Audit Risk and Materiality.

Audit Risk:
Audit risk is the risk that an auditor expresses an inappropriate opinion on the finacial statements.
Many times most of us think that after an audit, the statements are perfect and free from error. However, auditors just provide reasonable assurance that the statements are free from error. Secondly, the auditors' opinion means that the statements are free from material misstatement.
Inappropriate opinions include:

1. Issuing a qualified opinion where no qualification is necessary.
2. Issuing an unqualified audit report where a qualification is reasonably justified.
3. Failing to emphasize  a significant matter in the audit report.

Auditing is directly related to areas that pose the greatest risk.

The audit risk model:
Audit risk = Inherent risk x Control risk x Detection risk

Where:
Audit risk - This can be looked at as the product of the different risks which may be encountered in the performance of the audit.
The qualified tolerance for most firms is 5% or less.
Inherent risk - This is risk of a material misstatement in the finacial statements arising due to error or omission as a result of factors other than the failure of controls.
This risk is considered to be higher where a high degree of judgement and estimation is involved.
Control risk - Risk that a material misstatement might not be detected or prevented on time by the internal control systems.
This risk is connsidered to be high where the audit entity does not have adquate internal controls to prevent fraud.
Detection risk - Risk that the auditor fails to detect a material misstatement in the financial statements.
This risk can be reduced by the auditor increasing the number of sampled transactions for detailed testing.

Assessing the audit risk:
The inherent risk and control risk is assessed by the auditor at three levels. That is;

1. Low risk
2. Medium risk
3. High risk

High inherent and control risks call for a low detection risk so as to have an overall low audit risk. The auditor therefore needs to carry out more detection procedures to be convincingly assured about the financial statements being free from material misstatements.

Materiality:
Materiality refers to the truthfulness of the material. It is the magnitude of an omission or misstatement of accounting information that makes it probable that the judgement of the persons (such as management, investors and shareholders) relying on that information would have been changed by the misstatement. Materiality is a matter of proffesional judgement,
Net income before taxes is often the primary basis needed for evaluating materiality. Determination of materiality requires "delicate assessment of the interferences a 'reasonable shareholder' would draw from a given set of facts and the significance of those interferences to him..."

The steps in applying materiality are as outlined below:

1. Set preliminary judgement about materiality.
2. Allocate preliminary judgement about materiality to the segments.
3. Estimate total misstatements in each of the segments.
4. Estimate the combined misstatements.
5. Compare combined estimate with preliminary or revised judgement about materiality.

Materiality needs to be considered at two instances and these are:

1. When planning and designing the audit process.
2. When allocating the chances of errors in the financial statements in accordance to GAAP.

REFERENCE:
www.readyratios/reference/audit/audit_risk.html
TSC Industries, 4626 U.S. at 450

Audit Evidence.

Audit evidence refers to the information collected for reviewing the financial transactions of a company in addition to its internal control practices and other essential factors needed for the certification of financial statements. “The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to afford a reasonable basis for an opinion regarding the financial statements under audit.”

            In most cases, auditors emphasize the importance of sufficiency (measure of the quantity of audit evidence) and appropriateness (the degree to which the evidence can be considered trustworthy) of the audit evidence. However, the evidence should also be persuasive rather than convincing.

Audit evidence decisions:
A key decision the auditor must make is the appropriate types and amounts of evidence to draw conclusions regarding financial statements or internal control. You might suggest that all evidence available should be used--but unfortunately, the cost of sampling every piece of evidence in a population would be prohibitive. In practice, the profession of auditing often requires taking a sample, and then drawing a conclusion based on that sample.
There are types of decisions that an auditor must make:

1.   Sample size. This refers to the number of items that should be tested for each audit   procedure.
2.   Items to select. This emphasizes which items should be included in the audit exercise.
3.   Timing. This can vary from early in the accounting period to after it has ended.

Appropriateness and sufficiency are affected by the following factors:

1.   Timeliness. The balance sheet account evidence is better when it’s collected around the date of the financial statements.
2.   Independence. Evidence that is from external sources such as suppliers is stronger than that of sources within the organization.
3.   Auditor’s direct knowledge. The auditor’s determinations are stronger than the client’s views.
4.  Objectivity. Objective evidence is stronger than subjective evidence.
5.   Effectiveness of client’s internal controls. Good internal controls mean better information.
6.   Relevance. Must pertain to the audit objective being tested.
7.   Qualifications. Reliability of the information is enhanced if the person providing it is qualified to do so.

Types of audit evidence:

In deciding which procedures to use, the auditor may choose from different types of evidence:

1.    Inspection of tangible assets. This involves examining assets of the company being audited. It requires the auditor to physically count the tangible assets. This evidence provides assurance of existence of the asset.

2.    Observation.  This involves looking at the processes and procedures being performed by the client. For example, focusing on the client’s activities. However, this method has a downside in that it’s only limited to the time that those activities occur.

3.    Mathematic recalculation. Involves checking the arithmetic accuracy of the records. This can be done by use of computer-assisted audit techniques (CAATs) to check the accuracy of the summarization of the files. For example, recalculating depreciation and reconciling the ledgers.

4.    Analytical procedures. Consist of evaluations of financial information made by a study of recorded data with expectations developed by the auditor. These procedures help reveal unusual transactions, trends and ratios that might have implications for audit planning.

The types of analytical procedures include:

•          Preliminary analytical procedures.
•          Substantive analytical procedures.
•          Final analytical procedures. 

5.   Confirmations. This is the process of getting a representation of information directly from an independent third party. The client has request that the third party responds directly to the auditor. For example, the auditor may call the inventory agents to confirm the consignments or attorneys to confirm the contingent liabilities.

The reliability of the evidence got through confirmations may be affected by factors such as:

·         Nature of the information being confirmed.

·         Form of confirmation.

·         Prior experience with the entity.

Confirmations are of two types. That is:

·         Positive confirmation. This asks for response even if the balance is correct and it’s more reliable than negative confirmation.

·         Negative confirmation. Asks for a response only of the balance is incorrect.

6.    Inquiry. Involves auditors obtaining information from the client in response to questions. It may be in written form or oral form. Much evidence can be got through inquiry however; it cannot be thought of as final and may be biased in  favor of the client.

Inquiry alone is not sufficient to test the operating effectiveness of controls. Therefore, auditors need to use inquiry as well as other procedures to get sufficient appropriate audit evidence.

7.    Reperfomance. Involves the testing of mathematical accuracy to confirm the computations and transfers of information those can be done by use of CAATs.

8.    Scanning. This is the review of accounting data to identify unusual items. This includes the identification of abnormal individual items within account balances or other client data through analysis of entries on transactions, ledgers and other accounts.

9.    Inspection of documents. This consists of examining internal or external records that are in paper form, electronic or other media. The auditor should be aware about the reliability of the documents.

There are two types of documents and they include:

·         External documents. These are documents that are outside the client. They are held by    a third party. These documents are more reliable than internal sources.

·         Internal documents. They are documents prepared by the client company and don’t go outside the client. They could be biased and therefore not reliable.

Auditing Management Assertions.

Management assertions are claims by management about the accuracy of the financial statements. For example, if management states in the balance sheet that it has receivables worth $4500, then its claims by the managers that those are the true and accurate figures. As earlier noted, it is the responsibility of managers to present financial statements that are true and fair.

Auditors use management assertions to help guide audit evidence gathered. These assertions are classified below:

1. Transaction assertions: The following are classified as assertions related to transactions (mostly affecting the income statement).

• Occurrence. This claims that the business transactions available in the statements actually took place.
• Cut-off. The assertion is that all transactions were recorded within the correct reporting period.
• Completeness. The transactions that require recording have been recorded.
• Classification. The transactions have been recorded in their respective accounts.
• Accuracy. The assertion is that all transactions have been recorded with the correct figures.

     2. Account balance assertions: The following assertions relate to the ending  balances in                  accounts (mostly the balance sheet).

• Existence. The assertion is that all the assets, liabilities and equity balances actually do exist.
• Valuation and allocation. All assets, liabilities and equity have been valued properly.
• Completeness. The assertion is all the assets, liabilities and equity have been recorded.
• Rights and obligations. The business has right to assets it owns and the liabilities with in the statements are its obligations.

     3. Presentation and disclosure assertions: These assertions deal with the presentation   of information within the financial statements as well as the accompanying disclosures. 

• Accuracy and valuation. The information recorded is correct.
• Occurrence. The transactions actually did take place.
• Completeness. All events have been recorded.
• Rights and obligations. The business organisation has right to the assets it owns and the liabilities within the statements are its obligations.
• Classification and understandability. The financial information presented in the statements is clear and understandable.

The table below summarizes the assertions:

Image courtesy of http://www.financelearningacademy.com/auditingabc123.html

Independent Auditors' Report.

Under this, we are going to place our emphasis on the auditor's report. A qualified auditor's report says that the financial statements are presented fairly. But before the auditor can draft his report, he has to undergo through the following steps:

1. The auditor has to be engaged to perform the audit.
2. The auditor must follow GAAS.
3. The auditor must gather sufficient appropriate auditors' evidence.
4. The auditor must evaluate the fairness of presentation relevant to GAAP.
5. The auditor must have no reservations.

Let us take a look at the sections of a standard auditor's report:

1. It must include a title such as "Independent Auditor's Report." This emphasizes the independence of the auditor.
2. Management's responsibility. This shows that management is responsible for the preparation and fair presentation of the financial statements.
3. The auditor's  responsibility. This shows that the auditor is responsible for the expression of his opinions based on the audit carried out.
4. Opinion. This section shows that the financial statements are presented fairly, "in all material respects" in accordance with GAAP
5. The firm's name. This includes the name of the firm that the auditor works for.
6. Date. The report is dated "as at" the date the statements are approved at by management.

A sample of an independent auditor's report is given below:

INDEPENDENT AUDITOR'S REPORT

Board of Directors, Stockholders, Owners, and/or Management of
ABC Company, Inc.
123 Main St.
Anytown, Any Country

We have audited the accompanying financial statements of ABC Company, Inc. (a California corporation), which comprise the balance sheet as of December 31, 20XX, and the related statements of income, retained earnings, and cash flows for the year then ended, and the related notes to the financial statements.

Management's Responsibility for the Financial Statements

Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with U.S. generally accepted accounting principles; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, whether due to fraud or error.

Auditor's Responsibility

Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with U.S. generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement.

An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditors' judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity's preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity's internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements.

We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.

Opinion

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of ABC Company, Inc. as of December 31, 20XX, and the results of its operations and its cash flows for the year then ended in accordance with U.S. generally accepted accounting principles.

AUDITOR'S SIGNATURE
Auditor's name and address

Date = Last day of any significant field work
This date should not be dated earlier than when the auditor has sufficient audit evidence to support the opinion.

Modified audit opinions:
When the financial statements “give a true and fair view” and the organization under audit has gone in accordance with all requirements, the auditor will issue an unmodified audit opinion. A modified audit opinion is issued in all other circumstances such as  when the auditor concludes that, based on the audit evidence obtained, the financial statements as a whole are materially misstated or the auditor is unable to obtain sufficient appropriate audit evidence to conclude that the financial statements as a whole are free from material misstatement and must be identified as such.

Types

There are three types of modified audit opinions. The first is an opinion in which the auditor states that there is a possibility of a misstatement in the client’s financial records that is “material but not pervasive.” In this case, the auditor states that everything in the audit is fairly presented with the exception of a specific item, and why that item is an exception. The second type of modified audit opinion comes with a disclaimer or opinion, which is used when the misstatement in the financial record is due to a scope limitation and is both material and pervasive. The third modified audit opinion is adverse; in this case, the misstatement is both material and pervasive, and must originate from a departure from applicable financial reporting framework.

Disclaimers

At the end of an audit, Generally Accepted Auditing Standards mandate that auditors must either express an opinion of the financial records in question, or must issue a disclaimer of opinion. An auditor may decide to issue a disclaimer of opinion if one of four circumstances are applicable: a lack of independence, scope limitations, substantial doubt about the organization’s ability to survive or matters involving uncertainties.

Auditor's report reservation:

Reservation of opinion include:

1. Qualified Opinion - forms a positive opinion on the financial statements as a whole, but qualifies that opinion with respect to a departure from generally accepted accounting principles or a limitation in the scope of the audit.
2.  Adverse Opinion - forms an opinion that the financial statements are not presented fairly in accordance with generally accepted accounting principles.
3. Denial of Opinion - is unable to form an opinion on the financial statements as a whole because of a limitation in the scope of the audit.

REFERENCE:
http://smallbusiness.chron.com/modified-audit-opinion-26322.html

http://en.wikipedia.org/wiki/Auditor's_report

Auditing Ethics.

Business dictionary defines ethics as "the basic concepts and fundamental principles of decent human conduct."
To some, ethics are natural and inborn while to others, they are characters that must be learnt in school. However the big question is: Why do some people decide to do wrong while others do what is required of them?

Public accounting is a profession. A public accountant should therefore act in the interest of the public. This means that some ideas brought out may be contrary to the best interest of the company. Ethical dilemmas will always arise. Just like other occupations, public accountants take ethics seriously.
It is easy to do something simply because other accountants are doing doing but you need to judge and ask yourself, "Is what I am doing the right thing?"

Let me highlight on how such ethical dilemma can be controlled:

1. Obtain the facts. Once you have identified the issues at hand, get facts about them.
2. Identify ethical issues. Separate ethical issues from facts.
3. Determine who is affected by the dilemmas.
4. Identify ways to solve the dilemmas.
5. Weigh the outcomes of each dilemma.
6. Take action.

Some of the key rules that distinguish auditors from bookkeepers are as follows:

1. The auditor must maintain his independence. He must issue results that are unbiased
2. Confidentiality of information, Public accountants should not disclose any confidential information concerning their clients except under special circumstances such as when the client has accepted to such disclosure.
3. Integrity and due care. Public accountants should work with honest. If the auditor gives a wrong opinion, he can easily mislead the management and investors who make decisions basing on those financial statements. Therefore he can be sued.
4. Objectivity. Auditors should perform their services with an objective state of mind.
5. Competence. Auditors should sustain their competence by informed with the current state of the organisation and complying with developments in professional standards.
6. Communication with predecessors. An auditor should not accept an engagement with respect to the practice of public accounting or the public practice of a function not consistent with public accounting, where the auditor is replacing another auditor, without first communicating with such person and inquiring whether there are any circumstances the auditor should take into account which might influence the auditor's decision whether or not to accept the engagement.

If those rules are not followed, the penalties may include:

1. Public humiliation.
2. Monetary fines.
3. Restrictions to practicing auditing.
4. Upgrade quality control which is very costly.

REFERENCE:
http://www.businessdictionary.com/definition/ethics.html#ixzz2VnApBWLB

Merits and Limitations of Auditing.

It is important for companies to be audited. There advantages involved in auditing and some of them are as shown below:

1. Auditing helps reveal fraud and errors.
2. Auditing acts as evidence in court. If a case is filed against the company, it can provide the audited reports to prove its innocence.
3. Audited accounts help facilitate settlement of claims incase a partner dies.
4. Auditing gives room for suggestions and therefore improving the business organisation.
5. Auditing shows the financial status of the company.
6. Auditing helps the business to easily get loans since they have audited reports.
7. In some countries, it's a requirement by the government for tax purposes.
8. Auditing helps in proper valuation of assets.
9. Auditing helps to maintain the company accounts regularly.
10. Auditing provides information about the profit and loss of a company.

However, just like most things in life, auditing also has inherent limitations which include the following:

1. Non-detection of errors. Auditors may not be able to detect errors that were "smartly" covered up by the managers.
2. Effect of inflation. Financial statements may not give a true picture even after auditing has taken place because of inflation.
3. Difference in opinions. Auditors may have various conclusions concerning the financial statements. If these differences are not settled peacefully, they can easily lead to wrangles.
4. Alternative accounting principles. Different businesses use different GAAP. It is therefore the auditor's duty to find out which principles are being used by that company.
5. Influence of managers. The auditors may be corrupted by the management of the company so that they file reports which are in favour of the managers.

The Basics of Auditing.

Many people confuse auditing with accounting. The distinction between the two is:

                Auditing is the opinion on the fairness and presentation of financial statements. Auditing is the auditor’s responsibility.

While:

                Accounting is the process of preparing financial statements. Accounting is the responsibility of the management.

                An audit can be compared to a periodic check up with a mechanic. Just as a crumbling car must pass through a series of tests to ensure a clean “bill of health”, a company’s financial “good health” also relies on whether its financial statements abide by the Generally Accepted Accounting Principles (GAAP). Therefore in this case, the auditor is the mechanic and the car is the business organisation.

Auditing doesn’t promise faultless financial statements but it does give reasonable assurance that the financial statements are free from unnecessary mistakes.

Almost every organisation prepares financial statements. These provide information for the managers (to make good decisions), governments (for tax purposes), banks (to extend credit facilities) and investors (to influence their decisions of whether to invest in that business or not). The statements therefore need to be accurate.

There are generally two types of auditors:

a)      Internal auditors

b)      External auditors

a)  According to Investopedia, internal auditing is "the examination, monitoring and analysis of activities related to a company’s operations, including its business structure, employee behaviour and information systems." Internal auditing reveals that the company’s financial statements are consistent and trustworthy.

b) External auditing is the reviewing of a company’s financial statements by another qualified personnel who is not affiliated with the organisation. Such professionals include public accountants.

Components of an audit:

a)      Auditors need something to audit. These include financial statements which have transactions. Auditors are professional accountants. They don’t prepare financial statements. That is the work for managers. Auditors verify the financial transactions and give opinions.

b)      There should be evaluation criteria. If there was no basis to follow when preparing and evaluating financial statements, the users would have difficulty in trying to understand what the statements portray. Auditors therefore follow GAAP.                                                                                      

Other types of criteria include:

·         Tax rules (for tax auditors)

·         Company policy (for internal auditors)

c)       Audit evidence. Just as an attorney gathers information for his client to prove his innocence, so do auditors. Auditors need to get financial statements to evaluate, test and support (if they are correct) or conclude that the statements are adverse in case they do not abide by GAAP.

d)      Auditors. Auditors are not just people pulled from anywhere to come and verify the statements. They need to have a deep background in accounting. They need training in accounting professions. Only CPAs can issue opinions in auditing.

e)      Reporting. Auditors need a way of expressing their opinions and disclose their findings that will benefit the users.

Auditing is an interesting career. The advantages are that: you get to work in teams and travel in different locations always making new contacts.

However the downside of it is that it can be tedious in some areas.

REFERENCE:

http://www.investopedia.com/terms/i/internalaudit.asp