What are the steps in a financial statement audit

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AUDITING CHAPTER 7The Audit Process and
Detecting Fraud
Topic 1 Audit Process

• What are the steps in a financial statement
  audit?
• Communication with audit committee
• Accepting, continuing engagements
• Establish an understanding with the client
• Understand clients business strategies
• Planning
• Interim audit work
• Year-end audit work

AUDITING ACCT450 WKU
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AUDIT COMMITTEES History

• 1940 SEC ASR 19 encouraged
• 1978 required by NYSE
• 1999 the Blue Ribbon Committee recommended on
  Improving the Effectiveness of Audit Committee
  and suggested that audit committees
• Monitor GAAP compliance and use of the best
  accounting principles
• Members not having family or financial ties to
  the company
• Report to shareholders
• Post 2000 SEC Sarbanes-Oxley rules mandates
• Reviews of public company financial statement
  interim reports
• Disclosure in proxy statements whether audit
  committee discussed
• Financial statements with management
• Estimates, uncertainties, unusual transactions,
  new accounting principles, independence with
  auditor

• 2. A public companys audit committee should
  consist of
• Representatives of management, shareholders,
  suppliers, and customers.
• The audit partner, chief financial officer, legal
  counsel, and at least one outsider.
• Representatives of the major equity interests
  (bonds, preferred stock, common stock).
• Board members who are not officers or
  employees. (AICPA Adapted)

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QUALITY OF EARNINGS

• Auditor must discuss quality not just
  acceptability of accounting principles earnings
  with Audit committee (SAS 89)
• Consistency in use of accounting principles
• Clarity, completeness of financial statements
• Other typical responsibilities of audit
  committees include
• The scope and timing of the audit,
• Internal control,
• Internal audit,
• Accounting changes,
• The results of the audit.
• Disclosures within managements financial
  statements, and
• The quality of reported earnings.

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ACCEPTING, CONTINUING ENGAGEMENTS

• Establish policies, procedures to accept,
  continue clients (Stmt. Quality Control Stds. No.
  1 )
• Case 7-14 Jones is approached by a prospective
  client who wishes to engage him to perform an
  audit that in prior years was performed by
  another auditor. Discuss the procedures Jones
  should follow in accepting or declining the
  engagement.
• For new client
• Review financial statements
• Inquire about reputation, bankruptcy
• Evaluate ability to service client
• Investigate key managers

• What are the steps in a financial statement
  audit?
• Communication with audit committee
• Accepting, continuing engagements
• Establish an understanding with the client
• Understand clients business strategies
• Planning
• Interim audit work
• Year-end audit work

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COMMUNICATIONS WITH PREDECESSOR

• Successor auditor initiates communication
• Predecessor auditor obtains permission to
  disclose confidential information (Rule 301)
• Is prior auditors resignation, replacement
  linked to (SAS 84)
• Disagreement with management?
• Management integrity?
• Other reasons?

• 4. Communication with a predecessor auditor is
  initiated by
• Management
• The successor auditor
• The audit committee of the board of directors
• The chair of the board of directors

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Case 7-12 Predecessor and Successor Auditors

• The audit committee of the board of directors of
  Unicorn Corp. asked Tish Field, LLP, to audit
  Unicorns financial statements. Tish Field
  explained the need to make an inquiry of the
  predecessor auditor and requested permission to
  do so. Unicorns management agreed to predecessor
  auditor to respond fully to Tish Fields
  inquiries.
• After communicating with the predecessor auditor,
  Tish Field drafted an engagement letter that
  was mailed to the audit committee of Unicorns
  board of directors. The engagement letter
  described arrangements concerning the involvement
  of the predecessor auditor and other matters.
• What information should Tish Field have
  obtained during their inquiry of the predecessor
  auditor prior to accepting the engagement?
• Describe what other matters Tish Field would
  likely have included in the engagement letter.

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UNDERSTANDING WITH CLIENT

• What are the steps in a financial statement
  audit?
• Communication with audit committee
• Accepting, continuing engagements
• Establish an understanding with the client
• Understand clients business strategies
• Planning
• Interim audit work
• Year-end audit work

• Objectives limitations of engagement
• Managements responsibilities
• Financial statements
• Establishing, maintaining effective internal
  controls over financial reporting
• Assuring compliance with laws regulations
• Making records, information available
• Confirming representations made during engagement
• Example financial statement audit
• Objective express opinion whether statements
• Present fairly
• In all material respects
• In conformity with GAAP SAS 83 SSAE 7

• 5. Management is not responsibility for
• The audited financial statements c. The
  auditors report
• Preparing spreadsheets for the auditor d.
  Compliance with laws and regulations

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ENGAGEMENT LETTERS

• Drafted by auditor for CEOs signature
• Written agreement to state purpose of engagement
  role of auditor
• Optional but recommended by SAS 84 which requires
  some form of written understanding in work papers
• SAS 108 requires establishment of understanding
  with client through written communication
  (engagement letter)

• 10. To avoid misunderstandings between a
  practitioner and client, engagement arrangements
  are written in
• A legal letter
• An engagement letter
• A client representation letter
• A letter on reportable conditions

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Cheever Yates, LLP Suite 2600 650 Madison
Avenue New York, NY 10022 March 24, 2006 Mr.
Raymond Carver, President The Wilson Company 15
Artubus Drive Stony Brook, NY 11790 Dear Mr.
Carver This will confirm our understanding of
the arrangements for our audit of the financial
statements of The Wilson Company for the year
ended December 31, 2005. We will audit the
company's balance sheet at December 31, 2005, and
the related statements of income, retained
earnings, and cash flows for the year then ended
for the purpose of expressing an opinion on them.
Our audit will be made in accordance with
generally accepted auditing standards. Our
procedures will include tests of documentary
evidence supporting the transactions recorded in
the accounts, tests of the physical existence of
inventories, and direct confirmation of
receivables and certain other assets and
liabilities by correspondence with selected
customers, creditors, legal counsel, and banks.
At the conclusion of our audit, we will request
certain written representations from management
about the financial statements and related
matters.
The scope of the audit
The objective of the audit
Management representations
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Unavoidable risk
Managements responsibility for the financial
statements
Management is responsible for the fair
presentation of financial statements in
conformity with generally accepted accounting
principles and for the development,
implementation, and maintenance of adequate
internal controls. Although we may consult with
you about accounting principles, management is
responsible for their selection and application.
Our engagement is subject to the risk that
material errors, irregularities, or illegal acts,
if they exist, will not be detected. However, we
will inform you of any such matters that come to
our attention. We will review the company's
federal and state income tax returns for the
fiscal year ended December 31, 2005. These
returns, we understand, will be prepared by the
controller. Further, we will be available during
the year to consult with you on the tax effects
of any proposed transactions or contemplated
change in business policies. Our fee for these
services will be at our regular per diem rates,
plus travel and other out-of-pocket costs.
Invoices will be rendered every two weeks and are
payable on presentation. We are pleased to have
this opportunity to serve you. If this letter
expresses your understanding, please sign the
enclosed copy where indicated and return it to
us. Sincerely, Cheever Yates,
LLP Arrangements accepted _____________________
________ ___________________ President, The
Wilson Company Date
Fees and billing arrangements
Request for client confirmation
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PROPOSED ADJUSTING JOURNAL ENTRIES (AJE)

• Understanding with Client (Planning Stage)
• Management understands responsibility to
• record material proposed adjustments
• Represent that unrecorded proposed AJEs are
  immaterial
• Management Representations (Year End)
• Management represents in representation letter
  that
• Proposed but unrecorded AJEs are immaterial,
  both individually and in the
  aggregate
• Summary of proposed AJEs
• Communication with Audit Committee (Year End)
• Auditor informs audit committee
• managements responsibilities for adjustments
• Proposed but unrecorded AJEs are immaterial,
  both individually and in the
  aggregate

Engagement Letter
Management Representation Letter
Audit Committee Meeting
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UNDERSTANDING CLIENTS BUSINESS

• What are the steps in a financial statement
  audit?
• Communication with audit committee
• Accepting, continuing engagements
• Establish an understanding with the client
• Understand clients business strategies
• Planning
• Interim audit work
• Year-end audit work

• Understanding the following aspects of the
  entity and its environment, including
  internal control
• Industry, regulatory and other external factors
• Nature of the entity
• Objectives and strategies and related business
  risks that may result in a material misstatement
  of the financial statements
• Measurement and review of the entitys financial
  performance
• Internal control, including the selection and
  application of accounting policies
• Auditor considers effects of client business
  strategies on
• Risks
• Strategies to overcome risk
• Transactions, events as products of managements
  strategies

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CLIENT STRATEGY TEMPLATE

• Strategies
• Growth strategy
• Financial goals operating priorities
• Characteristics of business
• Major business units
• Markets
• Products
• Customers
• Competitors
• Strategic alliances joint ventures
• Potential adverse influences

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Client Strategy Template
Merck Company
Strategies



Growth Strategy Demonstrate the value of
medicines to patients, payers providers.
Discover new medicines through breakthrough
research.
Financial Goals Operating Priorities Remain in
the top quartile of leading health care
companies. Maximize revenue growth. Preserve the
profitability of core pharmaceutical business
through continuous improvements in productivity
and organizational effectiveness. Achieve the
full potential of managed pharmaceutical care.
Characteristics of the Business



Major Business Units The Americas,
Europe/Middle East/Africa, Asia Pacific,
Merck-Medco Managed Care, Vaccines
Markets Elevated cholesterol, Hypertension/heart
failure, Anti-ulcerants, Antibiotics,
Ophthalmologicals, Vaccines/Biologicals, Human
immunodeficiency virus (HIV), Osteoperosis,
Animal health/crop protection
Products Cozaar (high blood pressure), Zocor
(elevated cholesterol), Fosamax (postmenopausal
osteoporosis), Proscar (symptomatic benign
prostate enlargement), Pepcid (ulcers
gastroesophageal reflux disease), Mefoxin
(antibiotic), Primaxin (antibiotic), Dolobid
(arthritis pain), Indocin (arthritis),
Chibroxin (conjunctivitis), Timoptic (glaucoma),
Singulair (asthma), Pneumovax 23 (adult
pneumonia), Recombivax HB (hepatitis B),
Ivermectin (animal parasites), Thiabendazole
(crop fungal infestation), Maxalt (migraine
headaches)
Customers End Users (Human, Animal), Heath Care
Providers, Insurance Companies, Center for
Disease Control
Competitors American Home Products, Bayer,
Bristol-Myers Squibb, Eli Lilly, Johnson
Johnson, Pharmacia Upjohn, Pfizer,
Schering-Plough, Warner-Lambert
Strategic Alliances/Joint Ventures Astra,
DuPont, Johnson Johnson, Chugai, Pasteur
Merieux, Merial
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Client Strategy Template
Merck Company
Strategies



Growth Strategy Demonstrate the value of
medicines to patients, payers providers.
Discover new medicines through breakthrough
research.
Financial Goals Operating Priorities Remain in
the top quartile of leading health care
companies. Maximize revenue growth. Preserve the
profitability of core pharmaceutical business
through continuous improvements in productivity
and organizational effectiveness. Achieve the
full potential of managed pharmaceutical care.
Characteristics of the Business



Issues
Threat to Merck
Limited drug pipeline gt Leads to gt
At-risk growth strategy Managed care, generics
gt Leads to gt Competitive pricing
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Translates to a threat to Mercks Financial Goals
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Q? How would an auditor know this?
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Managed Care, Generics, Declining Exclusivity
Periods., Federal Drug Administration, Patent
Expiration, Market Acceptance Demand, Global
Domestic Politics, Interest Rates, Currency
Fluctuations, Knowledge Transmission
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Threats to Merck Audit Risk

• At-risk growth strategy
• Deutsche Bank Securities analysts report
• Company may need to ... consider a significant
  merger to boost its growth prospects.
• Dow Jones News Service
• ... there is concern in the market about its
  future growth ... because the company faces a
  number of upcoming patent expirations.
• Competitive pricing
• Discount demands from managed care groups.
• Federal and state legislative proposals to reduce
  healthcare costs.
• Increased patient co-payments for prescription
  drugs.
• Physician incentives to prescribe generics.
• Employer pressures to curb increases in
  healthcare costs

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FIRST SECOND QUARTERPLANNING

• First-Quarter (April-May)
• Review prior-year audit work
• Review 1st quarter results
• Prepare preliminary audit time budget
• Consider adverse influences

• Second-Quarter (July-August)
• Review 2nd quarter results
• Finalize budget
• Perform analytical procedures
• Prepare preliminary planning memo
• Coordinate staff with client
• Prepare interim audit programs

• What are the steps in a financial statement
  audit?
• Communication with audit committee
• Accepting, continuing engagements
• Establish an understanding with the client
• Understand clients business strategies
• Planning
• Interim audit work
• Year-end audit work

• 11. Which of the following procedures would an
  auditor most likely perform when planning an
  audit?
• Review prior-year audit documents
• Inquire about potential litigation, claims, and
  assessments.
• Obtain a representation letter from management
• Determine whether internal controls are applied
  as prescribed

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INTERIM AUDIT WORK Controls Programs

• 19. A purpose of reviewing first-quarter
  financial results during audit planning is to
• Identify unexpected fluctuations occurring in
  account balances since the prior-year financial
  statements
• Become familiar with accounts likely to appear in
  the financial statements
• Plan evidence to be gathered in auditing accounts
  that are new to the first-quarter financial
  statements
• Assess first-quarter financial position, results
  of operations, and cash flows

• What are the steps in a financial statement
  audit?
• Communication with audit committee
• Accepting, continuing engagements
• Establish an understanding with the client
• Understand clients business strategies
• Planning
• Interim audit work
• Year-end audit work

• September-October
• Understand internal control
• Perform tests of controls
• Assess control risk
• November
• Prepare preliminary audit programs

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YEAR-END AUDIT WORK

• What are the steps in a financial statement
  audit?
• Communication with audit committee
• Accepting, continuing engagements
• Establish an understanding with the client
• Understand clients business strategies
• Planning
• Interim audit work
• Year-end audit work

• December
• Coordinate with client
• Finalize audit program
• January-February
• Perform substantive tests, analytical procedures
• Evaluate audit test results
• Material errors, fraud
• Subsequent events
• Year-end Audit Documentation
• Management, legal representations
• Audit documentation review
• Staff work reviewed
• Audit reports

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ERRORS VS. FRAUD
Topic 2 Auditors responsibility to detect,
report fraud

• SAS No. 99, Consideration of Fraud in a
  Financial Statement Audit
• Fraud is a broad legal concept and auditors do
  not make legal determinations of whether fraud
  has occurred. Rather, the auditor's interest
  specifically relates to acts that result in a
  material misstatement of the financial
  statements. The primary factor that distinguishes
  fraud from error is whether the underlying action
  that results in the misstatement of the financial
  statements is intentional or unintentional. For
  purposes of the Statement, fraud is an
  intentional act that results in a material
  misstatement in financial statements that are the
  subject of an audit.

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ERRORS VS. FRAUD

• Errors
• Unintentional misstatements or omissions in
  financial statements
• Fraud
• Fraudulent financial reporting intentional
  misstatement or omission (earnings management)
• Misappropriation of assets embezzlement ( thefts
  of cash, securities, etc.)
• Risk of misstatement from fraud

• 15. Which of the following, if material, would be
  a fraud?
• Errors in the application of accounting
  principles
• Clerical errors in accounting data underlying the
  financial statements
• Misinterpretation of facts that existed when the
  financial statements were prepared
• Misappropriation of an asset or groups of assets

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RISK OF FRAUD Auditors Responsibility

• What is an auditors responsibility for fraud?
• Exercise professional skepticism,
• Discuss among staff the risk of fraud driving
  material misstatement,
• Obtain information needed to identify risk,
• Identify risks that may cause material
  misstatement,
• Assess the risks,
• Respond to the assessment, and
• Evaluate audit evidence.

• 14. Which of the following would auditors most
  likely discuss in a brainstorming session to
  identify and assess fraud risk?
• Pressures on client employees
• Audit time budgets
• The audit committees awareness of fraud
• Former auditors employed by the client

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RISK OF FRAUD Professional Skepticism

• Professional skepticism
• No presumption of dishonesty balanced with
  possibility of misstatement due to fraud

The auditor should conduct the engagement with a
mindset that recognizes the possibility that a
material misstatement due to fraud could be
present, regardless of any past experience with
the entity and regardless of the auditors belief
about managements honesty and integrity.

• Presume two fraud risks
• gt Improper revenue recognition
• Apply analytical procedures to disaggregated data
• Confirm sales contract terms
• Inquire of sales, marketing GC sales or
  shipments near year end
• Witness shipments at year end
• gt Internal control override
• Examine journal entries
• Review accounting estimates
• Evaluate business purpose for unusual transactions

e.g., Sunbeam, Global Crossing, Enron, Rite Aid,
WorldCom, Xerox
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RISK OF FRAUD Other Aspects

• Professional skepticism
• No presumption of dishonesty balanced with
  possibility of misstatement due to fraud
• Fraud screens
• Some financial ratios help
• Asset quality
• Total accruals to total assets
• Days sales in receivables

• 18. An increase in a companys asset-equity ratio
  could suggest that
• The market value of assets is increasing
• Working capital has shifted from receivables and
  inventory to cash
• Assets with less certain benefits are increasing
• The proportion of collectible receivables is
  increasing

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IDENTIFYING, ASSESSING RISK OF FRAUD
Incentive

• Fraud triangle
• Incentives, pressures to commit fraud
• Opportunities to commit fraud
• Managements rationalizations for committing fraud

Opportunity
Rationalization

• 16. Which of the following is an inappropriate
  reaction to a material fraud detected in a
  publicly traded company?
• Report the matter to the SEC
• Discuss the matter with the audit committee of
  the board of directors
• Obtain further evidence
• Suggest that the client consult with legal
  counsel about questions of law

• 17. Which of the following statements best
  describes an auditors responsibility to detect
  fraud?
• The auditor is responsible for failing to detect
  fraud when the failure clearly results from not
  performing audit procedures described in the
  engagement letter
• The auditor must extend auditing procedures to
  search actively for fraud
• The auditor must assess the risk that material
  fraud may exist
• The auditor is responsible for failing to detect
  fraud only when an unqualified opinion is issued.