King Saud University College of Administrative Sciences Accounting department

Auditing 2007

CHAPTER (6) Audit Responsibilities and Objectives

Pr Pofessor Dr. Modather Abou elkhair

Submit by Ghadeer Al- Mutawaa 1, May 2007 Chapter 6: Audit Responsibilities and Objectives

Steps to Develop Audit Objectives 1. Understand objectives and responsibilities for the audit. 2. Divide financial statements into cycles. 3. Know management assertions about accounts. 4. Know general audit objectives for classes of transactions and accounts. Know specific audit objectives for classes of transactions and accounts. 1

Understand objectives and responsibilities for the audit

Objective of Conducting an Audit of Financial Statements

SAS 1 (AU 110) states The objective of the ordinary audit of financial statements by the independent auditor is the expression of an opinion on the fairness with

The primary objective of the audit is to express an opinion on the financial statements. For public companies, the auditor also issues a report on internal control as required by Section 404 of the Sarbanes-Oxley Act. Auditors accumulate evidence to allow them to reach conclusion about whether the financial statements are fairly stated and the effectiveness of internal control, and they issue the appropriate audit report. If the auditor believes that the statements are not fairly presented or is unable to reach a conclusion because of insufficient evidence or prevailing conditions, the auditor has the responsibility of notifying the users through the auditors report.

Managements responsibilities
Management is responsible: For adopting sound accounting policies. Maintaining adequate internal control. Making fairness of the representations (assertions) in the financial statements carries with it the privilege of determining which disclosures it considers necessary, and for the preparation of the financial statements and the accompanying footnotes, it is acceptable for an auditor to draft the financial statements for the client or to offer suggestions for clarification. But: Auditors issue an opinion on fairness of the financial statements. Note: In recent years, the annual reports of many public companies have included a statement about managements responsibilities and relationship with the CPA firm. Why the Making fair of the representations in the financial statements rests with Management rather than with the auditor? Because they operate the business daily, a companys management knows more about the companys transactions and related assets, liabilities, and equity than auditor does. In contrast, the auditors knowledge of these matters and internal control is limited to that acquired during the audit. Case
In the even that management insists on financial statement disclosure that the auditor finds unacceptable, the auditor can either issue

Or
An adverse

Audit report

Or
Withdraw form the engagement

Qualified opinion

The Sarbanes-Oxley Act increases Managements responsibility for the financial statements by requiring the chief executive officer (CEO) and the chief financial officer

(CFO) of public companies to certify the quarterly and annual financial statements submitted to the SEC.

Auditors Responsibilities

SAS 1 (AU 110) states The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statemen

The auditors responsibility for 1. Detecting material misstatements in the financial statements. 2. When the auditor also reports on the effectiveness of internal control over financial reporting, the auditor is also responsible for identifying material weaknesses in internal control.

There is three Auditors Responsibilities In this chapter: 1). Auditors Responsibilities for Detecting Material Errors. 2). Auditors Responsibilities for Detecting Material Fraud. Auditors Responsibilities 3). Responsibilities for Discovering Illegal Acts.

1. Auditors Responsibilities for 2. Auditors Responsibilities for Detecting Material Fraud Detecting Material Errors Fraud resulting from fraudulent financial Reporting Versus Auditors spend a great portion of Misappropriation of Assets their time planning and performing audits to detect the unintentional mistakes made by Fraudulent financial Reporting Misappropriation of management and employees. Assets Auditors find a variety of errors * It is harms users by providing * When assets are resulting from such things as incorrect financial statement misappropriated, mistakes in calculations, information for their decision making. stockholders, omissions, misunderstanding * It is committed by management, creditors and others and misapplication of sometimes without the knowledge are harmed because accounting standards, and of employees. Management is in a assets are no longer incorrect summarizations and position to make accounting and available to their descriptions. reporting decisions without rightful owners. employees knowledge.
Both types of Fraud are potentially harmful to users.

Auditing standards make no distinction between the auditors responsibilities for searching for Errors versus fraud, whether from fraudulent financial reporting or misappropriation of assets. For both errors and fraud, the auditor must obtain reasonable assurance about whether the statements are free of material misstatements. The standards also recognize that it is often more difficult to detect fraud than errors because management or the employees perpetrating the fraud attempt to conceal the fraud. Usually, but not always, theft of assets is perpetrated by employees and not by management, and the amounts are often immaterial.

An important concept for Misappropriation of Assets is distinction between the theft of assets and misstatements arising from the theft of assets. There are three situations involving theft of assets: 1. Assets were taken and the theft was covered by overstating assets. 2. Assets were taken and the theft was covered by understanding revenues or overstating expenses. 3. Assets were taken, but the Misappropriation was discovered. The income statement and related footnotes clearly describe the Misappropriation. In all three situations, there has been a Misappropriation of Assets, but the financial statements are misstated only in situations 1 and 2. In situation1, the balance sheet is misstated, whereas in situation 2, revenues or expenses are misstated.

There are two types: 1. Direct-effect illegal acts * Certain violations of laws and regulations have a direct financial effect on specific account balances in the financial statements. * The auditors Responsibilities under SAS 54 for these Direct-effect illegal acts is the same as for Errors and Fraud 2. Indirect-effect illegal acts Most illegal acts affect the financial statements only indirectly. An indirect effect illegal act Potential material fines and sanctions indirectly affect financial statements by creating the need to disclose a contingent liability for the potential amount that might ultimately be paid.
Auditing standards clearly state that the auditor provides no assurance that indirect effect illegal acts will be detected. Auditors lack legal expertise, and the frequent indirect relationship between illegal acts and the financial statements makes it impractical for auditors to assume responsibility for discovering those illegal acts.

There are three levels of responsibility that the auditor has for finding and reporting illegal acts.
1. Evidence accumulation when there is no reason to believe indirect-effect illegal act exists Many audit procedures normally performed on audits to search for errors and fraud may also uncover illegal acts. The auditor should also inquire of management about policies they have established to prevent illegal acts and whether management knows of 2. Evidence accumulation and other actions when there is reason to believe direct- or indirect-effect illegal acts may exist The auditor may find indications of possible illegal acts in a variety of ways. When the auditor believes that an illegal act may have occurred, it is necessary to take several actions 1). The auditor should inquire of management at a level above those likely to be involved in the potential illegal act. 2). The auditor should consult 3.Actions when the auditor knows of an illegal act

The first course of action when an illegal act has been identified is to consider the effects on the financial statements, including the adequacy of disclosures. These effects may be complex and difficult to resolve. If the auditor concludes that the disclosures relative to an illegal act are inadequate, the auditor should modify the audit report

any laws or regulations that the company has violated. Other than these procedures, the auditor should not search for indirect-effect illegal acts unless there is reason to believe they may exist.

with the clients legal counsel or other specialist who is knowledgeable about the potential illegal act. 3). The auditor should consider accumulating additional evidence to determine whether there actually is an illegal act. All three of these actions are intended to provide the auditor with information about whether the suspected illegal act actually exists.

accordingly. The auditor should also consider the effect of such illegal acts on its relationship with management The auditor should committee or others of equivalent authority to make sure that they know of the illegal act. The communication can be oral or written.

Financial statement cycles

Audits are performed by dividing the financial statements into smaller segments or components. The division makes the audit more manageable and aids in the assignment of tasks of different members of the audit team. Each segment is audited separately but not on a completely independent basis. After the audit of each segment is completed, including interrelationships with other segments, the results are combined. A conclusion can then be reached about the financial statements taken as a whole.

Cycle approach to segmenting an Audit. A more common way to divide an audit is to keep closely related types (or classes) of transactions and account balance in the same segme

The logic of using the cycle approach can be seen by thinking about the way transactions are recorded in journals and summarized in the general ledger and financial statements. To the extent that it is practical, the cycle approach combines transactions recorded in different journals with the general ledger balances that result from those transactions. The types of cycles: Sales and collection cycle Acquisition and payment cycle Payroll and personnel cycle Inventory and warehousing cycle Capital acquisition and repayment cycle A trial balance is used to prepare financial statements and is a primary focus of every audit.

Transaction Flow Example

Transactions Journals Ledger, Trial Balance, and Financial Statements

Sales Cash receipts Acquisition of goods and services

Sales journal Cash receipts journal Acquisitions journal

General ledger and subsidiary records

General ledger trial balance

Cash disbursements Payroll services and disbursements Allocation and adjustments

Cash disbursements journal Financial statements

Payroll journal General journal

Relationships Among Transaction Cycles

General cash

Sales and collection cycle

Capital acquisition and repayment cycle

Notes: The cycles have no beginning or end except at the origin and final disposition of accompany 3

Inventory and warehousing cycle

Acquisition and payment cycle

Payroll and personnel cycle

Management Assertions

Are implied or expressed representations by management about classes of transactions and the related accounts in the financial st These assertions apply to both classes of Transaction and account Balance Management Assertions are directly related to generally accepted accounting principles (GAAP).

These assertions are part of the criteria that management uses to record and disclose accounting information in the financial statements. Auditors must understand the Assertions to do adequate audits. SAS 31 (AU 326) classifies Assertions into five broad categories: 1. Existence or occurrence 2. Completeness 3. Valuation or allocation 4. Rights and obligations 5. Presentation and disclosure 1. Assertions About Existence or occurrence
It is deal Assertions about existence with whether assets, obligations, and equities included in the balance sheet actually existed on the balance sheet date. It is concern whether recorded transactions included in the financial statements actually occurred 2.Assertions about occurrence Assertions about Completeness during the accounting period.

The Management Assertions state that all transactions and accounts that should be presented in the financial statements are included. The completeness assertion deals with matters opposite from those of the existence or occurrence assertions. What is the different between?

The Completeness assertion is concerned with the possibility of omitting items from the financial statements that should have been included Violations of the completeness assertion relate to account understatements. The failure to record a sale that did occur would be a violations of the Completeness assertion

The existence or occurrence assertion is concerned with inclusion of amounts that should not have been included. Violations of the existence assertion relate to account overstatements. The recording of a sale that did not take place would be a violations of occurrence assertion

3. Assertions about Valuation or allocation These assertions deal with whether asset, liability, equity, revenue, and expense accounts have been included in the financial statements at appropriate amounts. 4. Assertions about Rights and obligations This deal with whether assets are the Rights of the entity and liabilities are obligations of the entity at a given date.

5. Assertions about Presentation and disclosure This deal with whether components of the financial statements are properly combined or separated, described, and disclosed.

Setting Audit Objectives

Auditors conduct financial statement audits using the cycle approach by performing audit tests of the transactions making up ending balances and also by performing audit tests of the account balances themselves. There are two audit objectives

2). Balance-related audit objectives. 1). Transaction-related audit objectives There are several audit objectives that must be met for each account balance. There are several audit objectives that must be met before the auditor can conclude that the transactions are properly recorded.

T There are two types:

There are two

1 1) General Transaction-Related Audit Objectives 1 1) General Balance -Related Audit Objectives 2). Specific Transaction-Related Audit Objectives* It is follow and are closely related to management assertions. S S 2). Specific Balance -Related Audit Objectives* It is similar to the transaction-related audit objectives. S S

* These are intended to provide a framework to help the auditor accumulate sufficient competent evidence required by the third standard * They follow from management assertions and they provide a framework to help the auditor accumulate sufficient competent evidence. * There are also both general and specific balance-related audit objectives

There are two differences between Balance-Related and Transaction-Related audit objectives:

What is the different between?

Balance-Related Audit Objectives * It is applied to account balances. * There are more audit objectives for account balances than for classes of transactions. (There are nine balance-related audit objectives compared to six transaction-related audit 10 objectives). Transaction-Related audit * It is applied to classes of transactions such as sales transaction. * There are six transaction-related audit objectives.

Because of the way audits are done, Balance-related audit objectives are almost always applied to the ending balance in balance sheet accounts, such as accounts receivable, inventory, and notes payable. Some Balance-Related objectives are applied to certain income statements. And usually involve nonroutine transactions and unpredictable expenses, such as legal expense or repairs and maintenance. Other income statement accounts are closely related to balance sheet accounts and are tested simultaneously, such as depreciation expense with accumulated depreciation. When using the balance-related audit objectives as a framework for auditing account balances, the auditor accumulates evidence to verify detail that supports the account balance, rather than verifying the account balance itself.

1). Transaction-Related Audit Objectives 1. General Transaction-Related Audit Objectives

1

Existence

Recorded transactions exist.

This objective deals with whether recorded transactions have actually occurred. This objective is the counterpart to the management assertion of existence or occurrence.

Completeness

Existing transactions are recorded.

This objective deals with whether all transactions that should be included in the journals have actually been included. This objective is the counterpart to the management assertion of Completeness The existence and Completeness objectives emphasize opposite audit concerns. Existence deals with potential overstatement. Completeness deals with unrecorded transactions (understatement).

Accuracy

Recorded transactions are stated at the correct amount.

This objective deals with the accuracy of information for accounting transactions. Accuracy is one part of the valuation or allocation assertion.

Classification

Transactions are properly classified.

Classification is one part of the valuation or allocation assertion.

Timing

Transactions are recorded on the correct dates.

A timing error occurs if transactions are not recorded on the dates the transactions took place. Timing is one part of the valuation or allocation

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assertion.

Posting and Summarization Transactions are included in the master files and are correctly summarized.
This objective deals with the accuracy of the transfer of information from recorded transactions in journals to subsidiary records and the general ledger. Posting and summarization is one part of the valuation or allocation assertion

Recorded transactions are stated at the correct amount

2.Specific Transaction-Related Audit Objectives

Transaction-Related Audit Objectives and Management Assertion
Management Assertions Existence or occurrence Completeness Valuation or allocation General Transaction Related Audit Objectives Existence Completeness Accuracy, Classification Timing, Posting and summarization Rights and obligations Presentation and disclosure N/A N/A Specific Transaction Related Audit Objectives Recorded sales are shipments made to nonfictitictions. Existing sales transaction are recorded Recorded sales are for the amount of goods shipped and are correctly billed and recorded. Sales transactions are properly classified. Sales are recorded on the correct dates. Sales transactions are properly included in the master file and are correctly summarized. N/A N/A

Note:
The three only assertions are associated with transaction-related audit objectives. The two of the assertions are not satisfied by performing transaction-related audit tests.

Balance-Related Audit Objectives General Balance-Related Audit Objectives

1
Existence Amounts included exist.

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This objective deals with whether the amounts included in the financial statements should actually be included. This objective is the auditors counterpart to the management assertion of existence or occurrence.

Completeness

Existing amounts are included. This objective deals with whether all amounts that should be included have actually been included. This objective is the counterpart to the management assertion of Completeness The existence and Completeness objectives emphasize opposite audit concerns. Existence deals with potential overstatement. Completeness deals with unrecorded transactions (understatement). Amounts included are stated at the correct amounts. It is refers to amounts being included at the correct arithmetic amount. Accuracy is one part of the valuation or allocation assertion.

Accuracy

Classification

Amounts are properly classified. It is involves determining whether items on a clients listing are included in the correct accounts. Classification is one part of the valuation or allocation assertion.

Cutoff

Transactions are recorded in the proper period. In testing for cutoff, the objective is to determine whether transactions are recorded in the proper period. The transactions that are most likely to be misstated are those recorded near the end of the accounting period. It is proper to think of cutoff tests as a part of verifying either the balance sheet accounts or the related transactions, but for convenience, auditors usually perform them as a part of auditing balance sheet accounts. Cutoff is a part of the valuation or allocation assertion. Account balances agree with master file amounts, and with the general ledger Account balances on financial statements are supported by details in master files and schedules prepared by clients. The detail tie-in objective is concerned that the details on lists are accurately prepared, correctly added, and agree with the general ledger. The detail tie-in is a part of the valuation or allocation assertion.

Detail tie-in

Realizable

Assets are included at estimated realizable value.

The objective concerns whether an account balance has been reduced for declines from historical cost to net realizable value. The objective applies only to asset accounts and is also a part of the valuation or allocation assertion.

Rights and obligations

Assets must be owned.

Most assets must be owned before it is acceptable to include them in the financial statements. Similarly, liabilities must belong to the entity. Rights are always associated with assets and obligations.

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The objective is the auditors counterpart to the management assertion of Rights and obligations.

Account balances and Related disclosures are Properly presented in financial. statements Presentation and disclosure In fulfilling the presentation and disclosures objective, the auditor tests to make certain that all balance sheet and income statement accounts and related information are correctly set forth in the financial statements and properly described in the body and footnotes of the statements. The objective has its counterpart in the management assertion of presentation and disclosures. Presentation and disclosures is closely related to, but distinct from, classification

2. Specific Balance-Related Audit Objectives

There may be more than one Specific Balance-Related Audit Objectives for a general balancerelated audit objective .

Balance-Related Audit Objectives and Management Assertions

Management Assertions Existence or occurrence Completeness Valuation or allocation General BalanceRelated Audit Objectives Existence Completeness Accuracy, Specific BalanceRelated Audit Objectives All recorded inventory exists at the balance sheet date. All existing inventory has been counted and included in the inventory summary. Inventory quantities on the clients perpetual records agree with items physically on hand. Prices used to value inventories are materially correct. Extensions of price times quantity are correct and details are correctly added. Inventory items are properly classified as to raw materials, work in process, and finished goods. Purchase cutoff at year-end is proper. Sales cutoff at year-end is proper. Total of inventory items agrees with general ledger. Inventories have been written down where net realizable value is impaired. The company has title to all inventory items listed. Inventories are not pledged as collateral. Major categories of inventories and their bases of valuation are disclosed. The pledge or assignment of any inventories is disclosed.

Classification Cut off, Detail tie-in, Realizable Value Rights and obligations Presentation and disclosure Rights and obligations Presentation and disclosure

Relationships Among Management Assertions and Balance-Related Audit Objectives The reason there are more general balance-related audit objectives than management assertions is to provide additional guidance to auditors in deciding what evidence to accumulate. Note:

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There is a one-to-one relationship between assertions and objectives, except for the valuation or allocation assertion. The valuation or allocation assertion has multiple objectives because of the complexity of valuation issues and the need to provide auditors with additional guidance.

How Audit Objectives are met

The auditor must obtain sufficient competent audit evidence to support all management assertions in the financial statements. An audit process is a methodology for organizing an audit to ensure that the evidence gathered is both sufficient and competent and that

PCAOB Auditing Standard 2 requires that the audit of the effectiveness of internal control be integrated with the audit of the financial statements.

There are Four Phases of an Audit process:

Phase II Phase II Phase III Phase IV

1. Plan and design an audit approach. (Phase I)

Perform tests of controls and substantive tests of transactions. Perform analytical procedures and tests of details of balances. Complete the audit and issue an audit report.
2. Perform tests of controls and substantive tests of transactions * Tests of controls: The procedures involved To justify reducing planned assessed control risk when internal controls are considered effective, the auditor must test the effectiveness of the controls. This control is directly related to the accuracy transaction-related audit objective of sales. 3. Perform analytical procedures and tests of details of balances. There are two general categories 1. Analytical procedures use comparisons and relationships to assess whether account balances or other data appear reasonable. 2. Tests of details of balances are specific procedures intended to test for monetary misstatements in the balances in the financial statements. Tests of details of ending 4. Complete the audit and issue an audit report. After the auditor has completed all procedures for each audit objective and for each financial statement account, it is necessary to combine the information obtained to reach an overall conclusion as to whether the financial statements are fairly presented. This is a highly subjective process that

There are many ways in which an auditor can accumulate evidence to meet the overall audit objectives. Two overriding considerations affect the approach the auditor selects: 1.Sufficient competent evidence must be accumulated to meet the auditors professional responsibility (is the most important). 2.The cost of accumulating the evidence should be minimized. (cost minimization is necessary if CPA firms are to be competitive and profitable). If there were no concern for

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controlling costs, evidence decision-making would be easy. Auditors would keep adding evidence, without concern for efficiency, until they were sufficiently certain that there were no material misstatements. There are two key aspects of Planning and designing an audit approach: 1. Obtain knowledge of the clients business strategies and process and assets risks 2. Understand Internal Control and Assess Control Risks

One possible test of the effectiveness of this control is for the auditor to examine a sample of the clerks initials that were required on each duplicate sales invoice after verifying the unit selling price. * Substantive tests of transactions: Auditors also evaluate the clients recording of transactions by verifying the monetary amounts of transactions.

balances are essential to the conduct of the audit because most of the evidence is obtained form a source independent of the client and therefore is considered to be of high quality.

relies heavily on the auditors professional judgment. When the audit is completed, the CPA must issue an audit report to accompany the clients published financial statements.

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