Unit Four: Audit responsibilities and Objectives

4.1: Objectives of conducting Financial statement audit

4.2: Managements’ responsibility
4.3: Auditor’s responsibility
4.4: Management assertions
4.5: General transactions related audit objectives
4.6: General balance related audit objectives
4.7: Relationship of management assertions and audit
objectives
4.8: Phases of financial statement audit
Objectives
 Distinguish between management and auditors’
responsibility
 Know the management assertions
 Know the general transaction-related and general
balance-related audit objectives
 Be familiar with the different transaction cycles
Objectives of conducting Financial Statement audit

 The objective of an ordinary audit is “to express

an opinion as to the fairness with which the
financial statements present fairly, in all material
respects, the financial position, results of
operations, and cash flows, in conformity with
generally accepted accounting principles.”
 Thus the primary objective of Financial Statment
audit is to express an opinion on the financial
statements.
Objectives of conducting Financial Statement audit

 The objective of the ordinary audit of financial

statements is the expression of an opinion of the
fairness with which they present fairly, in all
respects, financial position, result of operations,
and its cash flows in conformity with GAAP.
Auditor’s Responsibilities
 The auditors are responsible to provide an opinion
as to the fairness of the F/S.
 These responsibilities include:
 planning and performing the audit and
 providing reasonable assurance that the statements
are free of material misstatement.
 Reporting on internal control weaknesses.
Auditor’s Responsibilities
 The term “reasonable assurance” requires professional judgment.
 The auditing standard does not require 100% assurance, but clearly,
there must be some substantive evidence available in judging the
financial statements.
 Typically, the assurance is based on sampling information—which
introduces the possibility of risk that problems may exist, but not
within the sample measures.
 Additionally, the complexity of accounting measures may add a
layer of difficulty in making a clear judgment.
 And one must also consider the possibility that employees may be
hiding some data from the auditor. All of these cloud the issue of
what is reasonable assurance
Auditor’s Responsibilities
Auditor are specially responsible to evaluate:
1. Going-Concern
2. Contingencies
3. Subsequent events
4. Significant Estimates
5. Adequacy of Disclosures
6. Management representations
Auditor’s Responsibilities
For Going-Concern Assumption
 Auditor is required to evaluate client's ability to remain a

going concern for reasonable period of time from the

balance sheet date.
 Indicators of potential going concern problems include

 Negative trends in key financial areas like cash flow, sales,

profits
 Internal matters, such as loss of key personnel, and

Outdated facilities and/or products

 External matters, such as new legislation, loss of significant

customer or supplier,
 uninsured casualty loss
Auditor’s Responsibilities
 Other matters, such as loan default, inability to pay dividends,
attempted debt restructuring.
 Significant changes in the competitive market and the
competitiveness of the client’s products
 If there is substantial doubt about ability of client to remain a
going concern, auditor should
 Discuss the situation with management
 Assess management's plan to overcome problems
 Consider the effects on the financial statements
 Consider the effects on the audit report and issue appropriate
audit opinion
Auditors responsibility for reviewing contingencies

 Contingent losses that are probable, reasonably

estimated, and remote should be accrued and
disclosed
 Contingent losses that are reasonably possible and
remote contingencies disclosed because of common
practice, should be disclosed in the notes to the
financial statements
Auditors responsibility for reviewing contingencies

Contingencies include:
 Threat of expropriation/confiscation of assets in a

foreign country
 Litigation, claims, and assessments

 Guarantees of debts of others

 Obligations of banks under standby letters of credit

 Agreements to repurchase receivables that have been

sold
 Purchase and sale commitments
Auditors responsibility for reviewing contingencies

 Management is responsible for identifying,

evaluating, and accounting for contingencies
 Auditor is responsible for determining client has
properly identified, accounted for, and disclosed
material contingencies
 Sources of Evidence for contingencies include
management and client's legal counsel, corporate
minutes, contracts, correspondence from
government agencies, and bank confirmations
Auditors responsibility for subsequent events

 Subsequent events are events coming in to existence after the balance

sheet date and require special audit attention
 Types of Subsequent Events

Type 1 subsequent events

 provide evidence about conditions that existed at the balance sheet

date and the financial statement numbers should be adjusted to reflect

this information.
 Examples of type 1 subsequent events:

 Major customer files for bankruptcy during subsequent period, its

deteriorating financial condition existed prior to the balance sheet

date
 Lawsuit settled for different amount than accrual

 Stock dividend or split during the subsequent period

Auditors responsibility for subsequent events

Type 2 subsequent events:

 provide evidence about conditions that did not exist at the balance

sheet date.
 The financial statement numbers should not be adjusted for these

events, but they should be considered for disclosure.

 Examples

 Uninsured casualty loss that occurs after the balance sheet date

 Significant lawsuit initiated for incident occurring after the

balance sheet date

 Significant loss due to natural disaster occurring after the balance

sheet date
 Major decisions made during the subsequent period such as to

merge, discontinue a line of business, or issue new securities

Auditors responsibility for subsequent events

Audit procedures used to identify subsequent events include:

 Read minutes of meetings of the board of directors,

stockholders, and other authoritative groups held after year

end
 Read interim financial statements; investigate significant

changes
 Inquire of management about:

 Significant changes noted in interim statements

 Significant contingent liabilities

 Significant changes in working capital, debt, or owners' equity

 Status of any tentative items

 Unusual accounting adjustments made after balance sheet date

Auditors responsibility for subsequent events

 If subsequent event occurs after end of fieldwork

but before audit report is issued, auditor must
decide whether to single or dual date the audit
report
 Single date: Use the date of the subsequent event
as the date of the audit report
 Dual date: using the dates of the original audit
report and the date of the event to disclose the work
done only on that event after the original audit
report date.
Auditors responsibility for Review of Significant Estimates

 Management estimates provide opportunities for the

entity to "manage" or even manipulate earnings.
 Companies may underestimate liabilities or
impairment of asset values to achieve reported
earning goals.
 The auditor shall provide reasonable assurance that
1. Management has information system to develop estimates
material to the financial statements
2. Estimates are reasonable and
3. Estimates are presented per GAAP
Auditors responsibility for Review of Significant Estimates

 In evaluating management estimates, the auditor

concentrates on key factors and assumptions that
are:
– Significant to the accounting estimate
– Sensitive to variations
– Deviations from historical patterns
– Susceptible to misstatement and bias
– Inconsistent with current economic trends
Auditors responsibility for Evaluating Adequacy of Disclosures

 Third standard of reporting states "When

informative disclosures are not reasonably
adequate, the auditor must note that fact in the
auditor’s report."
• Disclosures can be made either on the face of the
financial statements and/or in the notes to the
statements
Auditors responsibility for Evaluating Adequacy of Disclosures

Auditor must be sure that:

 Disclosed events and transactions occurred and

pertain to the entity

 All disclosures that should be included are included

 Disclosures are understandable to users

 Disclosures are accurate

Auditors” responsibility for Management Representations

 Auditor shall seek Management Certification of

Financial Statements
– Sarbanes/Oxley Act requires CEO and CFO to
certify financial statements are fairly presented in
accordance with GAAP
– Auditor should review management‘ processes for
certification and seek written Management
Representation Letter
Auditors” responsibility for Management
Representations

Management Representation Letter

 Reminds management of its responsibility for the
financial statements
 Confirms significant oral responses made by
management
 Reduces possibility of misunderstandings between
management and auditor
Auditors” responsibility for Management Representations

 Management Representation Letter is often prepared by

auditor on client letterhead, addressed to the auditor, and
normally signed by CEO and CFO
 Letter is dated as of the audit report date (end of fieldwork)
 Because management representations are not strong
evidences, the auditor should perform procedures to
corroborate the information in the letter
 Management's failure to provide this letter is a scope
limitation sufficient to preclude issuance of unqualified
opinion.
Managements’ responsibility
 Management is primarily responsible for the
fairness of the financial statements, which is
logical, because management operates the business.
 Auditors must base their conclusion of fairness on
the results of the audit.
 Thus management is primarily responsible for the
financial statements and for internal control
Management Assertions

Management Assertions are representations of management that

are expressed in the financial statements.
management assertions are about economic actions and events of
an entity.
Management assertions are in the form of balance sheet, income
statement, statement of cash flows and foot notes.
Broadly speaking a set of financial statements contains the
following five management assertions:
1. Assertions about existence or occurrence
2. Assertions about completeness
3. Assertions about valuation or allocation
4. Assertions about rights and obligations
5. Assertions about presentation and disclosure
Management Assertions

1. Existence or occurrence: Assets, liabilities, owners’ equity,

revenues and expenses reflected in the financial statements exist and
the recorded transactions have occurred.
2. Completeness: All transactions, assets, liabilities, owners’ equity,
revenues and expenses that should be presented in the financial
statements are included.
3. Rights and Obligations: The client has rights to assets and
obligations to pay liabilities that are included in the financial
statements.
4. Valuation or allocation: Assets, liabilities, and owners’ equity,
revenues and expenses are presented at amounts that are determined
in accordance with generally accepted accounting principles
Management Assertions

5. Presentation and disclosure: Accounts are described and

classified in the financial statements in accordance with generally
accepted accounting principles and all material disclosures are
provided.
 The audit program for each financial statement account must be

tailored to accomplish the specific audit objectives for that account.

 The specific objectives for auditing cash are not identical to the

specific objectives for auditing inventory. Although the specific

audit objectives and therefore, the audit procedures differ for each
account, it is useful to realize that each audit program follows
basically the same approach to verifying the balance sheet items
and related income statement amounts.
Transaction-Related Audit Objectives

 There are six general transaction-related objectives:

1. Existence—recorded transactions exist;
2. Completeness—existing transactions are recorded;
3. Accuracy—recorded transactions are stated at the correct
amounts
4. Classification—transactions included in the client's journals
are properly classified;
5. Timing—transactions are recorded on the correct dates;
6. Posting and summarization—recorded transactions are
properly included in the master files and are correctly
summarized.
Balance-Related Audit Objectives

There are 9 balance-related audit objectives:

1. Existence—amounts included exist
2. Completeness—existing amounts are included
3. Accuracy—amounts included are stated at correct amounts
4. Classification—amounts included in the client's listing are properly classified
5. Cutoff—transactions near the balance sheet date are recorded in the proper
period
6. Detail tie-in—details in the account balance agree with related master file
amounts, foot to the total in the account balance, and agree with the total in
the general ledger
7. Realizable value—assets are included at the amounts estimated to be realized
8. Rights and obligations
9. Presentation and disclosure—account balances and related disclosure
requirements are properly presented in the financial statements
Financial statement cycles

While auditing, auditors generally find it useful to subdivide the

overall audit engagement system into its major transaction cycles.
The term transaction cycle refers to the policies and the sequence
of procedures for processing a particular type of transaction.
Major transaction cycles include:
1. Sales and collection cycle
2. Acquisition and payment
3. Inventory and warehousing
4. Capital acquisition and repayment
5. Payroll and personnel
Financial statement cycles

 Sales and collection cycle: this cycle involves procedures

and policies for obtaining orders from customers,
approving credit, shipping merchandise, preparing sales
invoice, recording revenue and accounts receivable, billing,
handling and recording cash receipts
 Purchase or acquisition and payment cycle: This cycle
includes procedures for initiating purchases of inventory,
other assets or services , placing purchase orders,
inspecting goods upon receipts and preparing receiving
reports, recording liabilities to vendors, authorizing
payments and making and recording cash disbursements
Financial statement cycles

 Production (inventory and warehousing) cycle): includes

procedures for storing materials, placing materials in to production,
assigning production costs to inventories and accounting for the
cost of goods sold
 Financing cycle (capital acquisition and repayment cycle): this
cycle includes procedures for authorizing, executing, and recording
transactions involving bank loans, leases, bonds and capital stock
 Payroll and personnel cycle: Includes procedures for hiring,
firing, determining pay rates, timekeeping, computing gross
payroll, payroll taxes and amounts withheld from gross pay,
maintaining payroll records and preparing and distributing
paychecks
Sales and collection cycle:
Because sales transactions, receivables and cash receipts are closely
related, these accounts can be considered jointly in a discussion of
auditing objectives and procedures. In broad terms, sale sand collection
cycle includes the following business functions
1. Receiving of orders from customers and credit approval
2. Delivery of merchandise to the customer
3. Billing of merchandise to the customer
4. Recording of receivables
5. Collection of receivables
6. Write-off of receivables if any
From sales and collection cycle the following accounts can be
identified. Sales, Accounts receivable or Notes receivable, cash,
uncollectible accounts expense and allowance for doubtful account. The
auditor undertaking audit of sales and collection cycle should be quite
familiar with accounting recording of sales, collections and write-offs.
Sales and collection cycle:
Audit objectives for the audit of sales and collection cycle:
The audit objectives in auditing receivable and sales are to
determine that:
1. The recorded sales and receivables are valid (existence and
rights)
2. All sale and receivable are recorded (completeness)
3. Sale and Receivable records and supporting schedules are
mathematically correct and agree with general ledger
accounts (Measurement)
4. The valuation of receivables approximate their realizable
values (valuation).
5. The presentation and disclosure of sales and receivable are
adequate (presentation and disclosure)
Sales and collection cycle:
Internal controls over sales transactions and receivables
 An organization’s internal control structure consists of the policies
and procedures established to provide reasonable assurance that the
organization’s related objectives will be achieved.
 The nature and extent of the audit work to be performed on a
particular engagement depends largely upon the effectiveness of the
client’s internal control in preventing material misstatement in the
financial statements.
 In every audit, the auditors must obtain an understanding of the
internal control structure adequate to plan the audit--this includes
an understanding of the control environment, the accounting system
and control procedures.
Sales and collection cycle:
To strengthen internal control over credit sales, the following functions should
be performed.
1. Preparation of sales order
2. Credit approval
3. Issuance of merchandise from stock
4. Shipment and Billing
5. Invoice verification
6. Maintenance of control accounts
7. Maintenance of customers’ ledgers
8. Approval of sales returns and allowances
9. Authorization of write-off of uncollectible accounts- Receivables judged by
management to be uncollectible should be written-off and transferred to a
separate ledger and control account.
Sales and collection cycle:
Designing tests of Control and Substantive test of
Transactions
 Although specific audit procedures vary from one engagement

to the other, the fundamental steps which follow planning of the

audit process are essentially the same in every engagement.
 These are:

1. Obtain an understanding of internal control sufficient to plan

the audit
2. Asses control risk and design test of controls
3. Perform additional test of controls
4. Reassess control risk and design substantive tests
5. Perform substantive tests and complete the audit
Sales and collection cycle:
1. Obtain an understanding of internal control sufficient to plan the audit:
The second standards of field work sates Sufficient understanding of the
internal control structure is to be obtained to plan the adult and determine the
nature, timing and extent of test to be performed.
Understanding of internal control refers to the need to have knowledge and
understanding of:
1. How it works
2. What procedures are performed and who performs them
3. What controls are in effect
4. How various types of transactions are processed and recorded
5. What accounting records and supporting documentation exist
6. Sequence of procedures used in processing major categories of transactions
7. Proper authorization of transactions and activities
8. Appropriate segregation of duties (fundamental concept of internal control)
9. Adequate documentation and recording of transactions and events
10. Proper valuation of recorded amounts
Sales and collection cycle:
2. Asses control risk and design test of controls
 After analyzing the design of the internal control structure, the

auditors must decide whether the structure, as designed, seems

strong enough to prevent or to detect and correct material
misstatements.
 If they assess internal control to be weak (control risk is high),

they will rely primarily on substantive tests to reduce audit risk

to an acceptable level.
 On the other hand, if the system seems capable of preventing or

detecting and correcting material misstatements, the auditor muse

decide which additional controls if any can efficiently be tested?
Sales and collection cycle:
Control Risk: is the risk that the client’s system of
internal control will not prevent or correct such
errors. To assess control risk, the auditor should
consider the adequacy of control design as well as
test adherence of the client employees to control
polices and procedure.
 The auditor’s major objective at this point is to

determine which internal controls if any merit

additional testing. This involves:
Sales and collection cycle:
 Tests of controls are used by the auditors to obtain evidence about
whether the tested policy or procedure operates in a manner that
would prevent or detect material misstatement. That is test of
controls are used to evaluate the effectiveness of both the design
and operation of controls. Tests of controls focus on compliance
with procedures.
How to test controls?
 Controls may be tested by

1. Inquiries of appropriate client personnel

2. Inspection of documents and reports
3. Observation of the application of accounting policies or procedures
4. Re-performance of the application of the policy or procedures by
the auditors
Sales and collection cycle:
 After completing their tests of controls, the auditors are in a
position to reassess control risk based on the results of the test
and determine the nature, timing and extent of the substantive
tests necessary to complete the audit of sales and receivables.
 Substantive tests/procedures are tests designed to obtain

evidence as to the completeness, accuracy and validity of the

data produced by accounting system. They are of two types:
(1)Tests of details of transactions and balances.
(2)Analysis of significant ratios and trends including the resulting
investigation of unusual fluctuations and items.
Reading Assignment
 Acquisition and payment cycle
 Inventory and warehousing cycle
 Capital acquisition and repayment cycle
 Payroll and personnel cycle
Phases of Financial Statement Audit

In general for all transaction cycles, there are seven phases to be passed by auditor while
auditing financial statements: These are:
1. Audit planning: Involves
This is developing an overall strategy for performing the audit, including audit program

Establishing an understanding with their clients as to the nature of services to be provided

and responsibilities of each party (Engagement letter)

2. Obtain an understanding of the client and its environment including internal control
3. Assess Risks of misstatement and design further audit procedures
4. Perform tests of control
5. Perform substantive tests of procedures
6. Complete the audit’
7. Issue an audit report