AUDITING: A RISK

ANALYSIS APPROACH
5th edition

Larry F. Konrath

Electronic Presentation
by Harold
O. Wilson
 KEY CONCEPTS OVERVIEW
• Audits add creditability to published
financial statements.
• Opinions by independent CPAs, as to
fairness of financial statements are
generally required by securities laws.
• Auditors evaluate evidence supporting
financial statements and assess
fairness of presentations.
 GENERAL TOPICS
• Perspectives of Auditing.
• Attestations and Assurances.
• Auditing defined in contrast to accounting.
• Independent Auditor and Internal Auditor:
Training and Competencies.
• Evidence: Collection and Evaluation.
 LEARNING
OBJECTIVES
• Differentiate attestation and assurance.
• Identify various services by auditors.
• Define auditing and its assertions.
• Distinguish independent and internal audits.
• Understand audit evidence and its merits.
• Describe audit reports and their variations.
• Understand steps in the auditing process.
 ASSURANCE SERVICES,
ATTESTATION & AUDITING

• ASSURANCE SERVICES:
Independent professional
services designed to improve
the quality of information for
decision making. [A very
broad definition!]
 ASSURANCE SERVICES,
ATTESTATION & AUDITING
• ATTESTATION: An expert’s
communication of a conclusion
about the reliability of someone
else’s assertions. [A broad
definition.]
• ASSERTATIONS [in our context]: The
representations of management as to the
fairness of financial statements’ content.
 ASSURANCE SERVICES,
ATTESTATION & AUDITING
• AUDITING: A systematic process of
objectively obtaining and evaluating
evidence regarding selected assertions
about economic actions and events to
ascertain the degree of correspondence
between those assertions and
established criteria, and
communicating the results
to interested parties.
 SCHEMA

• AUDITING is a subset of...

• ATTESTATION which is a subset
of...
• ASSURANCE!
SCHEMA
 FINANCIAL STATEMENT
ASSERTIONS by Management
• Existence or Occurrence
• Completeness
• Rights & Obligations
• Valuations or Allocation
• Presentation & Disclosure

Assertions are to be truthful, fair,

and just--not misleading!
• Provide an impartial attestation as to
financial statement fairness
• Protect the equity of owners and creditors
(groups which may be far removed from
daily management)
• Enhance the work/reports of internal
auditors (concerned with policies,
procedures, operations, etc.)
 AUDITOR OBJECTIVES
Independent Auditors are to determine
whether management assertions are fair, and
not misleading, in light of established criteria:
• PFRS/IFRS AND PAS/IAS
• IASB pronouncements
• Other respected authorities
(e.g., SEC, BOA, BIR, BOI,
BSP )
 GENERALLY ACCEPTED
AUDITING STANDARDS
The AICPA’s Auditing Standards Board established
GAAS as the “principles of independent auditing,”
relative to competence, evidence and reporting.

• Internal Controls evaluated.

• Evidence (sample data) gathered.
• Presentations compared to GAAP.
• Audit Reports prepared.
 “EVIDENCE” UNDER GAAS
[A very broad concept!]
The stronger (more extensive) the client’s internal
control system, the higher the confidence in its
output! Evidence must support such conclusions by
auditor.
• Evidence (e.g., samples) must be sufficient,
valid & relevant.
• Evidence must be unbiased, and objectively
gathered in light of practicality.
 AUDIT REPORTS
• Scope of the audit work
• Financial statements identified
• Conclusions of the auditor:
– Unqualified Opinion (typical)
– Qualified Opinion (unusual circumstances)
– Adverse Opinion (rare in practice)
– Disclaimer of Opinion (various causes)
 Primary Concerns of
AUDITING vs. ACCOUNTING
• Auditing
– Verifying financial statement information and
its fairness, emphasizing evidence (and odds)
• Accounting
– Collecting, sorting, summarizing, and reporting
financial measurements, plus interpreting
financial information.

“The Link:” Generally Accepted Accounting Principles

 “RISK-BASED” AUDITS
• Risk-based audit: An audit in which the
auditor carefully analyzes the entity and its
existing internal controls, identifies areas
that pose a higher risk [probability] of
financial statement errors, and [therefore]
allocates a greater proportion of audit
resources to those areas.
“Errors,” “irregularities,” and/or “fraud” are
specific considerations as controls and test results
are analyzed objectively and subjectively.
 BASIC MOTIVES FOR
FRAUDS
• Management of earnings data
(to mislead or defraud outsiders)
• Internal embezzlement schemes

Auditors must think in terms of probabilities

and the internal controls designed to prevent
and/or detect potential misrepresentations.
Evidence should support reality or the
detection of defalcations!
 AUDITOR COMPETENCE &
KNOWLEDGE
• GAAP(PFRS/PAS): Accounting systems,
accounting theory, financial reporting
• Client’s industry & current authoritative
literature/pronouncements
• Clues to misrepresentations/frauds,
principles of statistics & probability
theory, evidence gathering & evaluation
• Related legal issues
 THE CHARGE
• Investigate prescribed internal controls;
consider potential impacts
• Design an audit program (instructions,
steps in an audit) considering the above
• Prepare working papers (the support that
client information was subjected to audit)
• Report on fairness of financial statements,
taken as a whole, in light of GAAP
 Sufficient & Competent
EVIDENCE
• Sufficient evidence provides reasonable [not
absolute] assurance of freedom from
material misstatement.
• Competence concerns the degree of reliability
– Externally generated evidence is more convincing
than client generated evidence.
– Generation under extensive controls is more
convincing than under weak control systems.
 AUDITOR’S REPORT
• Introductory paragraph
– Audit Work & Management’s role
• Scope paragraph
– Auditors followed GAAS (PSA/ISA)
• Opinion paragraph (The findings!)
– “Clean opinion,” “Qualifications,” “Adverse”

Of course, a report may be a

“Disclaimer of an Opinion.”
 THE AUDIT REPORT

ALWAYS POSSIBLE!
 AUDIT REPORTS:
OPINIONS
• “Clean Opinion.” No exceptions to GAAP
conformity and no audit scope restrictions
• “Fair, except for …” Specific qualification(s)
where auditor had specific scope
restrictions or not-too-severe reservations
(e.g., as to contingencies or alternatives)
• “Adverse Opinion.” Unfair or misleading
presentations; severe qualifications
 AUDIT REPORTS:
DISCLAIMER OF OPINION
If there is a lack of independence, or
there were severe scope restrictions,
OR a client’s financial statements have
material uncertainties (or “strange-
but-true inconsistencies” to GAAP),
the reasons for precluding the
formation of an opinion must be
clearly stated by the auditor.
 CAUTION!

A “Disclaimer” is NOT to be
issued in lieu of an “Adverse
Opinion” in cases where the
latter is appropriate!
THE AUDIT PROCESS
 AUDIT PROGRAMS &
PROCEDURES
• Planning the Audit
– Preliminaries (client interviews, screening
of clients, assessing staff needs, etc.)
– Design of Audit Programs/Procedures
– Engagement Letters (objectives, deadlines,
arrangements, fees, etc.)

Should Engagement Letters be required?

 AUDIT PROGRAMS:
PROCEDURES & SAMPLING
• Performing the Audit (Field Work)
– Audit Risk Analysis (investigating internal
controls prescribed, anticipated
problems and probabilities)
– Test of Transactions (interim periods)
– Test of Bona Fides (fiscal year end)
– Opinion on each “caption,” as completed
 AUDIT PROGRAMS &
PROCEDURES
• Concluding an Audit
– Discussion with client; obtaining a
Client’s Representation Letter
– Considerations of Subsequent Events
– The Audit Report (an opinion or a disclaimer)
– Management Letters (post-audit advice as to
improving internal control)
 AUDIT RISK ANALYSIS
Audit Risk (AR): Probability of rendering
an unqualified opinion on financial
statements that are materially misstated.
[MM$, in dollars; MM%, in percentages]

As a generalization, Audit Risk may be [or

should be] quantified as a Probability, P:

AR = P(MM$) < 5%
 AUDIT RISK ANALYSIS
AR = f(entity philosophy, personnel
pressures/integrity, characteristics of the
industry, internal controls, competency of
client personnel, results of audit testing,
objective and subjective probabilities as
evaluated by the auditor, and/or unknown
variables)
Professional Judgment is essential!
 AUDIT RISK ANALYSIS
AR = f(many variables), AND
P(“Fair Financials”) = 1 - AR
which “should be” 95% or better!

To extend audit procedures to reduce AR

below 5% is typically unnecessary and
impractical!
Professional literature does not define
a standard for required probabilities.
 AUDIT FIELD WORK:
AUDIT PROGRAMS
• Collections of audit procedures to be applied
to meet audit objectives [forming opinion]
• Refined during the audit, in light of ...
– interim tests of transactions, and
– year-end tests of bona fides (substantive testing)
• Note: Time Budgets are stringent guidelines
for the various defined procedures.
 A Note on Terminology
Tests of Transactions: Examining (sampling) “data
processing” cycles, such as the creation of
shipping tickets, approvals of prices, sales invoices,
journalizing, postings of such to general and
subsidiary ledgers, and the like.
Substantive Testing (Test of Bona Fides):
Examining (sampling) the components of an
account balance, such as the physical observation
of inventories, confirmation of accounts payable
at fiscal year end, calculations of prepaids, etc.
 A Note on Technology
Information processing systems have encouraged
“continuous auditing” throughout a client’s fiscal
year. Computer systems and personnel (and changes)
tend to obscure (or destroy) “audit trails” traditionally
“traced” by auditors. Auditor
ingenuity is continuously challenged!
“Audit Trails” refer to the documentary evidence and
related approvals occurring in the accounting cycle
(business transactions, documents, journalizing, posting or
sorting, and summarizing).
 CPA FIRMS’
NON-AUDIT SERVICES
• Tax planning and compliance services
• Management Consulting
• Accounting/Computer Systems advice
• Non-financial assurance services
• Investment processing
• Forensic Accounting; Expert Witnessing
• Other services (The CPA Vision Project)
End