Chapter 6

Audit responsibility and objectives

6-1 (Objective 6-1) State the objective of the audit of financial statements. In general terms, how do auditors meet that objective?

The objective of the audit of financial statements by the independent auditor is the expression of an opinion on the fairness with which the financial statements present financial position, results of operations, and cash flows in conformity with generally accepted accounting principles.

The auditor meets that objective by accumulating sufficient appropriate evidence to determine whether the financial statements are fairly stated.

6-2 (Objectives 6-2, 6-3) Distinguish between management’s and the auditor’s responsibility for the financial statements being audited.

It is management's responsibility to adopt sound accounting policies, maintain adequate internal control and make fair representations in the financial statements. The auditor's responsibility is to conduct an audit of the financial statements in accordance with auditing standards and report the findings of the audit in the auditor's report.

6-3 (Objective 6-3) Distinguish between the terms errors and fraud. What is the auditor’s responsibility for finding each?

An error is an unintentional misstatement of the financial statements. Fraud represents intentional misstatements. The auditor is responsible for obtaining reasonable assurance that material misstatements in the financial statements are detected, whether those misstatements are due to errors or fraud.

An audit must be designed to provide reasonable assurance of detecting material misstatements in the financial statements. Further, the audit must be planned and performed with an attitude of professional skepticism in all aspects of the engagement. Because there is an attempt at concealment of fraud, material misstatements due to fraud are usually more difficult to uncover than errors. The auditor’s best defense when material misstatements (either errors or fraud) are not uncovered in the audit is that the audit was conducted in accordance with auditing standards.

6-4 (Objective 6-3) Distinguish between fraudulent financial reporting and misappropriation of assets. Discuss the likely difference between these two types of fraud on the fair presentation of financial statements.

Misappropriation of assets represents the theft of assets by employees. Fraudulent financial reporting is the intentional misstatement of financial information by management or a theft of assets by management, which is covered up by misstating financial statements.

Misappropriation of assets ordinarily occurs either because of inadequate internal controls or a violation of existing controls. The best way to prevent theft of assets is through adequate internal controls that function effectively. Many times theft of assets is relatively small in dollar amounts and will have no effect on the fair presentation of financial statements. There are also the cases of large theft of assets that result in bankruptcy to the company. Fraudulent financial reporting is inherently difficult to uncover because it is possible for one or more members of management to override internal controls. In many cases the amounts are extremely large and may affect the fair presentation of financial statements.

6-5 (Objective 6-3) “It is well accepted in auditing that throughout the conduct of the ordinary audit, it is essential to obtain large amounts of information from management and to rely heavily on management’s judgments. After all, the financial statements are management’s representations, and the primary responsibility for their fair presentation rests with management, not the auditor. For example, it is extremely difficult, if not impossible, for the auditor to evaluate the obsolescence of inventory as well as management can in a highly complex business. Similarly, the collectibility of accounts receivable and the continued usefulness of machinery and equipment are heavily dependent on management’s willingness to provide truthful responses to questions,” Reconcile the auditor’s responsibility for discovering material misrepresentations by management with these comment.

True, the auditor must rely on management for certain information in the conduct of his or her audit. However, the auditor must not accept management's representations blindly. The auditor must, whenever possible, obtain appropriate evidence to support the representations of management. As an example, if management represents that certain inventory is not obsolete, the auditor should be able to examine purchase orders from customers that prove part of the inventory is being sold at a price that is higher than the company's cost plus selling expenses. If management represents an account receivable as being fully collectible, the auditor should be able to examine subsequent payments by the customer or correspondence from the customer that indicates a willingness and ability to pay.

6-6 (Objective 6-3) List two major characteristics that are useful in predicting the likelihood of fraudulent financial reporting in an audit. For

each of the characteristics, state two things that the auditor can do to evaluate its significance in the engagement. CHARACTERISTIC AUDIT STEPS 1.Management’s ? Investigate the past history of the firm and its characteristics and management. influence over the ? Discuss the possibility of fraudulent financial control environment. reporting with previous auditor and company legal counsel after obtaining permission to do so from management. 2. Industry conditions. ? Research current status of industry and compare industry financial ratios to the company’s ratios. Investigate any unusual differences. ? Read AICPA’s Industry Audit Risk Alert for the company’s industry, if available. Consider the impact of specific risks that are identified on the conduct of the audit. 3.Operating ? Perform analytical procedures to evaluate the characteristics and possibility of business failure. financial stability. ? Investigate whether material transactions occur close to yearend.

6-7 (Objective 6-4) Describe what is meant by the cycle approach to auditing. What are the advantages of dividing the audit into different cycles?

The cycle approach is a method of dividing the audit such that closely related types of transactions and account balances are included in the same cycle. For example, sales, sales returns, and cash receipts transactions and the accounts receivable balance are all a part of the sales and collection cycle. The advantages of dividing the audit into different cycles are to divide the audit into more manageable parts, to assign tasks to different members of the audit team, and to keep closely related parts of the audit together.

6-8 (Objective 6-4) Identify the cycle to which each of the following general ledger accounts will ordinarily be assigned: sales, accounts payable, retained earnings, accounts receivable, inventory, and repairs and maintenance. GENERAL LEDGER ACCOUNT CYCLE Sales Sales & Collection Accounts Payable Acquisition & Payment Retained Earnings Capital Acquisition & Repayment Accounts Receivable Sales & Collection Inventory Inventory & Warehousing Repairs & Maintenance Acquisition & Payment

6-9 (Objectives 6-4, 6-5) Why are sales, sales returns and allowances, bad debts, cash discounts, accounts receivable, and allowance for uncollectible accounts all included in the same cycle?

There is a close relationship between each of these accounts. Sales, sales returns and allowances, and cash discounts all affect accounts receivable. Allowance for uncollectible accounts is closely tied to accounts receivable and should not be separated. Bad debt expense is closely related to the allowance for uncollectible accounts. To separate these accounts from each other implies that they are not closely related. Including them in the same cycle helps the auditor keep their relationships in mind.

6-10 (Objective 6-6) Define what is meant by a management assertion about financial statements. Identify the three broad categories of 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. These assertions are part of the criteria management uses to record and disclose accounting information in financial statements. SAS 106 (AU 326) classifies assertions 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

6-11 (Objectives 6-5, 6-6) Distinguish between the general audit objectives and management assertions. Why are the general audit objectives more useful to auditors?

General audit objectives follow from and are closely related to management assertions. General audit objectives, however, are intended to evidence required by the third standard of field work. Audit objectives are more useful to auditors than assertions because they are more detailed and more closely related to helping the auditor accumulate sufficient appropriate evidence.

6-12 (Objective 6-7) An acquisition of a fixed-asset repair by a construction company is recorded on the wrong date. Which transaction-related audit objective has been violated? Which