Chapter 1- An Introduction to Assurance and Financial Statement Auditing

4-24 1. Tips Tips for for Learn Learning ing Aud Auditi iting ng a. Auditing focuses on learning learning the the analytical analytical and logical skills necessary necessary to evaluate the relevance and reliability of nancial information as ell as of the systems and processes responsible for recording and summari!ing that information. 2. The "eman "emand d for Auditing Auditing and Assu Assuranc rance e a. Auditing has uses uses outside outside of being compliant compliant ith ith the la. la. b. #rinc #rincipa ipals ls and Agents Agents i. The demand demand for for auditin auditing g can be be understo understood od as the the need need for accountability hen business oners hire others to manage their business$ as is typical in modern corporations. ii. The birth birth of modern modern accountin accounting g and auditing auditing occur occurred red during during the the industrial revolution$ hen companies became larger and needed to raise capital to nance e%pansion. iii. A public public company company is a compan company y that sells sells its stocks stocks or bonds bonds to the public$ giving the public a valid interest in the proper use of the company&s resources. 1. Thus$ Thus$ the groth groth of the modern modern corpor corporatio ation n led to diverse diverse groups of oners ho are not directly involved in running the business 'stockholders( and the use of professional managers hired by oners to run the corporation on a day-to-day basis. 2. )n this settin setting$ g$ managers managers serve serve as agents agents for the the oners oners 'ho are sometimes principals( and fulll a steardship function by managing the corporation&s assets. iv. iv. )nforma )nformation tion asymmetr asymmetryy- the manager manager genera generally lly has has more more information about the *true+ nancial position and results of operations of the entity than does the absentee oner. 1. ,ecause ,ecause their their goals may may not coincide$ coincide$ there there is a natural natural conict of interest beteen the manager and absentee oner. )f both parties seek to ma%imi!e their self-interest$ the manager may not alays act in the best interests of the oner. oner. 2. The oner oner can can attempt attempt to protect protect him him or herself herself again against st the possibility of improper use of resources by reducing the manager&s compensation by the amount of company resources that the oner e%pects the manager to consume. . /ne primary primary role role of account accounting ing informa information tion is to hold hold the manager accountable to the oner. c. The The 0ol 0ole e of Au Audi diti ting ng i. The auditor& auditor&s s role is to deter determine mine hether hether the the reports reports prepar prepared ed by the manager conform to the contract&s provisions. ii. The auditor& auditor&s s verication verication of of the nancial nancial inform information ation adds adds credibility to the report and reduces information risk$ or the risk

that information circulated by a company&s management ill be false or misleading. iii. 0educing educing informat information ion risk risk potentiall potentially y benets both both the oner and the manager.

iv. iv. )n summary$ summary$ auditin auditing g is demanded demanded because because it plays plays a valuable valuable role in monitoring the contractual relationships beteen the entity and its stockholders$ stockholders$ managers$ employees$ and debt holders. v. #As #As have been charg charged ed ith provid providing ing audit audit services services because because of their traditional reputation reputation of competence independence$ obectivity$ and concern for public interest. 1. As a result$ they are are able to add credibility credibility to information information produced and reported by management to outside parties. . An Assuran Assurance ce Analogy Analogy33 The ase of the the ouse )nspec )nspector tor a. The buyer buyer and seller seller of a home have have a natural natural conict conict of intere interest st and a certain amount of information asymmetry 'seller knos more about the home than the buyer(. This presents an information information risk to the buyer. b. 0elating 0elating the ouse )nspection )nspection Analogy Analogy to 5inancial 6tatement Auditing Auditing i. )nforma )nformation tion asymmetr asymmetry y and conicts conicts of of interest interest also also e%ist e%ist beteen the managers of companies and potential investors. ii. The compan companies ies selling selling stocks stocks or or bonds bonds to the publi public c typically typically hire and pay the auditor.

1. A reputable reputable indepen independent dent auditor& auditor&s s opinion opinion can provide provide assurance to thousands of potential investors. 2. ,y purchas purchasing ing the assur assurance ance provide provided d by an audit$ audit$ a company can sell its stocks and bonds to prospective oners and creditors at more favorable prices$ signicantly reducing reducing the cost of capital. iii. 0eputation eputation to an auditi auditing ng rm is everyth everything. ing. )nvesto )nvestors rs and creditors ant a name they can recogni!e. This is hy 789 of the auditing market is taken by the big four accounting rms. c. :anagement :anagement Asser Assertion tions s and 5inanc 5inancial ial 6tatemen 6tatements ts i. 5inancial inancial statemen statementt assertions assertions are managemen management&s t&s e%presse e%pressed d or implied claims about information information reected in nancial statements. ii. Assertio Assertions ns are are central central to auditing auditing becaus because e they are are the focus of of the auditor&s evidence collection e;orts. :uch of hat auditors do revolves around collecting and evaluating evidence about management&s nancial statement assertions. assertions. iii. /ne of the main main tasks tasks of the the auditor auditor is to collect collect su3 5or 5or cash$ cash$ to ensure ensure the amount amount e%ists$ e%ists$ the auditor auditor may e%amine bank statements or send a letter to the bank re?uesting conrmation conrmation of the balance. Then$ to insure the cash hasn&t been pledged or restricted$ you might revie the minutes of key management meetings to look for discussions or agreements on this issue. v. :anagement assertions can be divided into three aspects of information information reected in nancial statements3 transactions, account balances, and presentation and disclosure.

4. Auditing Auditing$$ Attest$ Attest$ and and Assuranc Assurance e 6ervices 6ervices "ened "ened a. Accounting professionals professionals can provide provide assurance assurance about about the reliability reliability and relevance of information given by one party to another. i. The broades broadestt category category of such such services services is simply simply called called assurance services. ii. Assuranc Assurancee- the evaluati evaluation on of evidenc evidence e to determine determine hether hether information has been recorded and presented in accordance ith a predetermined set of criteria$ together ith the issuance of a report that indicates the degree of correspondence. b. Auditing- a systematic systematic process process of obectively obectively obtaining obtaining and evaluating evaluating evidence regarding regarding assertions about economic actions and events to ascertain the degree of correspondence beteen those assertions and established criteria and communicating the results to interested users. i. *6ystemat *6ystematic ic process process+ + means that that there there should should be a ell-plann ell-planned ed and thorough approach for conducting an audit. ii. The approach approach involves involves *obec *obectivel tively y obtaining obtaining and evaluatin evaluating g evidence.+ iii. @hile @hile di;erent di;erent types types of *criteria *criteria+ + might be availab available le in di;erent di;erent settings$ AA# usually serve as the basis for evaluating management&s assertions assertions in the conte%t of a nancial statement audit. c. Attes ttesta tati tio on i. Auditors Auditors have have a reputation reputation of independ independence ence and obect obectivity ivity..

1. As a result result$$ it has alays alays been been common common for vario various us parties parties to re?uest that auditors attest to information information beyond historical nancial information. ii. Attest Attest services services occur occur hen hen a practition practitioner er is engaged engaged to issueB issueB a report on subect matter$ or an assertion about subect matter$ that is the responsibility of another party.

iii. iv. iv. The denition denition is broader broader than than the one previou previously sly discusse discussed d for auditing because it is not limited to economic events or actions. v. The subec subectt matter matter of attest attest services services can can take take many forms forms$$ including prospective information$ analyses$ systems and processes$ and even the specic actions of specied parties. d. As Ass sura urance nce i. Assuranc Assurance e servicesservices- independe independent nt profess professiona ionall services services that improve the ?uality of information$ or its conte%t$ for decision makers. 1. The denit denition ion focus focuses es on decision decision making. making. 2. The deniti denition on relate relates s to improvin improving g the ?uality ?uality of of information information or its conte%t. An assurance service engagement can improve ?uality through increasing condence in the information&s reliability and relevance. . The denitio denition n includes includes independe independence$ nce$ hich hich relates relates to the obectivity of the service provider. ii. ii. To sum summa mari ri!e !e$$ assurance services can services can include almost any service provided by accounting professionals that involves capturing informati information$ on$ improving its ?uality$ or enhancing its usefulness for decision makers. 8. 5undamental 5undamental oncepts oncepts in onducting onducting a 5inancial 6tatement Audit Audit a. )ntro3 i. The conceptu conceptual al and proced procedural ural details details of of nancial nancial statemen statementt audit build on three fundamental concepts3 materiality$ audit risk$ and evidence relating to management&s nancial statement assertions. ii. The auditor& auditor&s s assessment assessments s of audit audit risk and materi materiality ality inuenc inuence e the nature$ timing$ and e%tent of the audit evidence to be gathered.

b. :ate :ateri rial alit ity y i. :aterialit :aterialityy- refers refers to the the amount amount by hich hich a set of of nancial nancial statements could be misstated ithout a;ecting the udgment of  reasonable people. ii. /ne of the the auditor&s auditor&s rst rst tasks tasks in plann planning ing an audit audit is to make make a  udgment about about ust ho big a misstatement misstatement ould have to to be before it ould signicantly a;ect users& udgements. iii. )t isn&t isn&t practical practical or cost cost benecial benecial for for auditors auditors to ensur ensure e that nancial statements are completely free of any small misstatements. iv. iv. @hile @hile other factors factors must must be consider considered ed in determi determining ning materiality$ a common rule of thumb is that total 'aggregated( misstatements of more than  to 8 percent of income before ta% ould cause the nancial statements to be materially misstated. c. Audit 0i 0isk i. Audit Audit risk- the the risk that that the auditor auditor mistak mistakenly enly e%pre e%presses sses a clean clean audit opinion hen the nancial statements are materially misstated. ii. The auditor& auditor&s s standard standard repor reportt states states that the audit audit provide provides s *reasonable assurance+ that the nancial statements do not contain material misstatements. 1. )mplies )mplies that ther there e is alays alays some risk risk that that material material misstatement could be present in the nancial statements and the auditor ill fail to detect it. iii. "ue to cost cost constr constraints aints and and the sheer sheer imposs impossibil ibility ity of investigating investigating every item reected in an entity&s nancial statements$ the risk that an auditor ill mistakenly issue a clean opinion on materially misstated nancial statements should be lo$ but it cannot be driven to !ero. d. Audit Audit =vidence =vidence 0egar 0egarding ding :anageme :anagement nt Assertio Assertions ns

i. The third third maor maor concept concept involv involved ed in auditi auditing ng is evidenc evidence e regarding management&s assertions or$ more simply$ audit evidence. ii.