The Audit Process
Now that we have explained some of the fundamental concepts of auditing, let’s summarize the logical thought processes underlying a financial statement audit and then walk through the major phases of an audit. Be sure and take some time here—a thorough understanding of this section will be a great help to you in understanding subsequent chapters!
Overview of the Financial Statement Auditing Process Consider the auditor’s task from a logical perspective. The end product of an auditor’s work is an opinion indicating whether or not the client’s financial statements are free of material mis- statement. What might an auditor do to obtain the information needed to develop and support that opinion? The auditor must first obtain a thorough understanding of the client, its business and industry, and its information system. The auditor must understand the risks the client faces, how it deals with those risks, and what remaining risks are most likely to result in a material misstatement in the financial statements. Armed with this understanding, the auditor plans procedures that will produce evidence helpful in developing and supporting his or her opinion on the financial statements.
To understand this process intuitively, consider what financial statements are made of. From your financial accounting courses, you know that accounting systems capture, record, and summarize individual transactions. Entities must design and implement controls to ensure that those transactions are initiated, captured, recorded, and summarized appropriately. These individual transactions are grouped and summarized into various account balances, and finally, financial statements are formed by organizing meaningful collections of those account balances (e.g., current liabilities). We have just identified three stages in the account- ing process that take place in the preparation of financial statements: internal controls are implemented to ensure that the client’s information system appropriately captures and records individual transactions, which are then collected into ending account balances. This sum- mary might seem like an oversimplification, but it will help you understand the stages of a client’s accounting process on which auditors focus to collect evidence.
Keep in mind that the auditor’s job ultimately is to express an opinion on whether the financial statements are fairly stated. It makes sense, then, that the auditor can design
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procedures to collect direct information about the ending account balances that make up the financial statements. For example, an auditor might confirm the ending balance of the cash account by contacting the client’s bank, or the auditor might verify the ending balance of the inventory account by physically examining individual inventory items that make up the ending balance. But remember—account balances are made up of transactions that occurred over the past year (or earlier). If the auditor designs procedures to test whether the transac- tions were captured and handled properly, the auditor can obtain indirect information about whether the ending account balances are likely to be fairly stated. This information is clearly one step removed from the ending account balances themselves. But we can even back up one more step. If the auditor designs procedures to test whether the entity’s internal control over financial transactions is effective, the auditor can obtain additional indirect information regarding whether the account balances are fairly stated.
Carefully think through the logic in this last step: if controls are effective, then the trans- actions will probably be captured and summarized properly, which means in turn that the account balances are likely to be free of material misstatement. Thus, information about inter- nal control is even more indirect than information about transactions, but it is useful infor- mation nonetheless! In fact, while it is indirect, evidence about internal control is often a relatively cost-effective form of audit evidence.
To summarize, the auditor can collect evidence in each of three different stages in a cli- ent’s accounting system to help determine whether the financial statements are fairly stated: (1) the internal control put in place by the client to ensure proper handling of transactions (e.g., evaluate and test the controls); (2) the transactions that affect each account balance (e.g., examine a sample of the transactions that happened during the period); and (3) the end- ing account balances themselves (e.g., examine a sample of the items that make up an ending account balance at year-end). Evidence that relates directly to ending account balances is usually the highest quality, but also the costliest, evidence. Thus, an auditor will usually rely on a combination of evidence from all three stages in forming an audit opinion regarding the fairness of the financial statements. On which of these three areas it is best to focus depends on the circumstances, and this is generally left to the auditor’s discretion. Chapters 3 and 5 address the types of procedures and types of evidence available to the auditor in more detail.
Major Phases of the Audit The audit process can be broken down into a number of audit phases (see Figure 1–4). While the figure suggests that these phases are sequential, they are actually quite iterative and inter- related in nature. Phases often include audit procedures designed for one purpose that provide evidence for other purposes, and sometimes audit procedures accomplish purposes in more than one phase. Figure 1–4 shows the specific chapters where each of these phases is dis- cussed in detail.
Client Acceptance/Continuance Professional standards require that public account- ing firms establish policies and procedures for deciding whether to accept new clients and to retain current clients. The purpose of such policies is to minimize the likelihood that an auditor will be associated with clients that lack integrity. If an auditor is associated with a client that lacks integrity, the risk increases that material misstatements may exist and not be detected by the auditor. For a prospective new client, the auditor is required to confer with the predecessor auditor and the auditor frequently conducts background checks on top man- agement. The knowledge that the auditor gathers during the acceptance/continuance process provides valuable understanding of the entity and its environment, thus helping the auditor assess risk and plan the audit.
Preliminary Engagement Activities There are generally three preliminary engagement activities: (1) determine the audit engagement team requirements; (2) ensure the indepen- dence of the audit firm and audit team; and (3) establish an understanding with the client regarding the services to be performed and the other terms of the engagement.
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Once the decision has been made to accept an audit engagement, the auditor begins pre- liminary engagement activities by updating his or her understanding of the entity and its envi- ronment. This understanding includes the nature of the entity and the industry in which it operates, how it measures its own performance, the nature of its information system, and the quality of its internal control. The auditor’s understanding of the entity and its environment helps in assessing the risk of material misstatement and in setting the scope of the audit.
The engagement partner or manager forms an audit team composed of members who have the appropriate audit and industry experience for the engagement, determines whether special- ists (e.g., tax specialists) are needed, and makes sure that the audit firm and individual team members are free from prohibited relationships that might threaten the auditor’s objectivity.
Major Phases of an AuditF I G U R E 1 – 4
Client acceptance/ continuance (Chapter 3)
Audit business processes and related accounts
(e.g., revenue generation) (Chapters 10–16)
Preliminary engagement activities
(Chapter 3)
Plan the audit (Chapters 3, 4, and 5)
Consider and audit internal control (Chapters 6 and 7)
Complete the audit (Chapter 17)
Evaluate results and issue audit report (Chapters 1 and 18)
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Finally, the auditor establishes an understanding with the client regarding the services to be performed and the terms of the engagement, including such considerations as timing of the audit and expected audit fees. Chapter 3 addresses the preliminary engagement activities of the audit process in more detail.
Plan the Audit Proper planning is important to ensure that the audit is conducted in an effective and efficient manner. In order to plan the audit properly, the audit team must make a preliminary assessment of the client’s business risks and determine materiality. The audit team relies on these judgments to then assess risk relating to the likelihood of material mis- statements in the financial statements. Audit planning should take into account the auditor’s understanding of the entity’s internal control system (discussed next). This assessment of internal control will be in greater depth if the client is a public company, because for public companies the auditor is required to report on both the company’s internal control over finan- cial reporting and the company’s financial statements. The outcome of the auditor’s planning process is a written audit plan that sets forth the nature, extent, and timing of the audit proce- dures to be performed. You will learn about the issues that are involved in this phase of the audit in Chapters 3, 4, and 5.
Consider and Audit Internal Control A company’s system of internal control is put in place by the company’s board of directors and management to help the company achieve reliable financial reporting, effective and efficient operations, and consistent compliance with applicable laws and regulations. The quality of a company’s internal control over finan- cial reporting is of direct relevance to auditors. As part of obtaining an understanding of the entity and its environment, the auditor obtains an understanding of internal control to help the auditor assess risk and identify areas where financial statements might be misstated. Chapter 6 covers the role of internal control in a financial statement audit, and Chapter 7 specifically addresses the audit of internal control for public companies. Later chapters apply the process of considering and auditing internal control in the context of various busi- ness processes.
Audit Business Processes and Related Accounts Auditors usually organize audits by grouping financial statement accounts according to the business processes that primar- ily affect those accounts. For example, sales revenue and accounts receivable are both part of a company’s sales and collection process and are audited together. The auditor applies audit procedures to the accounts in order to obtain audit evidence about management’s asser- tions relating to each account and reduce the risk of undetected material misstatement to an appropriately low level. On most engagements, actually conducting the planned audit tests comprises most of the time spent on a financial statement audit or an audit of internal control over financial reporting. For public company clients, the audit of internal control is done in an integrated way with the financial statement audit. This topic is addressed in Chapter 7 and throughout the book where appropriate.
Complete the Audit The auditor must obtain sufficient appropriate evidence in order to reach and justify a conclusion on the fairness of the financial statements. After the auditor has finished gathering reliable evidence relating to management’s financial statement assertions, the auditor assesses the sufficiency of the evidence and obtains additional evidence where deemed necessary. In this phase, the auditor also addresses a number of issues, including the possibility of undisclosed contingent liabilities, such as lawsuits, and searches for any events subsequent to the balance sheet date that may impact the financial statements. Chapter 17 discusses the completion phase of the audit in detail.
Evaluate Results and Issue Audit Report The final phase in the audit process is to evaluate results and choose the appropriate audit report to issue. The auditor’s report, also known as the audit opinion, is the main product or output of the audit. Just as the report of a
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house inspector communicates the inspector’s findings to a prospective buyer, the audit report communicates the auditor’s findings to the users of the financial statements.
After completion of the audit work, the auditor determines if the preliminary assessments of risks were appropriate in light of the evidence collected and whether sufficient evidence was obtained. The auditor then aggregates the total known and estimated uncorrected mis- statements and determines whether they cause the financial statements to be materially mis- stated. If the uncorrected misstatements are judged to be material, the auditor will request that the client correct the misstatements. If the client refuses, the auditor issues an opinion that clearly indicates that the financial statements are materially misstated and explains the nature of the misstatement. If the uncorrected misstatements are insignificant enough that they do not cause the financial statements to be materially misstated, or if the client is willing to cor- rect the misstatements, the auditor issues an unqualified (i.e., “clean”) report.
The Unqualified/Unmodified Audit Report The unqualified audit report is by far the most common type of report issued.8 In this context, unqualified means that, because the financial statements are free of material misstatements, the auditor does not find it necessary to qualify (i.e. specify any exceptions to) his or her “clean” audit opinion. While it is fairly common for the auditor to find misstatements need- ing correction, audit clients are almost always willing to make the adjustments necessary to receive a clean opinion. Exhibit 1–1 presents an audit report issued on EarthWear Clothier’s financial statements. This report covers financial statements that include balance sheets for two years and statements of income, stockholders’ equity, and cash flows for three years. The audit report presented in Exhibit 1–1 is the standard type of unqualified audit opinion issued for publicly traded companies.
Take a moment to read through the report. You will see that the title refers to the “Inde- pendent Registered Public Accounting Firm” issuing the audit report. The report is addressed to the individual or group that is the intended recipient of the report. The body of the report begins with an introductory paragraph indicating which financial statements are covered by the report, that the statements are the responsibility of management, and that the auditor has a responsibility to express an opinion.
The second, or scope, paragraph communicates to the users, in very general terms, what an audit entails. In addition to indicating that the audit was conducted in accordance with appli- cable auditing standards, it emphasizes the fact that the audit provides only reasonable assur- ance that the financial statements contain no material misstatements. The scope paragraph also discloses that an audit involves an examination of evidence on a test basis (i.e., using samples rather than examining entire populations), an assessment of accounting principles used and significant estimates, and an overall evaluation of financial statement presentation. Finally, the scope paragraph expresses the auditor’s judgment that the audit provides a reasonable basis for the opinion to be expressed in the report.
The third paragraph contains the auditor’s opinion concerning the fairness of the finan- cial statements based on the audit evidence. Note two important phrases contained in this paragraph. First, the phrase “present fairly . . . in conformity with U.S. generally accepted accounting principles” indicates the criteria against which the auditor assesses management assertions. Second, the opinion paragraph contains the phrase “in all material respects,” emphasizing the concept of materiality. Note that the scope paragraph indicates how the audit was conducted—in accordance with the standards of the PCAOB—because EarthWear is a publicly traded company. Audit reports for nonpublic companies refer instead to “generally accepted auditing standards.”
The fourth paragraph contains explanatory language. As shown in Exhibit 1–1, when the auditor’s opinion on a public company’s financial statements is presented separately from the auditor’s report on the client’s internal control over financial reporting, as is the case here, the report must refer to the audit of internal control in an explanatory paragraph.
8A “clean” audit report is referred to as “unqualifed” by PCAOB auditing standards and as “unmodified” by AICPA and international auditing standards. See Chapters 2 and 18.\