Every new activity has a starting point. This lesson is designed to provide some insight, review, and curiosity.
This course focuses on developing five competencies related to perfomring a Risk Based audit:
Competency can be considered the intersection of Attitude, Knowledge, and Skills.
Apollo Shoes is a multipart audit case which covers some elements of the audit planning process and audit procedures for Cash, Accounts, Receivable and Collections, and Acquisitions and Expenditures.
You should also find that concepts from other business courses such as economics, finance, management, taxation, and business law are part of an audit. Why? Because an audit includes areas beyond the amounts and disclosures in the financial statements.
After completing this lesson you should be able to do the following:
By the end of this lesson, make sure you have completed the readings and activities found in the Lesson 1 Course Schedule.
The American Accounting Association defines auditing as: -
“a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between these assertions and established criteria and communicating the results to users of interest.”
This course applies the definition specifically to auditing financial statements.
An auditor refers to an individual who possesses the combination of attitude, knowledge, and skills necessary to perform an audit.
Since auditing is a systematic process, then you can expect the following:
Generally Accepted Auditing Standards (GAAS) are the codified guidance and procedures for a financial statement audit. GAAS covers planning, conducting the audit, and issuing the proper audit report.
The “criteria” referred to in auditing is Generally Accepted Accounting Principles (GAAP).
Auditing starts with a set of financial statements prepared by the client. Now, the auditor exams the underlying account balance and records looking for misstatement. The term misstatements is a deliberate use of the word. The auditor is looking for the misstatements at the account or transaction level. Once identified, a misstatement is classified as either an error or a fraudulent act. An error gets corrected, fraud requires more work.
Note: students often develop an interest in Forensic Accounting after completing this course. This could be you.
An audit is usually not a voluntary activity for a client. It comes at the request of a Decision Maker or External User who demands audited financial statements to evaluate the overall financial condition of the client as part of a decision-making process.
The client hires the auditor who in turn performs the audit and supplies an opinion as part of the Independent Auditor’s Report. The audit opinion gives the decision maker a level of assurance that they can rely on financial statements and disclosures.
The auditor’s opinion satisfies the demand for financial information that is relevant, complete, timely, comparable, and verifiable. Decision makers do not want to verify the information themselves. That would be costly and inefficient.
The audit also reduces information risk. This is the risk that the information is incorrect or misleading in some way. Some of the potential causes of information risk could be:
As a review, Figure 1 is a partial list of Decision Maker’ and related decisions.
| Stakeholder/Decision Maker | Type of Decision |
|---|---|
| Management | Operational decisions and preparation of reports for capital markets |
| Shareholders | Buy or sell stock |
| Investors | Buy or sell stock |
| Bondholders | Buy or sell bonds |
| Financial institutions | Lending decisions, including terms and risk |
| Taxing authorities | Taxable income and tax liability |
| Regulatory agencies | Monitor compliance, existing regulations, and development of new regulations |
| Vendors | The termination of credit risk |
| Court system | Determine company's financial position during litigation |
| Retired employees | Impact on pension and other post-retirement benefits |
Your accounting courses have covered accounting as a series of steps in a process that result in the preparation of financial statements. Intermediate Accounting introduced Generally Accepted Accounting Principles and the calculation,
As an auditor, you are expected to be proficient in your understanding and application of Generally Accepted Accounting Principles (GAAP). Exhibit 1 summarizes the GAAP Reporting Framework. Audit tests and procedures are designed to satisfy the level of compliance with GAAP. This is what you should know.
Next, the steps of the accounting processing cycle, shown in Exhibit 2, are the systems used to ensure that transactions are properly recorded. We will test this process during the audit, as well as the related system of internal control associated with the process.
Exhibit 2. Steps in the Accounting Processing Cycle
Exhibit 3 serves as a reminder of the formal link between the income statement accounts and the balance sheet accounts. Notice the effects, as indicated by the arrows, can be direct or indirect.
Exhibit 3. Adjusting Entries
We express the impact of a misstatement (error) in the accounting records in terms of an overstatement or understatement. I suggest that you adopt this method of analysis and expression. Experience has shown that it helps students apply the auditing concepts and procedures more easily and completely.
Our review would not be complete without mentioning the accounting records and reports. Exhibit 4 presents the flow of transactions through the accounting process and the various reports (journals, ledgers, and trial balance) that are part of the accounting system. You need to be familiar with the label and purpose of the Specialty Journals and the interaction between a Subsidiary Ledger and related General Ledger account.
Exhibit 4. Flow of Accounting Transactions
Never forget the mechanics of accounting. It will always serve you well. It is quite easy to become reliant on technology. Why the comment on technology?
Technology or Information Systems (IS) in this context refers to the programs that run the accounting software. The developer “codes” the software to mimic the Steps 3 through 10 in Exhibit 2 and the flow of data from Exhibit 4. Your ability to visualize the steps in Exhibits 2 and 4 may be helpful when you must analyze data to correct an error. Auditors and accountants both rely on the reconciliation process.
Accounting estimates are used to allow for probable events where a degree of uncertainty exists, and an exact dollar amount cannot be determined. Common examples:
You will find reference to accounting estimates in planning and performing the audit.
Reconciliationis a process where two sources or sets of information are compared and adjusted so both amounts agree. You are probably familiar with bank reconciliations. If not, you will be because it is part of the Apollo Shoe case procedures for Cash. Subsidiary ledgers are also reconciled to the controlling general ledger account. Example: - Accounts Receivable subsidiary ledger Customer Detail report to Account Receivable amount in the General Ledger.
The GAAP review was designed to get you ready to learn about auditing because the auditor must establish that the financial statements were prepared in accordance with Generally Accepted Accounting Principles.
Corporate governance is referred to throughout this course and extensively in auditing standards. The OECD Principles of Corporate Governance states:
"Corporate governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined."
Milton Friedman’s (noted conservative economist) view of social responsibility:
“There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception and fraud."
You can’t discuss corporate governance without a mention of “agency theory.” The officers and board of directors of the company act as agents on behalf of the shareholders according to agency theory. The executive management team implements the directives received by the board of directors. Management cannot act in certain regards without board approval.
The board of directors handles strategic planning as well as some of the following:
· Hiring, overseeing, and terminating the executive management team
This audit committee decides which CPA firm to hire and when to hire them. The committee also handles the fee arrangements and all the components that go into determining what services are going to be provided during the audit engagement.
The committee members are independent directors, meaning they are from outside the company. They are not employees, and they have no direct or indirect relationship with the company. Additionally, under the Sarbanes-Oxley Act, publicly traded companies must ensure that all members of the audit committee are independent and that at least one member of the committee is a financial expert who has knowledge and understanding of what's involved in the audit process. Again, here we find independence on the client’s side of the transaction.
Check out the video clip below from the Center for Auditing Quality to learn more about the auditing committee.
Auditors learn of the board’s activities by reading the minutes of the meetings. Why? Minutes document the discussions and decisions of the board for each meeting. The topics may be financial and non-financial such as authorizing management to borrow money from a bank or approving changes to company policies. The auditor makes a list of issues that may have audit relevance as part of the planning process. Call it a list of what to look for.
Audit Case Alert: Your 2nd assignment will include reading the minutes for three board meetings and identifying items of audit relevance.
Auditing is a process of examining the connection between the framework, GAAP or IFRS, and the methods used to prepare financial statements and disclosures by the client. The audit concludes with the issuing of an audit opinion on the overall fairness of the financial statements. The opinion will be relied upon by 3 rd party decision makers.
The auditor must be competent in the proper application of GAAP/IFRS and knowledgeable in other areas of business well.
I hope you enjoy the course and continue to build your passion for accounting.
Next, we cover an overview of auditing in Lesson 2.