auditing chapter 7 audit process

AUDITINGCHAPTER 7

Audit Process & Detecting FraudByDavid N. Ricchiute

GBW 8th ed., Ch. 72

TOPICS

Audit process Client acceptance, client strategies,

planning, interim & year end work Auditor’s responsibility to detect, report

fraud

GBW 8th ed., Ch. 73

PRELIMINARY STEPS IN AUDIT PROCESS

Communication with audit committeeAccepting, continuing engagementsUnderstand client’s business strategiesPlanningInterim, year-end audit work

GBW 8th ed., Ch. 74

AUDIT COMMITTEES:History

1940 SEC ASR #19 encouraged 1978 required by NYSE1999 recommendations from Blue Ribbon on audit committee effectiveness Consistency of accounting

principles Clarity, completeness of financial

statements

GBW 8th ed., Ch. 75

SEC & SARBANES-OXLEY RULES: Post 2000

Mandates Reviews of public company financial

statement interim reports Disclosure in proxy statements

whether audit committee discussed Financial statements with management Estimates, uncertainties, unusual

transactions, new accounting principles, independence with auditor

GBW 8th ed., Ch. 76

QUALITY OF EARNINGS

Auditor must discuss quality not just acceptability of accounting principles & earnings with Audit committee (SAS 89) Consistency in use of accounting

principles Clarity, completeness of financial

statements

GBW 8th ed., Ch. 77

ACCEPTING, CONTINUING ENGAGEMENTS

Establish policies, procedures to accept, continue clients (Stmt. Quality Control Stds. No. 1 )For new client Evaluate ability to service client Review financial statements Inquire about reputation, bankruptcy Investigate key managers

GBW 8th ed., Ch. 78

COMMUNICATIONS WITH PREDECESSOR

Successor auditor initiates communicationPredecessor auditor obtains permission to disclose confidential information (Rule 301)Is prior auditor’s resignation, replacement linked to (SAS 84)Disagreement with management? Management integrity? Other reasons?

GBW 8th ed., Ch. 79

UNDERSTANDING WITH CLIENT

Objectives & limitations of engagementManagement’s responsibilitiesExample: financial statement audit Objective: express opinion whether

statements Present fairly In all material respects In conformity with GAAP

SAS 83 & SSAE 7

GBW 8th ed., Ch. 710

MANAGEMENT’S RESPONSIBILITIES

Financial statementsEstablishing, maintaining effective internal over financial reportingAssuring compliance with laws & regulationsMaking records, information availableConfirming representations made during engagement


ENGAGEMENT LETTERSDrafted by auditor for CEO’s signatureWritten agreement to state purpose of engagement & role of auditorOptional but recommended by SAS 84 which requires some form of written understanding in work papers


PROPOSED ADJUSTING JOURNAL ENTRIES (AJE)

SAS 88 “Audit Adjustments” Management’s responsibility to

record material proposed adjustments Management must confirm

responsibility for adjustments at year end in representation letter

Auditor informs audit committee of management’s responsibilities for adjustments


UNDERSTANDING CLIENT’S BUSINESS

Auditor considers effects of client business & strategies on Risks Strategies to overcome risk Transactions, events as products of

management’s strategies


CLIENT STRATEGY TEMPLATE-Strategies

Growth strategyFinancial goals & operating priorities


CLIENT STRATEGY TEMPLATE-Characteristics

Characteristics of business Major business units Markets Products Customers Competitors Strategic alliances & joint ventures Potential adverse influences


BUSINESS: Units, Markets, Products, Customers

Demonstrate value of productR&D to develop new products


FINANCIAL GOALS, OPERATING PRIORITIES: Merck

Remain in top quartileMaximize revenue growthPreserve profitability of core businessAchieve full potential


ERRORS VS. FRAUD

Errors Unintentional misstatements or

omissions in financial statements

Fraud Fraudulent financial reporting:

intentional misstatement or omission Misappropriation of assets: theft


PLANNING

Risk of misstatement from fraudFirst quarter planningSecond quarter planning


RISK OF FRAUD: Auditor’s Responsibility

Discuss risk with staffObtain pertinent informationIdentify & assess risksPlan according to assessmentEvaluate evidence


RISK OF FRAUD: Other Aspects

Professional skepticism No presumption of dishonesty

balanced with possibility of misstatement due to fraud

Fraud screens Some financial ratios help

Asset quality Total accruals to total assets Days sales in receivables


IDENTIFYING, ASSESSING RISK OF FRAUD

Fraud triangle Incentives, pressures to commit fraud Opportunities to commit fraud Management’s rationalizations for

committing fraud


FIRST-QUARTER PLANNING

Review prior-year audit workReview 1st quarter resultsPrepare preliminary audit time budgetConsider adverse influences


SECOND-QUARTER PLANNING

Review 2nd quarter resultsFinalize budgetPerform analytical proceduresPrepare preliminary planning memoCoordinate staff with clientPrepare interim audit programs


INTERIM AUDIT WORK: Controls & Programs

Understand internal controlPerform tests of controlsAssess control riskPrepare preliminary audit programs


YEAR-END AUDIT WORK

Coordinate with clientFinalize audit programPerform substantive tests, analytical proceduresEvaluate audit test results Material errors, fraud

Subsequent events


YEAR-END AUDIT DOCUMENTATION

Management, legal representationsAudit documentation review Staff work reviewed

Audit reports

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