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Audit (Internal control (Management Objectives with Respect to I/C…

- - - - Independence in fact is a mental state and is difficult to prove.
      - Independence in appearance is governed by legislation and rules of professional conduct.
  - - - Familiarity Threat
        
        Definition: Occurs when it is difficult to behave with professional skepticism during the engagement.
        
        There is a long association of senior staff with the client (e.g. being on the engagement for ten years).
        
        A former partner of the firm is now the chief financial officer of the client.
        
        Cooling off period if you are leaving to work for client
        Cannot date your client
      - Intimidation Threat
        
        Definition: The client intimidates the firm or staff with respect to the content of the financial statements or with respect to the conduct of the audit.
        
        The client threatens to replace the audit firm over a disclosure disagreement.
        
        The client places a maximum upon the audit fee that is unrealistic with respect to the amount of work that needs to be completed.
      - Advocacy Threat
        
        Definition: When the firm or member is perceived to promote (or actually does promote) the client’s position.
        
        PA is acting as an advocate in resolving a dispute with a major creditor of the client.
        
        The firm or PA is promoting the sale of shares or other securities for the client, or is receiving a commission for such sales.
      - Self interest Threat
        
        Definition: When the member has a financial interest in the client or in the financial results of the client.
        
        An auditor’s independence is deemed to be impaired if they borrow from a client.
        
        A member of the firm owns shares in the client
        
        The client fees are significant in relation to the total fee base of the PA or of the firm
      - Self-review Threat
        
        PA prepared original data or records for the client as part of a bookkeeping engagement.
        
        PA designed and implemented an accounting information system used to process client records. (consulting services)
        
        Definition: When the PA is placed in the position of having to audit his or her own work during the audit.
- - - - Only by choosing to belong do they become subject to the rules.
      - The institutes have a responsibility to investigate all complaints.
- - - - Obtain and review financial information.
      - Inquire of third parties.
      - Communicate with the predecessor auditor
      - Consider unusual business or audit risks.
      - Determine if the firm is independent.
      - Determine if the firm has the necessary skills and knowledge (competence).
      - Will acceptance violates any of the Code of Professional Conduct?
  - - - It helps to assess the risk that F/S might contain material misstatements.
      - Used to establish an overall audit strategy, design the audit plan and audit programs.
    - - Gain an understanding of the client
      - Set materiality
      - Understand I/C
      - Develop an audit strategy
  - - - developments in taxation and regulation
      - specific industry characteristics
      - geographic location
      - national economic condition and policies
      - Why:
        
        It may impact the client’s ability in the future
        
        e.g. Your client may buy from the States that may be tax-free…
    - - Identify related parties
        
        Identify and quantify transaction
        
        GAAP requires we disclose the related parties and related party transactions
        
        Identify parties
        
        Tax purpose: parent and subsidiary are related for audit purpose (parent company may want to move its profit to a sub in a lower-tax-rate country)
        
        From an audit perspective, non-arm-length/related parties transactions (influencers transactions) need to be identified
        
        e.g. Chairman of a business has some control, he/she might push the entity to buy his/her land
      - Conduct preliminary analytical procedures
        （3 times during auditing）
      - Assess the possibility of illegal acts （examples: - environmental waste）
      - Document audit strategy and plan and prepare audit programs
      - Assess the need for specialist
    - - The objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and assertion levels, through understanding the entity and its environment, including the entity's internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement
    - - the risk resulting from significant conditions, events, circumstances, action or inaction that could adversely affect the entities ability to achieve their objectives and execute their strategy or from setting inappropriate objectives and strategies.
        CAS 315.4(b)
  - - - By understanding the client’s business and identifying where errors are likely to occur, the auditor can allocate more resources to investigate necessary accounts
    - - Compare current balances with company’s anticipated results.
      - Compare current balances and financial relationships with industry. (doing better than the industry is not risk-free, the company may manipulate, ask why they are doing better)
      - Evaluate the relationships between current balances for conformity to predictable patterns. (turn-over, growth margin)
      - Compare current with prior year(s) balances.
      - Evaluate the relationships of current balances to nonfinancial info
    - - Analysis of the draft statements may show relationships that do not make sense.
        
        Indicates problem areas where misstatements may exist.
        
        The analysis of the draft statements is attention directing.
- - - - Tthe lower the acceptable audit risk, the greater the certainty that the auditors want to achieve --- the more work(evidence) we do, the higher expense
      - The more user, the lower risk we are going to set
    - - Gather more evidence can help auditors reduce achieved audit risk
    - - Audit risk will occur when:
        
        internal controls fail to detect or correct the misstatement (control risk) #
        
        The risk that the client’s internal control system will not prevent or detect a material misstatement is CR.
        
        Auditors do not create or control CR; they simply evaluate or assess probability of failure to detect material misstatements.
        
        This assessment of effectiveness may be tested by the auditor in the audit.
        
        Assessment is based on study and evaluation of the company’s control system.
        
        audit procedures also fail to detect the misstatement (detection risk).
        
        The risk that any material misstatement that has not been corrected by the client’s internal control will not be detected by the auditor is DR.
        
        Auditors can control this risk by conducting substantive (balance audit) tests.
        #
        
        Substantive tests include audit of details of transactions and balances, and analytical procedures applied to dollar amounts in the accounts.
        
        Why does detection risk exist? (2-4 non sampling risk)
        
        the auditor may select ineffective audit procedures
        ( Inappropriate audit procedure)
        
        the auditor may apply procedures ineffectively
        (Fail to detect when using  appropriate audit procedure)
        
        the auditor samples (sampling risk)
        
        the auditor may incorrectly evaluate the results of procedures
        (Misinterpreting audit results)
        
        a material misstatement has been made in the transactions or balances (inherent risk)
        
        The probability of material misstatement occurring in transactions entering the accounting system or being in the account balances is inherent risk.
        
        Auditors do not create or control IR.
        
        Auditors only try to assess its magnitude based on prior experience, management bias, and nature of the transactions.
        
        The auditor will consider the characteristics of the client’s business, types of transactions, and effectiveness of accountants.
        
        Inherent risk considerations
        
        nature of client’s business
        
        integrity of management
        
        client motivation to misstate the F/S
        
        results of previous audits
        
        initial vs. repeat engagements
        
        related parties
        
        non-routine transactions (estimates)
        
        judgment required to correctly record transactions
        
        susceptibility to defalcation
        
        makeup of the population
        
        Nature of the Data processing system
      - AR = IR × CR × DR
        Auditors usually like to limit audit risk to less than 5%.
      - Audit Risk = RMM × DR
        
        AR: Set by auditor at acceptable level before audit planning is done
        
        Risk of material misstatements includes inherent risk & control risk; Auditor assesses but has no control over these risks
        
        Detection risk:  Risk that auditor will not detect misstatements; Auditor designs audit procedures to reduce this to a level that results in AR which is below the acceptable level
  - - - Materiality is the largest amount of uncorrected misstatement that might exist in F/S that still fairly present the company’s financial position and results of operations.
      - Information is material and should be disclosed if it is likely to influence the economic decisions of F/S users.
        - Focus on users of the F/S
    - - Materiality is both a quantitative and a qualitative judgment.
        
        Small misstatements may be material in some cases - such as …?
        
        Small misstatement are also considered material - if they …?
        
        Quantitative
        
        Auditors are generally left without definite, quantitative guidelines to determine materiality.
        
        Quantitative guidelines:
        
        5% to10% of normalized income from continuing operations,
        
        ½ to 2% of revenues or expenses for non-for profit entities,
        
        ½ to 1% of net asset value for the mutual fund industry,
        
        1% of revenue for the real estate industry
        
        Common Materiality Bases
        
        For-profit entities
        
        Total assets or revenues (1/2% to 2%)
        
        Gross profit (1/2%-5%)
        
        Normalized income from continuing operations before tax (5%-10%) [not net income]
        
        Not-for-profit entities
        
        Total revenues or total expenses (1/2% to 2%)
        
        Total assets (1/2% to 2%)
        
        Qualitative
        (Should consider)
        
        User related factors
        
        Nature of the item or issue
        
        Other circumstances
        
        Effect on share price
- - - - Occurrence
      - Completeness
      - Cut-off
      - Accuracy
      - Classification
    - - Accuracy
      - Classification
      - Valuation
      - Rights (to assets) and Obligations (for liabilities)
      - Completeness
      - Occurrence
      - Understandability
    - - Valuation and Allocation
      - Rights (to assets) and Obligations (for liabilities)
      - Completeness
      - Existence
    - - Rights and Obligations: entity holds or controls the rights to assets and is obligated to pay liabilities
      - Valuation and Allocation: ALE and any valuation or allocation adjustments are recorded in FS at appropriate amounts
      - Completeness: all transactions, events, ALE, and disclosures that should have been recorded for the period have been recorded
        #
      - Accuracy: transactions, events and other information are recorded or disclosed fairly and at appropriate amounts
        #
      - Occurrence: recorded or disclosed transactions and events have occurred and pertain to the entity
        #
      - Cutoff: transactions and events have been recorded in the correct accounting period
        #
      - Existence: Assets, liabilities, and equity (ALE) recorded at year-end actually exist
      - Classification and Understandability: transactions and events have been recorded in proper accounts; financial information is appropriately presented and described in FS and notes; information disclosed in notes is clearly expressed
        #
  - - - Senior management lacks integrity
      - Management has low regard for sound controls over financial reporting
      - Close to missing analysts’ earnings target
      - Economic downturn has significantly hampered business
      - Close to violating current ratio debt covenant
      - Management to buy out existing shareholders
    - - A/P clerk is incompetent and not supervised
        
        A/P
        
        Existence, Completeness, Obligations, Valuation
      - Warehouse manager has a gambling problem
        
        Inventory
        
        Existence
      - Employee responsible for inventory count shows up drunk
        
        Inventory
        
        Existence, Completeness, Rights
      - A competitor has begun selling a more advanced version of a popular product
        
        Inventory
        
        Valuation
      - Credit manager on sick leave for two months but no one assigned to job in their absence
        
        A/R
        
        Valuation
- - - - Opinions on Accuracy
        
        SAAE
      - Opinions on Completeness
        
        SAAE
      - Opinions on Cut-off
        
        SAAE
      - Opinions on Classification
        
        SAAE
      - Opinions on Occurence
        
        SAAE
    - - Opinions on Rights
        
        SAAE
      - Opinions on Completeness
        
        SAAE
      - Opinions on Valuation
        
        SAAE
      - Opinions on Existence
        
        SAAE = which includes the evidence used to identify and assess the RMM for the assertion and the evidence gathered to support an opinion on whether violations of the assertion have caused MM in the account
- - - - Monitoring may include reviews of reconciliations, internal audit evaluations, and legal department evaluations of compliance
      - Management’s monitoring of controls includes considering whether they are operating as intended.
      - Controls are modified as required to accommodate changes in business conditions.
    - - Involves managements identification and analysis of risks relevant to the preparation of F/S in conformity with GAAP
      - How does management identify risks relevant to the preparation of F/S?
    - - Significant Classes of Transactions
      - Financial Reporting Process
      - Accounting Records
      - Information Technology (IT) and Manual Systems
      - Initiation, Authorization, Recording, Processing and Reporting
    - - Control Activities are policies & procedures that ensure the achievement of the entity’s goals, including financial reporting goals
      - Appropriate Segregation of Duties
      - Proper Authorization of transactions
      - Adequate Documents and Records
      - Independent verification of performance & accuracy
      - Adequate Physical Controls over access to and use of assets / records
    - - Influences the control consciousness of its people
      - Represents the foundation for all other components of I/C - discipline and structure
      - CE factors are assessed as part of the knowledge of business and are used to develop a client risk profile
        #
      - characterized by management attitudes, effective communication of control objectives and supervision of personnel and activities
      - Sets the tone of an organization
  - - - Classified – proper account
      - Summarized
      - Accurate – correct amount is assigned
      - Posted
      - Recorded – completeness
      - Timely – timing / cut-off
      - Real – existence/occurrence
  - - - Fraud consists of knowingly making material misrepresentations of fact, with the intent of inducing someone to believe the falsehood and act upon it and thus suffer a loss or damage.
        
        Misappropriation of
        Assets
        
        Financial
        Reporting
      - Fraud and other irregularities refer to an intentional misstatement in F/S, including an omission of amount or disclosure, or to a misstatement arising from theft of the entity’s assets.
        
        misrepresentation
        
        misapplication
        
        Deception
      - Auditor’s Responsibility Related to Fraud
        
        CAS 240
        
        The auditor should maintain an attitude of professional skepticism throughout the audit, recognizing the possibility that a material misstatement due to fraud could exist, notwithstanding past experience with the entity about the honesty and integrity of management and those charged with governance.(12)
        
        CAS 240.05
        
        An auditor is responsible for obtaining reasonable assurance that the F/S are free from material misstatement, whether caused by fraud or error.
        
        “Owing to the inherent limitations of an audit, there is an unavoidable risk that some material misstatements of the F/S may not be detected, even though the audit is properly planned and performed in accordance with the CASs”
        
        Why is it difficult for an auditor to detect fraud?
        
        the fraud will be intentionally concealed
        
        client management may have the ability to override internal controls
        
        the auditor’s knowledge of client’s I/C may be inferior to that of employees
        
        weak internal controls = greater risk of fraud
      - Fraud Risk Triangle
        
        Opportunities
        
        Attitudes or Rationalizations
        
        Incentives or Pressures
      - Fraudulent Financial Reporting
        Conditions that should be considered:
        
        profit squeeze
        
        strong foreign competition
        
        high debt
        
        lack of working capital
        
        rapid expansion
        
        product obsolescence
        
        slow customer collections
        
        related party transactions
        
        excess capacity
        
        unfavourable industry conditions
      - Specific Fraud Risk Areas
        During fieldwork, the auditor should be alert for:
        
        Conflicting or missing evidence
        
        Problematic or unusual relationship between the auditor and management
        
        Discrepancies in the accounting records
        
        Other issues, e.g. accounting policies inconsistent with industry norms