ACCT413 - Module 3-Sem 211

YANBU UNIVERSITY COLLEGE
Management Science Department
ACCT 413 – AUDITING & ASSURANCE

SERVICES
MODULE 3 – THE AUDIT PROCESS 1

(CHAPTER 6, 7, 8, 9)
© Yanbu University College

AUDIT RESPONSIBILITIES AND OBJECTIVES
LEARNING OBJECTIVES:
1. Explain critically the objective for conducting the audit of

financial statements
2. Analyze the roles and responsibilities of auditor and
management
3. Describe management assertions and the process of setting
up of audit objectives
4. Explain the nature and types of audit evidence
5. Analyze audit planning while considering risk and materiality
© Yanbu University College Slide 2

OBJECTIVE OF CONDUCTING AN AUDIT OF
FINANCIAL STATEMENTS
The purpose of an audit is to provide

financial statement users with an opinion
by the auditor on whether the financial
statements are presented fairly, in all
material respects, in accordance with
applicable financial accounting framework.
© Yanbu University College 6-3

Management’s vs Auditor Responsibilities
• Management Responsibilities – to adopt sound accounting
policies, maintaining adequate internal control, and
making fair representations in the financial statements.
• Auditors Responsibilities – to obtain reasonable assurance
whether financial statements free from material
misstatement, whether due to fraud and to give an
opinion on whether financial statements are presented in
all material respects accordance with applicable financial
reporting framework ; and to report on the financial
statements, and communicate as required by auditing
standards in accordance with audit findings.

Management’s Responsibilities
6-5
OBJECTIVES OF THE AUDITOR
Obtain Free from

Financial
reasonable material
statements
assurance misstatements
Applicable
Financial
Opinion reporting
statements
framework
Communicate
Financial
Report per audit
statements
standards
6-6
Auditors Responsibilities
• Material VS Immaterial Misstatements – Auditors
are responsible for obtaining reasonable assurance
that the materiality threshold has been satisfied.
• Reasonable Assurance - a measure of the level of
certainty that the auditor has obtained at the
completion of the audit.
• Error VS Fraud – Unintentional misstatements vs
Intentional Misstatements

Auditors Responsibilities
• Professional Skepticisms – Audit must be planned and
performed with an attitude of professional skepticisms
in all aspects of management. Characteristics of
skepticisms:
1. Questioning Mindset
2. Suspension of Judgment
3. Search for knowledge
4. Interpersonal understanding
5. Autonomy
6. Self-Esteem
Steps to Develop Audit Objectives
6-9
DIVIDE FINANCIAL STATEMENTS INTO CYCLES

What is Management Assertions?
• Management Assertions are implied or expressed
representations by management about classes of
transactions and the related accounts and
disclosures in the financial statements.
• Management Assertions are directly related to the
financial reporting framework used by the
company i.e GAAP or IFRS as they are part of the
criteria that management uses to record and
disclose accounting information in financial
statements.
Management assertions:
• Classified into three categories:

1. Assertions about classes of transactions and
events for the period under audit
2. Assertions about account balances at period
end
3. Assertions about presentation and disclosure
Within this three categories there are specific
assertions related to it.
Management Assertions for
Each Category of Assertions
Transactions and Events Account Balances Presentation and Disclosure

Occurrence Existence Occurrence and rights
and obligations
Completeness Completeness Completeness
Accuracy Valuation and Accuracy and
allocation valuation
Classification Classification and
understandability
Cutoff
Rights and
obligations
6-13
MANAGEMENT ASSERTIONS FOR EACH CATEGORY
TRANSACTIONS & EVENTS
• Occurrence – the recorded transactions included in the financial

statements actually occurred during the period.
• Completeness – all transactions that should be included in the

financial statements are in fact included.
• Accuracy – transactions have been recorded at correct amounts.
• Classification – transactions are recorded in the appropriate

accounts.
• Cutoff – transactions are recorded in the proper accounting period.

ACCOUNT BALANCES
• Existence – Assets, Liabilities and Equity interests exist
• Completeness – All assets, liabilities and equity
interests that should have been
• Valuation and Allocation - All assets, liabilities and
equity interests are included in the financial statements
at appropriate amounts and any resulting valuation
adjustments are appropriately recorded
• Rights & Obligation – The entity holds or controls the
rights to assets, and liabilities are the obligation of the
entity
PRESENTATION AND DISCLOSURES

• Occurrence and rights and obligations – Disclosed
events and transactions have occurred and pertain to
the entity
• Completeness – All disclosures that should have been
included in the financial statements have been included
• Accuracy and valuation – Financial & other information
are disclosed appropriately and at appropriate amount.
• Classification and understandability – Financial & other
information is appropriately presented and described
and disclosures are clearly expressed.
Hillsburg Hardware Co.
(Applied to Sales Transactions)
6-17
Hillsburg Hardware Co. .
(Applied to Inventory)
6-18
Hillsburg Hardware Co.
(Applied to Notes Payable)
6-19
NATURE OF AUDIT EVIDENCE
 Any information used by the auditor to
determine whether the information being
audited is stated in accordance with
established criteria
 The use of evidence is not unique to auditors
 Evidence is also used by scientists,
lawyers,and historians

Nature of Evidence
7-21
PERSUASIVENESS OF EVIDENCE
Two determinants:
Appropriateness Sufficiency
The persuasiveness of evidence can be evaluated only after

considering the combination of appropriateness and sufficiency
7-22
PERSUASIVENESS OF EVIDENCE
APPROPRIATENESS – MEASURE THE QUALITY OF
EVIDENCE THAT IS RELEVANCE AND RELIABILITY OF
IN MEETING AUDIT OBJECTIVES. APPROPRITAES
DEALS ONLY WITH AUDIT PROCEDURES.
• EVIDENCE OBTAINED MUST BE RELEVANT TO
AUDIT OBJECTIVE BEFORE IT CAN BE APPROPRIATE
• RELIABILITY REFERS TO THE DEGREE TO HICH
EVIDENCE CAN BE BELIEVABLE OR WORTHY OF
TRUST

CHARACTERISTICS AND PERSUASIVENESS OF EVIDENCE
RELIABILITY AND APPROPRIATENESS DEPEND ON THE

FOLLOWING CHARACTERISTICS:
1. Independence of provider – external source versus
internal source
2. Effectiveness of client’s internal controls
3. Auditor’s direct knowledge – Evidence through own
findings
4. Qualification of individuals providing the information –
person provided is qualified
5. Degree of objectivity – Objective versus Judgment
6. Timeliness – when is the evidence obtained
SUFFICIENCY
• THE QUANTITY OF EVIDENCE OBTAINED
DETERMINES ITS SUFFICIENCY. SUFFICIENCY IS
MEASURED BY SAMPLE SIZE OF AUDITORS.

Persuasiveness and Cost
In making decisions about evidence

for a given audit, both persuasiveness
and cost must be considered.
The auditor’s goal is to obtain a

sufficient amount of appropriate
evidence at the lowest total cost.
7-26
Types of Audit Evidence
Physical
Examination
Confirmation
Observation
Audit
Reperformance Inspection
Evidence
Analytical
Recalculation
Client Inquiries procedures
7-27
• Physical Examination - It is the inspection or count by the
auditor of a tangible asset. This type of evidence is most
often associated with inventory and cash.
• Inspection - It is the auditor’s examination of the client’s
documents and records either internal or external
documents.
• Inquiries of client - It is the obtaining of written or oral
information from the client in response to questions
from the auditor.
• Recalculation - Involves rechecking a sample of
calculations made by the client
• Analytical Procedures –consists of evaluations of financial
information through the analysis of plausible
relationships among financial and non-financial data. It is
required to perform during planning and completion
phases of an audit :
Understand the client’s industry and business
Assess the entity’s ability to continue as a going concern
Indicate the presence of possible misstatements in the
financial statements
Reduce detailed audit tests

Types of audit evidence
• Reperformance - The auditor’s independent tests of client
accounting procedures or controls that were originally
done as part of the entity’s accounting and internal
control system.
• Observation –
 Use one’s senses to assess client activities.
 Tour plant to obtain a general impression of client’s
facilities.
 Observation is rarely sufficient by itself.
 Often need to corroborate with another kind of
evidence
• Confirmations – the receipt of a direct response from a third
party verifying the accuracy of information that was requested
by the auditor. Can be either paper or electronic form.

Audit Documentation
• Audit documentation is the record of the audit procedures performed,
relevant audit evidence, and conclusions the auditor reached.
• Purpose
A Basis for Audit Planning
A record of the evidence Accumulated and the Results of the tests
Data to determine proper type of audit report
A Basis for review by supervisors and partner
• Ownership - Auditor’s Property
• Confidentiality
• Requirements for Retention of Audit Documentation
Auditing Standards – Private Companies 5 years
The Sarbanes-Oxley Act requires auditors of public companies to prepare
and maintain audit working papers for a period of not less than seven years

Audit File Contents and Organization
7-33
Types of Audit Files
• Permanent Files - These files are intended to contain
data of a historical or continuing nature pertinent to
the current audit.
• Current Files – The contents are as follows:

Audit program
General information
Working trial balance
Adjusting and reclassification entries
Supporting schedules
AUDIT PLANNING
Three Main Reasons for Planning
1. To obtain sufficient appropriate evidence for
the circumstances
2. To help keep audit costs reasonable
3. To avoid misunderstanding with the client

STAGES OF PLANNING
• INITIAL PLANNING
• UNDERSTAND CLIENT’S BUSINESS AND INDUSTRY
• ASSESS CLIENT BUSINESS RISK
• PERFORM PRELIMINARY ANALYTICAL PROCEDURES

(1) Initial Audit Planning
1. Client acceptance and continuance
2. Identify client’s reasons for audit
3. Obtain an understanding with the client
4. Develop overall audit strategy
8-37
Client Acceptance and
Continuance
New client investigations
 If previously audited, the new auditor is
required to communicate with the
predecessor auditor
 Client permission required
Continuing clients
 Annual evaluations whether to continue
based on issues, fees, and client integrity
8-38
Obtaining an Understanding
with the Client
Engagement terms should be understood
between CPA and client.
Standards require an engagement letter
describing:
 objectives
 responsibilities of auditor and management
 schedules and fees
Informs client that auditor cannot guarantee
all acts of fraud will be discovered
8-39
Identify Reasons for the Audit
Two major factors affecting acceptable risk

 Likely statement users
 Intended uses of the statements
Likely to accumulate more evidence for

companies that are
 Publicly held
 Have extreme indebtedness
 Likely to be sold
8-40
Develop Overall Audit Strategy
Preliminary audit strategy should consider

 client’s business and industry
 material misstatement risk areas
 number of client locations
 past effectiveness of controls
Preliminary strategy helps auditor determine
resource requirements and staffing
 staff continuity
 need for specialists
8-41
(2) Understanding of the Client’s
Business and Industry
Client business risk is the risk

that the client will fail to meet
its objectives.
Declines in economic conditions

Information technology
Global operations
Human capital
8-42
Understanding of the Client’s Business
and Industry
8-43
Industry and External Environment
Reasons for obtaining an understanding of the

client’s industry and external environment:
1. Risks associated with specific industries

2. Inherent risks common to all clients in
certain industries
3. Unique accounting requirements
8-44
Business Operations and Processes
Factors the auditor should understand:
 Major sources of revenue

 Key customers and suppliers
 Sources of financing
 Information about related parties
8-45
Understanding Business Operations and
Processes
Tour the plant and Office –Touring the physical
facilities enables the auditor to assess asset
safeguards and interpret accounting data related
to assets.
Identified Related Parties

•Affiliated companies
•Principal owners of the client
•Any other party with which the client deals
•A party who can influence management or client policies
8-46
Management and Governance
Governance includes:
Governance insights:
Organizational
Corporate charter
structure
and bylaws
Board activities
Code of ethics
Audit committee
Meeting minutes
activities.
Management establishes the strategies and

processes followed by the client’s business.
8-47
Client Objectives and Strategies
Strategies are approaches followed by the

entity to achieve organizational objectives.
Auditors should understand client objectives.
Financial reporting reliability

Effectiveness and efficiency of operations
Compliance with laws and regulations
8-48
Measurement and Performance
The client’s performance measurement system

includes key performance indicators. Examples:
 market share  Web site visitors

 sales per employee  same-store sales
 unit sales growth  sales/square foot
Performance measurement includes ratio analysis

and benchmarking against key competitors.
8-49
(3) Risk Terms
 Acceptable audit risk – Is a measure of how willing

the auditor is to accept that the financial statement
may be materially misstated after the audit is completed
and an unqualified opinion has been issued.
 Inherent risk – is a measure of the auditor’s
assessment of the likelihood that there are material
misstatement in an account balance before considering
the effectiveness of Internal control
8-50
Assess Client Business Risk
Client business risk is the risk that the

client will fail to achieve its objectives.
 What is the auditor’s primary concern?

 Material misstatements in the financial
statements due to client business risk
8-51
Sarbanes-Oxley Act
Management must certify it has designed

disclosure controls and procedures to
ensure that material information about
business risks is made known to them.
Management must certify it has informed

the auditor and audit committee of any
significant control deficiencies.
8-52
(4) Preliminary Analytical Procedures
Comparison of client ratios to industry

or competitor benchmarks provides an
indication of the company’s performance.
Preliminary tests can reveal unusual

changes in ratios.
8-53
Examples of Planning Analytical
Procedures
8-54
Analytical Procedures
Analytical procedures may be performed

at any of three times during an
engagement.
1. Required in the planning phase

2. Often done during the testing phase
3. Required during the completion phase
8-55
What is materiality concept?
• “Materiality
– …the magnitude of an omission or misstatement of
accounting information that, in the light of surrounding
circumstances, makes it probably that the judgment of
a reasonable person relying on the information would
have been changed or influenced by the omission or
misstatements

Materiality
 Major consideration in determining the
appropriate audit report
 Referenced in auditor’s responsibility section of
the audit report
 Auditor’s responsibility is to determine whether
financial statements are materially misstated.
 Auditor will bring material misstatements to the
client’s attention so corrections can be made.

Set Preliminary Judgment About Materiality
• Auditors set materiality thresholds early in the

engagement.
• Thresholds represent the maximum amount
that statements could be misstated and still
not affect users’ decisions.

Factors Affecting Judgment
Materiality is a relative rather than an

absolute concept.
Benchmarks are needed for evaluating
materiality.
Qualitative factors also affect materiality.
9-59
Qualitative Factors:
• Considerations that may render material a
quantitatively small misstatement include:
1. Amounts involving fraud
2. Minor misstatements but material if there are
possible consequences arising from contractual
obligations – loan covenants
3. Misstatement that are immaterial but may be
material if affecting trends

Guidelines
Accounting and auditing standards do not

provide specific materiality guidelines.
Professional judgment is used to set and

apply materiality guidelines.
9-61
Allocate Preliminary Judgment
About Materiality to Segments
Evidence is accumulated by segments

rather than for the financial statements
as a whole.
Most practitioners allocate materiality

to balance sheet accounts.
9-62
Risk
Auditors accept some level of

risk in performing the audit.
Risks exist, are difficult to measure, and require

careful thought in response.
Proper risk response is critical to achieving a

high-quality audit.
9-63
Risk and Evidence
Auditors need to understand the client’s

business and assess business risk.
The audit risk model helps identify the

potential and likelihood of misstatements.
9-64
Audit Risk Model for Planning
9-65
Audit Risk Model for Planning
PDR = AAR ÷ (IR × CR)
where: PDR = Planned detection risk
AAR = Acceptable audit risk
IR = Inherent risk
CR = Control risk
9-66
Audit Risk Model Components
• Planned Detection Risk – the risk that audit evidence for an audit
objective will fail to detect misstatements exceeding performance
materiality.
• Inherent Risk – the auditors’ assessment of the susceptibility of an
assertion to material misstatement before considering the
effectiveness of related internal controls.
• Control Risk – measures the auditors’ assessment of the risk that a
material misstatement could occur in an assertion and not be
prevented or detected on a timely basis by the client’s internal control.
• Acceptable Audit Risk – is a measure of how willing the auditor is to
accept that the financial statements may be materially misstated after
the audit is completed and an unqualified opinion has been issued.

Engagement Risk and Its Impact on AAR
• What is Engagement Risk? It is the risk that the
auditor or audit firm will suffer harm after the
audit is finished even though the audit report was
correct. In other words, it is the risk of lawsuit or
unfavorable publicity resulting from being
associated with this client.
• Auditors decide engagement risk and use
that risk to modify acceptable audit risk. Engagement
risk is closely relates to client business risk.

Factors Affecting Acceptable Audit Risk
 The degree to which external users

rely on the statements
 The likelihood that a client will have

financial difficulties after the
audit report is issued
The auditor’s evaluation of management’s

integrity
9-69
Methods Practitioners Use to Assess
Acceptable Audit Risk
9-70
Factors Affecting Inherent Risk
Nature of Client’s Audit Experience

Business
 Prior audit results
 Initial vs. repeat engagement
 Industry practices
 Audit judgment required to
 Non-routine transactions
 Makeup of the population correctly record balances and
transactions
Culture
 Related parties
 Factors related to fraudulent
financial reporting
 Factors related to
misappropriation of assets
9-71
Audit Risk for Segments
Both control risk and inherent risk are

typically set for each cycle, each
account, and often each audit
objective, not for the overall audit.
9-72
Tolerable Misstatement, Risks,
and Balance-related Audit Objectives
It is common to assess inherent and control

risk for each balance-related audit objective
It is not common to allocate materiality

to objectives
9-73
Risk and Evidence
9-74
Measurement Limitations
One major limitation in the audit risk model is

the difficulty of measuring the components
of the model.
Known Unknown
Preliminary +/-
Actual level of
Assessed Level risk achieved
of Risk on the audit
9-75
Revising Risks and Evidence
The auditor must revise the original

assessment of the appropriate risk.
The auditor should consider the effect

of the revision on evidence requirements,
without the use of the audit risk model.
9-76
END OF MODULE

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YANBU UNIVERSITY COLLEGE

Management Science Department

ACCT 413 – AUDITING & ASSURANCE

MODULE 3 – THE AUDIT PROCESS 1

© Yanbu University College

1. Explain critically the objective for conducting the audit of

© Yanbu University College Slide 2

The purpose of an audit is to provide

© Yanbu University College 6-3

© Yanbu University College Slide 4

Obtain Free from

© Yanbu University College Slide 7

© Yanbu University College Slide 10

• Classified into three categories:

Transactions and Events Account Balances Presentation and Disclosure

• Occurrence – the recorded transactions included in the financial

• Completeness – all transactions that should be included in the

• Accuracy – transactions have been recorded at correct amounts.

• Classification – transactions are recorded in the appropriate

• Cutoff – transactions are recorded in the proper accounting period.

PRESENTATION AND DISCLOSURES

© Yanbu University College Slide 20

The persuasiveness of evidence can be evaluated only after

© Yanbu University College Slide 23

RELIABILITY AND APPROPRIATENESS DEPEND ON THE

© Yanbu University College Slide 25

In making decisions about evidence

The auditor’s goal is to obtain a

© Yanbu University College Slide 29

© Yanbu University College Slide 31

© Yanbu University College Slide 32

• Current Files – The contents are as follows:

© Yanbu University College Slide 35

© Yanbu University College Slide 36

1. Client acceptance and continuance

2. Identify client’s reasons for audit

3. Obtain an understanding with the client

4. Develop overall audit strategy

Two major factors affecting acceptable risk

Likely to accumulate more evidence for

Preliminary audit strategy should consider

Client business risk is the risk

Declines in economic conditions

Reasons for obtaining an understanding of the

1. Risks associated with specific industries

Factors the auditor should understand:

 Major sources of revenue

Identified Related Parties

Management establishes the strategies and

Strategies are approaches followed by the

Auditors should understand client objectives.

Financial reporting reliability

The client’s performance measurement system

 market share  Web site visitors

Performance measurement includes ratio analysis

 Acceptable audit risk – Is a measure of how willing

Client business risk is the risk that the

 What is the auditor’s primary concern?

Management must certify it has designed

Management must certify it has informed

Comparison of client ratios to industry

Preliminary tests can reveal unusual

Analytical procedures may be performed

1. Required in the planning phase