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ADMS 4551 (3)

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York University
Administrative Studies
ADMS 4551
Larry Yarmolinsky

ADMS 4551: CHAPTER 5+20 (WEEK 2) The objective of the Audit- Management and Auditor Responsibilities Managements Responsibilities  The purpose of the financial statement audit is to express an opinion of the financial statements o The opinion being an assessment of whether the financial statements are presented fairly, in the context of materiality, in conformity with an applicable financial reporting framework as the criteria for the assessment The responsibility of management is to adopt sound and appropriate financial reporting framework  and corresponding accounting policies, maintaining adequate internal control, and making fair representation in the financial statement.  In the event that management insists on financial statement disclosure that the auditor finds unacceptable, the auditor can either issue an adverse or qualified opinion, or as a last resort, withdraw from the engagement  The Canadian Securities Administration have filed rules that impose requirements similar to those of the US Sarbanes-Oxley Act for most companies listed on the Canadian Stock Exchange o The CEO and CFO of such companies must certify annual and interim financial statements as well as management discussion and analysis and certain information forms that are filed with the stock exchanges Auditor's Responsibilities  Professional skepticism means that the auditor should not be blind to evidence that suggests that documents, books, or records have been altered or are incorrect  The concept of reasonable assurance indicates that the auditor is not an insurer or guarantor of the correctness of the financial statements, due to 3 reasons o Most audit evidence results from testing a sample of a population, such as accounts receivable or inventory, which includes some risk of not uncovering a material misstatement o Accounting representations from management contain complex estimates which involve uncertainty and can be affected by future events o Fraudulently prepared financial statements are often extremely difficult, if not impossible, for the auditor to detect, especially when there is collusion among management  CAS 240 distinguishes between errors and fraud and other irregularities o An error is an unintentional misstatement of the financial statements o Fraud and other irregularities are intentional  In terms of fraud, there is a distinction o Fraud is often referred to as defalcation or employee fraud includes corruption such as managers or others taking bribes or having the corporation pay for personal expenses o Fraudulent financial reporting is often called management fraud is committed for the apparent benefit of the company Management Fraud  Difficult to uncover because it is possible for one or more members of management to override internal controls and there is typically an effort to conceal the misstatement o May include omission of transactions or disclosures, fraudulent amounts, or misstatements of recorded amounts o Careful examination of journal entries and other adjustments made by management may help to identify risks of management fraud Employee Fraud  The auditor should evaluate the likelihood of material employee fraud, which is done initially as part of understanding the entity's internal control and assessing control risk and fraud risk Computer Fraud  Consists of fraud conducted with the assistance of computer software/hardware, including deliberately programming functions into a computer program so it incorrectly calculates interest, placing unauthorized employees on a computerized payroll system, falsifying an electronic mail message, obtaining free long distance telephone services, or creating fraudulent electronic cash transactions Illegal Acts  Examples of illegal acts are a violation of income tax laws and a violation of an environmental protection law  It is an auditor's responsibility to comply with generally accepted auditing standards (GAAS), and the auditor as a result, may not detect non-compliance or become aware that an illegal act has occurred if management has not disclosed it to the auditor  When an illegal act is discovered, the auditor must consider whether such an act is a reflection of the company's corporate culture Direct-effect illegal acts  Certain violations of laws/regulations have a direct financial effect on specific account balances in financial statements  Auditor's are responsible for these acts and must evaluate whether there is evidence available to indicate material violations of such laws, which is done by discussions with client personnel and examination of reports, etc. Indirect-effect illegal acts  Affect the financial statements indirectly due to violation of a law, and the consequence would be a fine or a sanction  Auditing standards state that the auditor provides no assurance that indirect effect illegal acts will be detected, as they lack legal expertise, and it is impractical for auditors to assume responsibility for discovering such acts  One of the first things that an auditor would do upon discovering an illegal act would be to consult a lawyer Before Accepting an Engagement, Preparing Takes Place Preplan the Audit  Takes place prior to acceptance and early in the engagement  Involves the following steps: o Identify the client's reason for the audit o Conduct an independence threat analysis o Decide whether to accept or continue doing the audit for the client o Select staff for the engagement o Obtain a signed engagement letter Identify client reasons for audit  Factors affecting how much and what type of evidence the auditor needs to collect are: o Who are the financial statement users, and o The intended use of the financial statements  An auditor is likely to accumulate more evidence when the financial statements are to be used extensively  The use of the financial statements can be determined from previous experience in the engagement and discussion with management Conduct independence threat analysis  An auditor may conduct an audit only if independent  The five threats to independence must be explicitly assessed, and any potential threats described o Such 5 threats are: self interest, self review, advocacy, familiarity, and intimidation  If there are any threats, the auditor determines whether it is possible to implement safeguards to mitigate the threat (i.e. changing the partner in charge to deal with the familiarity threat)  If the safeguards can be put to place, the engagement can be accepted, otherwise it must be declined Client acceptance or continuance  Some public accounting firms may refuse clients in what they perceive to be high-risk industries  Accounting fi rms investigate the company to determine its acceptability, its standing in the business community, financial stability and relations with its previous accounting firms  Many unstable firms fail financially and expose the public accounting firm to significant potential liability  For potential clients that have previously been audited by another public accounting firm, the new accounting firm is required to communicate with the previous auditor for the purpose of helping the new auditor evaluate whether to accept the engagement o The communication may inform the auditor about problems with following accounting principles, audit procedures or fees  Before the auditor can communicate with the previous auditor, permission from the potential client must be obtained, because of confidentiality requirements Continuing clients  Public accounting firms evaluate existing clients annually to determine whether there are reasons for not continuing to do the audit Identify staff available for the engagement  Assigning the appropriate staff to the engagement is important to meet quality control standards in GAAS and to promote audit efficiency  A major consideration affecting staffing is the need for continuity from year to year o Continuity helps the public accounting firm maintain familiarity with technical requirements and close interpersonal relations with the client's personnel Obtain a signed engagement letter  A written agreement between the accounting firm and the client for the conduct of the audit and related services  The engagement letter should contain the terms and should clarify the responsibilities of management and the auditor  Specifies whether the auditor will perform an audit, a review, or a compilation, plus any other services such as tax returns or management services Audit Phases  There are 8 phases, and they can be broken down into 3 sections: Risk Assessment, Risk Response, and Reporting  In the Risk Assessment, the auditor identifies what could go wrong with the financial statements and the approaches for dealing with the risks o Information must be collected and analyzed about the industry, business environment, and client to identify and assess risks  In Risk response, specific audit programs and processes are designed and tests conducted to obtain reasonable assurance with respect to the financial statements in the context of assessed risks  In Reporting, the auditor decides upon the reporting to be issued, issues the report ,and communicates with management and the audit committee Risk assessment  The auditor determines what could go wrong in the financial statements, the client industry, or business, before tailoring the risk response to those assessed risks  The risk assessment section is broken down into 3 phases Phase 1-Preplanning  The auditor first decides whether to accept the new client or continue with the existing client  Only when the auditor decides to proceed with the engagement, the engagement letter is provided Phase 2-Client Risk Profile  The auditor needs to be aware of the business environment and regulatory environments within which the business functions  Once the auditor understands the industry, then the auditor can more effectively understand and assess the client for the purposes of developing a client risk profile  Knowledge of industry and business helps the auditor develop expectations of client results in the context of the overall business environment to properly conduct procedures that help assess the ability of the client to continue as a going concern Phase 3-Plan the Audit  The knowledge of the business, industry, and environment will enable the auditor to assess the likelihood of material misstatement in financial statements as a whole or by assertion before the consideration of internal controls o Using financial results of the client, the auditor will set preliminary materiality levels  After the auditor gains an understanding of internal control, he is in a position to evaluate how effective controls should be in preventing and detecting errors/fraud and other irregularities  The auditor then determines the risk of material misstatement of financial statements, which helps identify the depth of audit work required for the individual accounts and transaction streams  The outcome of the planning process is a strategic audit approach for the audit, which must ne approved by audit team management before being implemented Risk Response Phase 4-Design further audit procedures  Prepared to respond to the risks of material misstatement identified in the risk assessment phases of the audit  The auditor considers the different types of tests, the type of sampling to be used to actually conduct the tests, and adding unpredictability to the testing process o Conduced in relationship to the materiality levels determined Phase 5-Tests of Control  Where the auditor has decided to rely upon internal controls, the auditor must test the effectiveness of the controls  Test of controls are audit procedures that test the effectiveness of control policies and procedures in support of a reduced assessed control risk Phase 6-Substantive tests  3 categories of substantive procedures: o Analytical procedures are those that assess the overall reasonableness of transactions and balances using comparisons and relationships  i.e. have the auditor run a report for unusually large amounts and compare total monthly sales to prior years o Tests of details of balances are intended to test for monetary misstatements in the balances in the financial statements  i.e. to test the accuracy of A/R, direct written communication with the client's customers will be conducted o Tests of key items focus on specific transactions that could be at risk of material error  i.e. the purchase of shares in a subsidiary company may be at risk of incorrect valuation Phase 7-Ongoing evaluation, quality control, and final evidence gathering  Links to all of the other phases of the engagement  Supervisions and QC are ongoing, as papers are regularly reviewed and unusual items followed up  May result in a revision to materiality or the audit programs  The auditor then combines the information obtained into an audit summary memo to reach an overall conclusion as to whether the financial statements are fairly presented o This is highly subjective process that relies on the auditor's professional judgment Reporting Phase 8-Reporting  The accounting firm must issue an auditor's report to accompany the client's published
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