Supervision involves directing the efforts of assistants involved in accomplishing the objectives of the audit and determining whether those objectives were accomplished Elements of supervision include:
• Keeping informed of significant issues encountered,
• Reviewing the work performed, and
• Dealing with differences of opinion among firm personnel
The extent of supervision appropriate in a given instance depends on many factors, including the complexity of the subject matter and the qualifications of persons performing the work, including knowledge of the client’s business and industry
The auditor with final responsibility for the audit should communicate with members of the audit team regarding the susceptibility of the entity’s financial statements to material misstatement due to error or fraud, with special emphasis on fraud Such discussion helps all audit team members understand the entity and its environment, including its internal control, and how risks that the entity faces may affect the audit The discussion should emphasize the need to maintain a questioning mind and to exercise professional skepticism in gathering and evaluating evidence throughout the audit
In addition, assistants should be informed of their responsibilities and the objectives of the audit procedures they are to perform They should be informed of matters that may affect the nature, timing, and extent of audit procedures they are to perform, such as the nature of the entity’s business as it relates to their assignments and possible accounting and auditing issues The auditor with final responsibility for the audit should direct assistants to bring to his or her attention accounting and auditing issues raised during the audit that the assistant believes are of significance to the financial statements or auditor’s report so the auditor with final responsibility may assess their significance Assistants also should be directed to bring to the attention of appropriate individuals in the firm difficulties encountered in performing the audit, such as missing documents or resistance from client personnel in providing access to information or in responding to inquiries
The work performed by each assistant, including the audit documentation, should be reviewed to determine whether it was adequately performed and documented and to evaluate the results, relative to the conclusions to be presented in the auditor’s report
In the case where there is a disagreement between a junior auditor and the supervisor, the issue should be settled between the parties with the senior person explaining his or her position If the junior person is still in disagreement with the superior, the junior person should simply document this disagreement and then disassociate from the resolution of the matter
Question 4: The element of the audit planning process most likely to be agreed upon with the client before implementation of the audit strategy is the determination of the: a) Evidence to be gathered to provide a sufficient basis for the auditor’s opinion b) Procedures to be undertaken to discover litigation, claims, and assessments c) Pending legal matters to be included in the inquiry of the client’s attorney d) Timing of inventory observation procedures to be performed
CPA Audit Understanding the Entity and Its Environment
Understanding the Entity and Its Environment
Note: This is a further discussion of the 2 nd Standard of Fieldwork – Understanding the Entity and its Environment
The second standard of field work (further developed in SAS 109) relates to the understanding of the entity and its environment in which it operates:
“The auditor must obtain a sufficient understanding of the entity and its environment, including its internal control, to assess the risk of material misstatement of the financial statements whether due to error or fraud, and to design the nature, the timing and the extent of further audit procedures.” (SAS 105)
The auditor’s understanding of the entity and its environment consists of an understanding of the following five aspects of the business:
1) Industry, Regulatory, and Other External Factors,
The auditor should obtain an understanding of relevant industry, regulatory, and other external factors These factors include industry conditions, such as the competitive environment, supplier and customer relationships, and technological developments; the regulatory environment encompassing, among other matters, relevant accounting pronouncements, the legal and political environment, and environmental requirements affecting the industry and the entity; and other external factors, such as general economic conditions
The nature of an entity refers to the entity’s operations, its ownership, governance, the types of investments that it is making and plans to make, the way that the entity is structured, and how it is financed An understanding of the nature of an entity enables the auditor to understand the classes of transactions, account balances, and disclosures to be expected in the financial statements
The entity may have a complex structure with subsidiaries or other components in multiple locations These will impact the possibility of misstatements in the financial statements
An understanding of the ownership, management, and other key personnel and their relations between owners and other people or entities is also important in determining whether related-party transactions have been identified and accounted for appropriately
3) Objectives and Strategies and the Related Business Risks That May Result In a Material Misstatement of the Financial Statements
The entity conducts its business in the context of industry, regulatory, and other internal and external factors
To respond to these factors, the entity’s management (or those charged with governance) define objectives, which are the overall plans for the entity Strategies are the operational approaches by which management intends to achieve its objectives
Business risks result from significant conditions, events, circumstances, actions, or inactions that could adversely affect the entity’s ability to achieve its objectives and execute its strategies, or through the setting of inappropriate objectives and strategies
Just as the external environment changes, the conduct of the entity’s business is also dynamic and the entity’s strategies and objectives change over time
Understanding the Entity and Its Environment CPA Audit
4) Measurement and Review of the Entity’s Financial Performance
Performance measures and their review indicate to the auditor aspects of the entity’s performance that management and others consider to be important
Performance measures, whether external or internal, create pressures on the entity that, may motivate management to take action to improve the business performance or to misstate the financial statements Obtaining an understanding of the entity’s performance measures assists the auditor in considering whether such pressures result in management actions that may have increased the risks of material misstatement
5) Internal Control, Which Includes the Selection and Application of Accounting Policies
The auditor should obtain an understanding of the five components of internal control sufficient to assess the risk of material misstatement of the financial statements whether due to error or fraud, and to design the nature, timing, and extent of further audit procedures
The auditor should obtain a sufficient understanding by performing risk assessment procedures to evaluate the design of controls relevant to an audit of financial statements and to determine whether they have been implemented The auditor should use such knowledge to:
• Identify types of potential misstatements,
• Consider factors that affect the risks of material misstatement, and
• Design tests of controls, when applicable, and substantive procedures
Note: The five components of internal control are discussed in the section on Internal Controls
Documentation of the Understanding Obtained
One “definition” of materiality is that it is the amount that would cause someone to change his or her decision The auditor is most concerned with making certain that all material misstatements are detected by the audit
Materiality can be measured both quantitatively (amount) and qualitatively (characteristic), and is a matter of professional judgment An example of a qualitative measurement would be a $100 error that is the difference between a $50 profit and a $50 loss Though the amount itself is not large, the fact that it causes a change from profitability to loss makes this amount qualitatively material
There is no rule for determining how much is material and you will not need to make such a calculation on the exam Materiality impacts the preliminary level of control risk and sample sizes for planned substantive tests
Note: The prior year’s audited financial statements are the most likely determining factor in shaping the auditor’s preliminary judgment concerning materiality for the current year This assessment will probably change, but the auditor needs to start somewhere
When misstatements are found in the financial statements, the auditor needs to assess whether or not they are material This assessment should be done both individually (each misstatement by itself) and in aggregate (in total), in order to determine if they are material While an individual small mistake by itself may not be material, if there are a lot of small mistakes in the same area, they may in total be a material misstatement
In making the final determination of materiality, the auditor should consider the needs of a reasonable individual relying on the information found in the financial statements This is where the measurement of materiality as the amount that would cause a user to change their decision is applicable
Note: If management does not correct material misstatements, the auditor should issue a qualified or adverse opinion This is covered the material on audit reports
Material misstatements may result from:
2) Omissions of necessary information, or
CPA Audit Audit Risk and Materiality
Materiality Levels in the Audit
Materiality levels are developed for each of the financial statements individually, but the smallest amount of materiality for any of the statements should be used when planning the audit This smallest level of materiality must be kept in mind because of the fact that the balance sheet and the income statement are connected This means that a misstatement in fixed assets will also impact the income statement through depreciation expense
A change in the acceptable level of audit risk may change materiality Additionally, the assessment of materiality can change as the audit progresses and more information becomes available to the auditor
Any decrease in the level of materiality (meaning a smaller amount is material) or a decrease in the acceptable level of risk (meaning that the auditor has less tolerance for a mistake in the opinion) requires the auditor to:
1) Perform more effective auditing procedures, and/or
2) Perform procedures closer to (or after) the balance sheet date, and/or
3) Increase the extent (amount) of auditing tests performed.
Audit risk is the risk that an auditor will give an unqualified (everything is fine) opinion, when in reality there is one or more than one material misstatement in the area being audited The risk of a material misstatement is the calculated result of the multiplication of three individual risk factors These three risks represent the three events that must occur in order for the audit opinion to contain an error These three events are:
1) There is an error made in the first place, and
2) The internal controls fail to detect the error, and
3) The auditor fails to detect the error
In order for the audit opinion to be wrong, all three of these events must occur Technically speaking, audit risk is made up of three components and these components mirror the three events that bring about an error The three components of audit risk are:
• Inherent risk – this is the risk that is natural in an element of the financial statements or the function being audited, assuming that there are no controls It is the susceptibility to a material mis- statement that exists “just because.” An example of an inherent risk is the calculation of pension liabilities, which by nature are extremely complex This is the risk that there is an error in the first place
• Control risk – this is the risk that an internal control will not prevent or detect a material misstate- ment in a timely manner As we saw in the section on Internal Control, internal control is not a guarantee that an organization will achieve its financial reporting, operational and compliance objec- tives No matter how well designed and operated it is, internal control can provide only reasonable assurance to management and the board of directors that the organization’s objectives will be achieved Major risks are that controls may fail because of human error, or they can be circumvented by collusion, or management may override internal control procedures This is the risk that the inter- nal controls do not detect the error
• Detection risk – this is the risk that an auditor will not detect a material misstatement in the financial statements through their audit testing This is the risk that the auditor does not detect the error
Detection risk may further be broken down into two parts based on the types of tests performed by the auditor:
1) Test of details risk, and
Audit Risk and Materiality CPA Audit
These three components are multiplied together to calculate the total level of audit risk
Audit Risk (AR) = IR * CR * DR
Note: Inherent risk and control risk together are called “Risk of Material Misstatement.” This may be abbreviated RMM The formula can be rewritten as AR = RMM * DR
Assessing the Components of Audit Risk
The assessment of inherent risk and control risk requires professional judgment These risks are related to both the client and the company’s financial environment If either the inherent risk or the control risk is assessed at less than maximum (meaning that the auditor thinks that there is a less than maximum chance for either of these to occur), the basis for this assessment must be documented in the working papers
Conformity with US GAAP 159 2 Consistency of GAAP Application 159 3 Adequacy of Disclosure 160 4 Expression of Opinion 161
The first standard states that the report that is written by the auditor must state if the financial statements are presented in conformity with US GAAP This, unfortunately, is not as simple as making sure that all of the accounting policies that are used exist within GAAP Because of the different possible treatments under GAAP (such as different methods of inventory and depreciation), there are no single “correct” financial statements for a company Rather, the financial statements will need to fall within an acceptable range of balances and amounts that can all be supported under GAAP
Another publication that you need to be aware of is called Accounting Trends and Techniques This is published by the AICPA and focuses on accounting and implementation issues that are faced by companies This is not in the table above because it is not really a source of GAAP, but more a source of the implementa- tion of GAAP You should be aware of this publication and its use as a guide to implementation issues that have been faced
The second standard of reporting essentially has two parts, specifically that the audit is to provide assurance that:
1) Comparability has not been materially affected by changes in accounting principles, and
2) If comparability has been materially affected, the auditor has disclosed the changes and their effects
Related to this standard, you should know what is considered to be a change that affects consistency and what does not Below are two lists: the first list gives events that will affect consistency and the second is a list of changes that do not affect consistency
Note: In the standard audit opinion, there is no mention of consistency This means that the standard audit report implicitly states (there are no words to this effect, but it is implied) that the presented financial statements are consistent Therefore, consistency is only addressed in the audit report if the financial statements are not consistent
The Reporting Standards CPA Audit
Events That Cause a Reportable Lack of Consistency
Events that affect consistency and therefore need to be included in the report are below This inclusion may be part of either an unqualified opinion (as additional language, which is covered later) or a qualified opinion
• Changes in accounting principle – This includes a change from GAAP to GAAP and/or changes in the application of a GAAP principle An example of a change in application would be a change in the method of the allocation of overhead
If the change is not justified, the auditor should express this and a qualified opinion should be giv- en If it is a justified change, an unqualified opinion with additional language may be given
• Change in the reporting entity – This is usually a situation related to combined and consolidated financial statements when the companies that are combined or consolidated are changed
• Correction of an error in principle – This is a change from non-GAAP to GAAP and this change will need to be accounted for as a correction of an error
• Change in principle and estimate – If the change in principle cannot be separated from a change in estimate, it is accounted for as a change in estimate, but it is included in the report as a lack of consistency issue
• Changes in the presentation of cash flows – If the company changes its definition of cash equivalents, the change must be disclosed in the audit report
Events That Do NOT Cause a Reportable Lack of Consistency
These items do not require inclusion in the report, but if they are material they may need to be disclosed in a note to the financial statements
If they are not properly disclosed and accounted for in the financial statements, a qualified opinion will be required
• Error correction that is not an error in principle,
• Changes in classification and reclassification,
• Different principles as a result of different transactions, and
• Changes expected to have a material future effect
The third Standard of Reporting states that the financial statements should contain adequate disclosure of all material matters What constitutes adequate disclosure is determined by circumstances, facts and the professional judgment of the auditor
Also, because of the confidential nature of some information disclosed to the auditor by management, the auditor should not disclose items that are not required by GAAP without the permission of the client
CPA Audit The Reporting Standards
Under the fourth standard of reporting, the auditor is able to express different opinions for each of the different financial statements if that is what is necessary This may lead to an unqualified opinion in respect to the balance sheet, but a qualified opinion for the income statement and statement of cash flows
The auditor may also issue an opinion on one financial statement and not all of them This is covered in a later section in more detail
Also, the auditor is able to express an opinion on certain identified items in limited situations This may be done if:
1) These items are not a major portion of the financial statements,
2) The report on the financial statements was unqualified or qualified, and
3) The report is presented separately from the report on the financial statements
Note: This type of reporting on specific items is covered again in more detail later
Types of Opinions CPA Audit
There are five types of opinions that the auditor can issue For the exam you must be able to identify which opinion is appropriate given the situation outlined in the problem The five types of opinions are listed below
On the following pages we look at the requirements for each of these opinions in much more detail The five different opinions and what they convey are:
Unqualified Opinion 162
respects, the financial position of the company (This is often called the standard, or clean, report.)
2) Unqualified opinion, additional language – The financial statements fairly present, in all material respects, the financial position of the company, but there is some matter that is drawing the atten- tion of the reader
3) Qualified opinion – The financial statements fairly present, in all material respects, the financial position of the company, except for one or more matters that are listed in the opinion, which are not correct (This is often called an “except for” opinion.)
4) Adverse opinion – The financial statements do not fairly present, in all material respects, the financial position of the company in conformity with GAAP
5) Disclaimer of opinion – The auditor has no opinion regarding the financial statements
We will now look at these different opinions in more detail
As you will have noted from the list above, there are two different types of unqualified opinions They both are saying that the financial statements are correct in accordance with GAAP However, in the unqualified opinion with additional language, there is something else that the auditor feels the reader should know
Generally, in order to issue either type of unqualified opinion, six conditions must exist:
1) No unjustified departures from GAAP,
2) Disclosures are adequate and complete,
3) No unusual uncertainties exist (may be in an explanatory paragraph),
5) GAAP is consistently applied between periods in all material respects, or all changes in application are justifiable (may be in an explanatory paragraph), and
Generally, if any one of these conditions is not met, the auditor may not issue an unqualified opinion In some cases in which one of these conditions is not met (especially items 3 and 5), an unqualified opinion with additional language may be given if the event is properly disclosed and accounted for
Note: There is in essence a seventh requirement and that is that the audit must have been conducted in accordance with GAAS However, for whatever reason, this is not included in the list of requirements, but is identified separately
CPA Audit Types of Opinions
The standard report consists of three paragraphs The form of the standard report is:
1) Title – This must include the word independent
2) Address – The report is usually addressed to the company, the board of directors or the sharehold- ers
3) Introductory Paragraph – This identifies the financial statements audited and includes a statement that the financial statements are the responsibility of management while the responsibility of the au- ditor is to express an opinion
4) Scope Paragraph – This paragraph states that the audit was conducted in accordance with GAAS (see note below), a brief description of an audit and a statement that the audit provides a reasonable basis for the expression of an opinion
5) Opinion Paragraph – This is the opinion itself and for an unqualified opinion, it states that the financial statements present fairly, in all material respects, the position of the company in conformity with US GAAP
6) Signature – The signature of the firm is included
7) Date – The date is usually the date that the audit work is completed
Note: The Public Company Accounting Oversight Board has issued PCAOB Standard No 1 that requires that for engagements conducted in accordance with PCAOB standards should state that the audit was conducted in accordance with the standards of the PCAOB instead of GAAS
The standard audit report is illustrated on the following page, and you should memorize this report because it is the basic form for all reports Other reports are mainly modifications of this report It is possible that one of the essays or problems will relate to some sort of report, and the question may require you to write a report, comment on one written by someone else, or correct an existing report
If you know this standard audit report, you will be able to make a good approximation of other reports simply by making modifications to it
Note: If the auditor is engaged to audit a company that is not a client (usually by someone who is a client) the audit report should be addressed to the company that has engaged the auditor, not the company being audited
Types of Opinions CPA Audit
We have audited the accompanying balance sheet of X Company as of December 31, 2011 and the related statements of income, retained earnings and cash flows for the year then ended These financial state- ments are the responsibility of the Company’s management Our responsibility is to express an opinion on these financial statements based on our audit
We conducted our audit in accordance with US GAAS Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall financial statement presenta- tion We believe that the audit provides a reasonable basis for our opinion
In our opinion, the financial statements present fairly, in all material respects, the financial position of X Company as of December 31, 2011 and the results of its operations and its cash flows for the year then ended in conformity with US GAAP
(The manual or printed signature of the auditor’s firm.)
(The date of the audit report.)
Question 116: The existence of audit risk is recognized by the statement in the auditor’s standard report that the auditor: a) Assesses the accounting principles used and also evaluates the overall financial statement presentation b) Realizes some matters, either individually or in the aggregate, are important while other matters are not important c) Is responsible for expressing an opinion on the financial statements, which are the responsibility of management d) Obtains reasonable assurance about whether the financial statements are free of material mis- statement