant information and access

to personnel


AICPA Guidance - Responsibilities

• The auditor’s responsibilities include• Having appropriate competence and capabilities to

perform audit• Complying with ethical requirements• Maintaining professional skepticism throughout the

audit


AICPA Guidance - Performance

• Obtain assurance that financial statements are free from material misstatement• Limitations - Lack of absolute assurance about financial

statements being free from misstatement• Requires an auditor to:• Plan and supervise work• Determine materiality levels• Identify risks of material misstatement• Design and implement audit responses to assessed risks


AICPA Guidance - Reporting

• Expressing either of the following• Financial statements are free of material misstatement• Stating that an opinion cannot be expressed


Integrated audit

• Combines audits of an organization’s financial statements and its internal control over financial reporting• In this audit:• Opinion provided on effectiveness of internal control

over financial reporting• Additional audit work done to be able to issue that

opinion


Auditing in Practice - Benefits of Integrating the Audits

• Integrating audits of internal controls and of financial statements makes sense • Both the tests of controls and direct tests of account

balances provide evidence related to each other• Example:• Tests of controls provide indirect evidence that financial

statements are free from misstatement• Further, if material misstatements found in account

balances or disclosures, it implies that there were material weaknesses in internal controls


List the Phases and Related Activities in the Audit Opinion Formulation Process



EXHIBIT 5.2 - OVERVIEW OF CLIENT’S PREPARATION OF FINANCIAL STATEMENTS AND MANAGEMENT REPORT ON

INTERNAL CONTROL


Exhibit 5.3 - Activities of each Phase of the Audit Opinion Formulation Process


Important Concepts Affecting Audit Opinion Formulation Process

• Accounting cycles• Management assertions• Audit evidence and audit procedures• Documentation


Explain the Concept of Accounting Cycles and Discuss Their Importance to the Audit Opinion

Formulation Process



Accounting Cycles

• Recording and processing transactions that affect a group of related accounts• Begin when a transaction occurs and ends when it is

recorded in financial statements• Break the audit into manageable sections of related

accounts


Accounting Cycles

• Auditor focuses on:• Flow of transactions within a particular cycle• Identifying: • Points where material misstatement can occur • Controls that have been designed and implemented to

mitigate those risks• Understanding risks and controls within each cycle• Helps determine specific audit procedures to be used and

specific audit evidence to be obtained


Exhibit 5.4 - Illustrations of Cycles and Related Accounts


Describe the Assertions that Are Inherent to Financial Statements and Explain Their Importance to the

Audit Opinion Formulation Process



Financial Statement Assertions

• Assertions made by management• Existence• Completeness• Rights and obligations• Valuation• Presentation and disclosure

• Related evidence is obtained for accounts and disclosure in financial statements


MANAGEMENT’S FINANCIAL STATEMENT ASSERTIONS IN PCAOB STANDARDS


Define Audit Evidence and Describe the Purpose and Types of Audit Procedures Used to Obtain

Audit Evidence



Audit Evidence and Procedures

• Audit evidence: Information used by auditor in arriving at conclusions on which the opinion is based• Audit procedures: Procedures designed to obtain

audit evidence to support audit opinion(s)• Risk assessment procedures• Provide information for assessing the risks of material

misstatement in the financial statements• Do not provide sufficient evidence upon which to base an

audit opinion• Used for purposes of planning the audit


Audit Evidence and Procedures

• Tests of controls: Designed for evaluating operating effectiveness of controls in preventing, or detecting and correcting, material misstatements, typically at assertion level• Substantive procedures• Designed for detecting material misstatements at

assertion level• Comprising of tests of details and substantive

analytical procedures


Audit Procedures

• Sufficient appropriate audit evidence: Measure of the quantity of audit evidence about following factors of audit procedures• Nature• Timing• Extent

• Audit program• Lists audit procedures to be followed in gathering

evidence • Helps monitor progress and supervising work


Exhibit 5.6 - Types of Audit Procedures


Discuss the Importance of Audit Documentation and Provide Examples



Audit Documentation

• Record of audit procedures performed, relevant audit evidence obtained, and conclusions the auditor reached• Known as working papers or workpapers


Purposes of Audit Documentation

• Assisting engagement team in: • Planning and performing audit• Supervising and reviewing audit work

• Retaining a record of matters of continuing significance to future audits• Enabling internal or external inspections of

completed audits• Assisting auditors in understanding work performed

in prior year


Examples of Audit Documentation

• Audit programs• Analyses prepared by client or auditor• Memorandums• Summaries of significant findings or issues• Letters of confirmation and representation• Checklists• Correspondence concerning significant findings or

issues


Discuss Audit Activities in Phase I of the Audit Opinion Formulation Process



Phase I - Making Client Acceptance and Continuance Decisions

• Preconditions for accepting auditing engagements• Use of an acceptable financial reporting framework• Agreement of management to acknowledge and

understand its responsibilities


Auditing in Practice - Accepting a New Audit Engagement

• Communicate with predecessor auditor• Following issues should be addressed• Information regarding integrity of management• Disagreements with management about accounting

policies, auditing procedures• Communications to management and those in charge

with governance regarding: • Fraud and noncompliance with laws• Deficiencies and material weaknesses in internal control


Audit Engagement Letter

• Document specifying responsibilities of client and auditor that includes the following:• Objective and scope of audit of financial statements• Responsibilities of auditor and management• Statement that some material misstatements may not be

detected due to inherent limitations of audit and internal control

• Identification of applicable financial reporting framework for preparation of financial statements

• Reference to expected form and content of any reports to be issued


Discuss Audit Activities in Phase II of the Audit Opinion Formulation Process



Phase II - Performing Risk Assessment

• Identifying relevant risks and determining audit procedures required to address them• Continuing clients - Update information from

previous year’s audit• New clients - the risk assessment process is more

time consuming


Identifying and Assessing Risks of Material Misstatement

• Essential to audit planning• Requires identification of significant:• Accounts• Disclosures• Relevant assertions

• Auditor establishes a materiality level overall and for specific accounts and disclosures


EXHIBIT 5.7 - Examples of Sources of Risk of Material Misstatement


Risks at assertion level

• Inherent risk• The susceptibility of an assertion to a misstatement, due to

error or fraud, that could be material, individually or in combination with other misstatements, before consideration of any related controls

• Control risk• The risk that a misstatement due to error or fraud that

could occur in an assertion and that could be material, individually or in combination with other misstatements, will not be prevented or detected on a timely basis by the organization's internal control


Risk assessment procedures

• Inquiries for information to assist in identifying risks of material misstatement due to fraud or error• Preliminary analytical procedures• Observation and inspection of documentation


Types of controls

• Entity-wide controls • Transaction controls • Fraud-related controls


Auditing in Practice - Controls to Address Fraud Risk

• PCAOB has identified the following• Controls over significant, unusual transactions, particularly

those resulting in unusual journal entries• Controls over journal entries and adjustments made in the

period-end financial reporting process• Controls over related-party transactions• Controls related to significant management estimates• Controls mitigating incentives for, and pressures on,

management to falsify financial results


types of procedures toassess design effectiveness

• Inquiry of appropriate personnel • Observation of the organization’s operations• Inspection of relevant documentation• Performance of walkthroughs• Documentation of preliminary assessment of control

design and basis for that assessment• Understand the approach used by management for

conclusions on effectiveness of internal control


AUDITING IN PRACTICE - DOCUMENTING AUDITOR’S UNDERSTANDING OF AN ORGANIZATION’S INTERNAL

CONTROLS

• Process of documentation uses:• Narratives • Flowcharts• Questionnaires

• Once documented, in subsequent years audit firms focus on:• Changes in the system • Effectiveness of monitoring controls


Assessing range of control risk

• High control risk• Weak internal controls• Auditor cannot rely on controls to reduce substantive

procedures for account balances• Assessing control risk as low• Strong internal controls• Auditor will test operating effectiveness of controls to

reduce substantive procedures for account balances


AUDITING IN PRACTICE – EXAMPLE FOR WEAK INTERNAL CONTROL DESIGN AND LINKS TO SUBSTANTIVE AUDIT

PROCEDURES

• Scenario - Client’s internal control design assessed as ineffective that makes a preliminary assessment of control risk as high• Requires expanding substantive tests for sales

returns by:• Arranging to be on hand at year end to observe the

taking of physical inventory• Determining if receipts for items returned by

customers are issued in the correct time period


AUDITING IN PRACTICE – EXAMPLE FOR WEAK INTERNAL CONTROL DESIGN AND LINKS TO SUBSTANTIVE AUDIT

PROCEDURES

• Reviewing credit memos issued shortly after year end• Increasing number of accounts receivable

confirmations sent to the client’s customers


Additional Considerations for an Integrated Audit

• Risk assessment procedures apply to:• Audit of internal control over financial reporting • Audit of financial statements

• Top-down approach - Used for audit of internal control over financial reporting to select controls to test• Begins at financial statement level• Focuses on entity-wide controls• Works down to significant accounts and disclosures and

their relevant assertions


Responding to Identified Risks of Material Misstatement

• Purpose of risk assessment procedures• Identify risks of material misstatement• Determine where misstatements in financial

statements may occur• Design appropriate audit strategy

• Controls reliance audit: Includes tests of controls and substantive procedures• Substantive audit: Includes substantive procedures

and does not include tests of controls


Responding to Identified Risks of Material Misstatement

• Selecting specific audit procedures to respond to identified risks• Assembling an audit team having knowledge, skill,

and ability needed to address assessed risks• Emphasizing the need for professional skepticism• Providing an appropriate level of supervision for

assessed risks • Incorporating elements of unpredictability in

selection of audit procedures


EXHIBIT 5.8 - Responding to Identified Risks through Evidence Decisions


Additional Considerations for an Integrated Audit

• Audit strategy that includes tests of controls to accomplish objectives of both audits• Sufficient evidence related to operating effectiveness

of controls to support auditors:• Control risk assessments for purposes of the audit of

financial statements• Opinion on internal control over financial reporting as

of year-end


Fraud Considerations

• Performing tests of controls and substantive procedures susceptible to fraud risks• Performing procedures related to risk of

management override of controls• Examining journal entries• Reviewing accounting estimates for biases• Evaluating business rationale for significant unusual

transactions


Discuss audit activities in Phase III of the audit opinion formulation process



PHASE III - Obtaining Evidence about Internal Control Operating Effectiveness

• Auditor tests controls • Determine whether controls are operating effectively

at year-end or throughout the year• Auditor obtains more persuasive audit evidence• As the reliance auditor places on effectiveness of a

control increases


Auditing in Practice - Risk Assessment Procedures and Tests of Operating Effectiveness of Controls

• Auditor’s risk assessment procedures include• Inquiring about management’s use of budgets• Inspecting documentation of management’s

comparison of monthly budgeted and actual expenses• Inspecting reports pertaining to the investigation of

variances between budgeted and actual amounts


Selecting Controls to Test

• Involves choosing controls that effectively indicate capability to address the assessed risk of material misstatement for relevant assertions• Auditor selects:• Entity-wide controls• Reduce number of control activities selected for testing

• Transaction controls


EXHIBIT 5.9 - Linking Financial Statement Assertions and Selecting Controls to Test


Types of Controls and Examples of Concepts Affecting Control Testing



Authorizations

Reconciliations

Reviews for unusual transactions


First Approach to Testing Controls

• Take sample of customer orders and trace it through the system to determine whether: • There was proper review of credit and • Credit authorization or denial was proper

• Advantage - Most effective because it helps in determining that the control worked effectively• Requires documentation of all credit applications and

purchase orders required• Based on audit sampling


Second Approach to Testing Controls

• Taking a sample of recorded items and tracing back to credit approval process • Provides evidence on proper credit approval for all

items presently recorded• Does not provide evidence as to whether other items

should have been approved for credit, but had not been approved


Third Approach to Testing Controls

• Uses a computer audit program and develops a print-out of account balances exceeding their credit authorization• Cost-effective• Requires an inference about the control• Covers only the operation of the controls related to

the current account balances• 100% evaluation of each item currently recorded


Testing the Operating Effectiveness

• Auditor tests relevant principles of components of:• Control environment • Risk assessment• Information and communication • Monitoring


Results of Tests of Controls For financial statement audit

• If control deficiencies are identified• Assess them to determine whether preliminary control risk

assessment should be modified• Record the implications for substantive procedures

• If no control deficiencies are identified• Assess whether preliminary control risk assessment is still

appropriate• Determine extent that controls can provide evidence on

accuracy of account balances• Determine planned substantive audit procedures


Results of Tests of Controls For financial statement audit

• Determine how much assurance about reliability of account balances can be obtained from the effective operation of controls• Within any audit, level of assurance will vary across:• Accounts • Disclosures• Assertions


Discuss audit activities in Phase IV of the audit opinion formulation process



Phase IV - Obtaining Substantive Evidence about Accounts, Disclosures, and Assertions

• Substantive procedures include:• Substantive analytical procedures • Tests of details of account balances

• Considerations in determining appropriate substantive procedures:• Source of potential misstatement• Extent and type of potential misstatement


EXHIBIT 5.12 - Factors Affecting Substantive Procedures to be Performed


Discuss audit activities in Phase V of the audit opinion formulation process



Phase V - Completing the Audit and Making Reporting Decisions

• Completing various review and communication activities• Making a decision about what types of opinions

should be issued• Deciding on the appropriate opinion to be issued• It can be based on financial statements and internal

control• It can be issued in one report or in two separate

reports


APPLY THE CONCEPTS RELATED TO THE AUDITOR’S ASSESSMENT OF INTERNAL CONTROL DESIGN

EFFECTIVENESS, IMPLEMENTATION, AND OPERATING EFFECTIVENESS



Management Assessment of Controls

• Factors considered in deciding whether to categorize a deficiency as significant or not• Risk that is being mitigated and whether other controls

operate effectively • Materiality of related account balances• Nature of deficiency• Volume of transactions affected• Subjectivity of account balance that is subject to control• Rate at which control fails to operate



• Deficiency of segregation of duties• Did not rise to a significant deficiency or a material

weakness• Management decides to use this deficiency as a

motivation to centralize purchases



• Deficiency of lack of approval considered as a significant deficiency based on the following rationale:• Major departure from an approved process• Could lead to purchase of unauthorized goods• Could be shipped elsewhere and lead to material

misstatement in financial statements


Auditor Assessment of Controls

• Auditor reviews:• Management’s documentation of its internal control• Management’s evaluation and findings related to

internal control effectiveness• Auditor then gathers evidence on operating

effectiveness of these controls• By taking a random sample auditor needs to

independently determine that the controls are working or not


Auditor Assessment of Controls

• Implications for substantive procedures in financial statement audit:• Auditor will do limited testing of inventory quantities

at year end• Auditor will assess year-end inventory for potential

obsolescence• Auditor will continue to examine all adjusting entries at

the end of the year

johnstone 9e auditing chapter5 pptfinal

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