AUDITING I

ACC231

Chapter 6
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Audit Responsibilities
and Objectives
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The purpose of financial statement audit :

- Financial statement audit aimed at providing an opinion on whether financial statement

are in accordance with GAAP.

- A private sector should provide an opinion on financial statements, but public sector
should provide an opinion on financial statements and internal control.

- Opinion must be based on evidence.

Management responsibility :

1- Preparation and fair presentation of financial statements.

2- Selection of appropriate accounting principles and estimates.
3- Maintenance of internal control.

CEO and CFO must certify (sign / Confirm) Financial Statements :

- For public sector , management could be subject to large monetary fines or imprisonment
up to 20 years.

 Auditors Responsibilities :
1- Obtaining reasonable assurance.
2- Expressing an opinion.
3- Report on financial Statements.

 Material misstatements :

- A misstatements is considered to be material if the combined effect of errors and fraud

influence made by a reasonable user.

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 Reasonable assurance :

Assurance A level of certainty.

Reasonable Acceptable level of assurance (highest level auditor can provide) , but not
absolute , not guarantee or not insurance.

Why Reasonable assurance ?

1. Auditing depends on samples rather than population.

2. Accounting includes lots of difficult estimates.
3. Fraudulent Financial Statements are very difficult to discover.

- Two Types pf Misstatements :

Error Fraud
Unintentional misstatements Intentional misstatements
Misappropriation Fraudulent
e.g : e.g : e.g :
 Clerk taking cash from  Increasing sales in
 Clerical Mistakes. a sales transaction. income statements.
 Mathematical mistakes.  Employee taking  Decreasing cost of cost
 Misapplication of accounting inventory from stores. of goods sold.
principles.
 Misinterpretation of facts.
Employee Fraud Management Fraud

Unavailable Assets Misleading decision making

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 Professional skepticism :
The auditor should perform the audit with an attitude of doubt.

- Two Elements
Questioning Mind Critical assessment

Trust but verify. Analyze and look for unusual or inconsistent

fluctuations.

Notes :

- The auditor has the same responsibility for errors and fraud (reasonable assurance).

- Fraud is more difficult to discover than errors because is hidden by another misstatement.

Illegal Act :

It is violation of governmental laws and regulations.

 Two types of Illegal Act :

1- Direct-effect Illegal Act :

The auditor is responsible for it and he provides reasonable assurance.

E.g (Tax laws , Pension Funds)

2- In-direct-effect Illegal Act :

The auditor is not responsible for it and provides no assurance.

E.g : (environmental laws , Safety laws , Operating licenses)

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Summary of Auditors Responsibility :

Item Responsibility
1- Audit of Financial Statements. Reasonable assurance
2- Review of Financial Statements. Limited assurance
3- Accounting and Bookkeeping / tax services / No assurance
Management consulting
4- Material misstatements. Reasonable assurance

5- Immaterial misstatements. No assurance

6- Error (Miss calculation of sales revenue) Reasonable assurance

7- Fraud (Theft of cash) Reasonable assurance

8- Fraud (Increasing sales revenue on income statement) Reasonable assurance

9- Illegal act from violating tax laws (Direct-effect- Illegal Reasonable assurance
act)
10-Illegal act from violating tax laws (In-direct-effect- No assurance
Illegal act)

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Cycle Approach :

The auditor divides the financial statements into smaller segments based on the operating
cycles of the company.

Operating Cycles :

1. Capital acquisition and repayment cycle.

2. Acquisition and payment cycle.
3. Payroll Cycle.
4. Inventory and warehousing cycle.
5. Sales and collection cycle.

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Management Asserts :

They are implied or expressed representations by management about transactions, balances,

and presentation and disclosure.

I. Transactions – Related Management Assertions :

1- Occurrence :

- Record transactions occur or exist.

e.g : (All sales transactions involve actual exchange pf products).

- Violations of “Occurrence” lead to overstatement of accounts.

e.g : Record sales from non-existing customer.

2- Completeness :

- Existing transactions are recorded, included, or complete.

e.g : (All loans taken by company are recorded as notes payable).

- Violations of “Completeness” lead to Understatement of accounts.

e.g : Omitting sales from existing customers.

3- Accuracy :

- Transactions are recorded at correct amounts.

e.g : Calculating price times quantity to verify sales.

Counting quantity of products.

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4- Classification :

- Transactions are recorded at correct accounts.

e.g : (Credit sales transactions are debited to “Accounts Receivable”).

(Inventory items are allocated to “Raw materials” , “Work-In-Process” , and “finished
Products).

5- Cutoff :

- Transactions are recorded in the correct accounting Period.

e.g : (Sales are recorded in December when products are delivered while cash is received in
January next year).

- “Violations of “Cutoff” : Sales are recorded in January for products delivered in

December.

II. Balances Related Management Assertions :

1- Existence :

- Recorded balances of assets , liabilities and Capital. Actually exist.

e.g : (“Merchandise Inventory” on the balance sheet reflects the value of inventory
items in stores).

- Violation of “existence” leads to overstatements of accounts.

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2- Completeness :

- Recorded balances of assets , liabilities and Capital are recorded, included,

complete.

e.g : Physical count of cash recoded is recorded as “cash” balance on the balance sheet.

- Violation of “Completeness” leads to overstatements of accounts.

3- Violation and Allocation :

Balances are recorded at correct amounts and accounts.

e.g :
o All assets or property should be recorded at historical cost.
o Accounts Receivable should be recorded at net realizable value.
o “Plant Assets” should be recorded at book value.
o “Liabilities” should be recorded at carrying value.
o “Capital” should be recorded at par value.

4- Rights and obligation :

- Assets must be own by company and liabilities must owed by the company.

- Violation
e.g :
o Assets sold should not be reported on balance sheet.
o Liabilities paid or discounted should not be reported on balance sheet.
o Assets held as collateral (guaranteed) should not be reported on balance sheet.
o The company has title to same assets.

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General Transaction-related Audit Objectives

1. Occurrence :

- Recorded transactions exist.

(Recorded sales are for shipment made to non-fictitious customers).

2. Completeness :

- Existing transactions are recorded , included , complete.

Existing sales transactions are recorded.

3. Accuracy :

- Recorded transactions are stated at the correct amounts

(Recorded sales are for the amount of goods shipped and are correctly billed and recorded).

4. Posting and summarization :

- Transactions are included in the master files (General Journal) and are correctly
summarized (Ledger) .

(Sales transactions are properly included in the master file and are correctly summarized).

5. Classification :

- Transactions are properly classified into correct accounts.

(Sales transactions are properly classified).

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6. Timing :

- Transactions are recorded on the correct dates.

(Sales transactions are recorded on the correct dates).

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General Balance-related Audit Objectives

1. Existence :

- Amounts included exist.

(All recorded inventory exist at the balance sheet date).

2. Completeness :

- Existing amounts are included, recorded complete.

(All existing inventory has been counted and included in the inventory summary).

3. Accuracy :

- Amounts included are stated at the correct amounts.

o Inventory quantities on the client’s perpetual records agree with items physically on hand.
o Prices used to value inventories are materiality correct.
o Extensions of price times quantity are correct and details are correctly added.

4. Classification :

- Amounts are properly classified

(Inventory items are properly classified as to “raw materials” , “Work-In-Process” , and
“Finished goods”).

5. Cutoff :

- Amounts are recorded in the proper period

o Purchase cutoff at year-end is proper.
o Sales cutoff at year-end is proper.

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6. Detail tie-in :

- Account balances agree with master file amounts, and with the general ledger.

(Total of inventory items agrees with general ledger).

7. Realizable value :

- Assets are included at estimated realizable value.

Account Receivable :
o Uncollectable Accounts Receivable.
o Estimating allowance for doubtful accounts.
o Bad debts expense.
o Aging od accounts receivable.

(Inventories have been written down where net realizable value is impaired).

Inventory :
o Lost or expired inventory items.
o Unavailable inventory items should be written down.

8. Rights and obligations :

- Assets must be owned and liabilities must be owed.

o (The company has title to all inventory items listed).

o (Inventories are not pledged as collateral).

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Questions :

6-20 (Objective 6-3) The following questions deal with errors and fraud.
Choose the best response.

1. An independent auditor has the responsibility to design the audit to provide reasonable
assurance of detecting errors and fraud that might have a material effect on the financial
statements. Which of the following, if material, is a fraud as defined in auditing standards?

a. Misappropriation of an asset or groups of assets.

b. Clerical mistakes in the accounting data underlying the financial statements.
c. Mistakes in the application of accounting principles.
d. Misinterpretation of facts that existed when the financial statements were prepared.

2. What assurance does the auditor provide that errors, fraud, and direct-effect illegal acts
that are material to the financial statements will be detected?

Errors Fraud Direct-Effect Illegal Acts

a. Limited Negative Limited
b. Reasonable Reasonable Reasonable
c. Limited Limited Reasonable
d. Reasonable Limited Limited

3. Which of the following statements describes why a properly designed and executed audit
may not detect a material misstatement in the financial statements resulting from fraud?

a. Audit procedures that are effective for detecting unintentional misstatements may be
ineffective for an intentional misstatement that is concealed through collusion.
b. An audit is designed to provide reasonable assurance of detecting material errors, but
there is no similar responsibility concerning fraud.
c. The factors considered in assessing control risk indicated an increased risk of intentional
misstatements, but only a low risk of unintentional misstatements.
d. The auditor did not consider factors influencing audit risk for account balances that
have effects pervasive to the financial statements taken as a whole.

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6-21 (Objective 6-1) The following questions concern the reasons auditors do
audits. Choose the best response.

1. Which of the following best describes the reason why an independent auditor reports on
financial statements?

a. A misappropriation of assets may exist, and it is more likely to be detected by

independent auditors.
b. Different interests may exist between the company preparing the statements and the
persons using the statements.
c. A misstatement of account balances may exist and is generally corrected as the result
of the independent auditor’s work.
d. Poorly designed internal controls may be in existence.

2. Because of the risk of material misstatement, an audit should be planned and performed
with an attitude of

a. Objective judgment.
b. Independent integrity.
c. Professional skepticism.
d. Impartial conservatism.

3. The major reason an independent auditor gathers audit evidence is to

a. Form an opinion on the financial statements.

b. Detect fraud.
c. Evaluate management.
d. Assess control risk.

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6-21 (Objective 6-6) The following questions deal with management

assertions. Choose the best response.

1. An auditor reviews aged accounts receivable to assess likelihood of collection to support

management’s assertion about account balances of

a. Existence.
b. Completeness.
c. Valuation and allocation
d. Rights and obligations.

2. An auditor will most likely review an entity’s periodic accounting for the numerical
sequence of shipping documents to ensure all documents are included to support
management’s assertion about classes of transactions of

a. Occurrence.
b. Completeness.
c. Accuracy.
d. Classification.

3. In the audit of accounts payable, an auditor’s procedures will most likely focus primarily
on management’s assertion about account balances of

a. Existence.
b. Completeness.
c. Valuation and allocation.
d. Classification and understandability.

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6-26 (Objectives 6-6, 6-8) The following are specific balance-related audit
objectives applied to the audit of accounts receivable (a through h) and
management assertions about account balances. The list referred to in the
specific balance-related audit objectives is the list of the accounts receivable
from each customer at the balance sheet date.

For each specific balance-related audit objective, identify the appropriate

management assertion. (Hint: See Table 6-4)

1. Existence.
2. Completeness.
3. Valuation and allocation.
4. Rights and obligations.

Specific Balance-Related Audit Objectives Management Assertions

a. There are no unrecorded receivables. Completeness

b. Receivables have not been sold or discounted. Rights and obligations
c. Uncollectible accounts have been provided for Valuation and allocation
d. Receivables that have become uncollectible
have been written off. Valuation and allocation
e. All accounts on the list are expected to be
collected within 1 year. Valuation and allocation

f. The total of the amounts on the accounts

receivable listing agrees with the general ledger Valuation and allocation
balance for accounts receivable.
g. All accounts on the list arose from the normal
course of business and are not due from related Valuation and allocation
parties.
h. Sales cutoff at year-end is proper. Valuation and allocation

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