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AUDITING CHAPTER 7

AUDITING CHAPTER 7. Audit Process & Detecting Fraud By David N. Ricchiute. TOPICS. Audit process Client acceptance, client strategies, planning, interim & year end work Auditor’s responsibility to detect, report fraud. PRELIMINARY STEPS IN AUDIT PROCESS. Communication with audit committee

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AUDITING CHAPTER 7

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  1. AUDITINGCHAPTER 7 Audit Process & Detecting Fraud By David N. Ricchiute

  2. TOPICS • Audit process • Client acceptance, client strategies, planning, interim & year end work • Auditor’s responsibility to detect, report fraud GBW 8th ed., Ch. 7

  3. PRELIMINARY STEPS IN AUDIT PROCESS • Communication with audit committee • Accepting, continuing engagements • Understand client’s business strategies • Planning • Interim, year-end audit work GBW 8th ed., Ch. 7

  4. AUDIT COMMITTEES:History • 1940 SEC ASR #19 encouraged • 1978 required by NYSE • 1999 recommendations from Blue Ribbon on audit committee effectiveness • Consistency of accounting principles • Clarity, completeness of financial statements GBW 8th ed., Ch. 7

  5. SEC & SARBANES-OXLEY RULES: Post 2000 • 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 GBW 8th ed., Ch. 7

  6. 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 GBW 8th ed., Ch. 7

  7. ACCEPTING, CONTINUING ENGAGEMENTS • Establish policies, procedures to accept, continue clients (Stmt. Quality Control Stds. No. 1 ) • For new client • Evaluate ability to service client • Review financial statements • Inquire about reputation, bankruptcy • Investigate key managers GBW 8th ed., Ch. 7

  8. COMMUNICATIONS WITH PREDECESSOR • Successor auditor initiatescommunication • Predecessor auditor obtains permission to disclose confidential information (Rule 301) • Is prior auditor’s resignation, replacement linked to (SAS 84) • Disagreement with management? • Management integrity? • Other reasons? GBW 8th ed., Ch. 7

  9. UNDERSTANDING WITH CLIENT • Objectives & limitations of engagement • Management’s responsibilities • Example: financial statement audit • Objective: express opinion whether statements • Present fairly • In all material respects • In conformity with GAAP SAS 83 & SSAE 7 GBW 8th ed., Ch. 7

  10. MANAGEMENT’S RESPONSIBILITIES • Financial statements • Establishing, maintaining effective internal over financial reporting • Assuring compliance with laws & regulations • Making records, information available • Confirming representations made during engagement GBW 8th ed., Ch. 7

  11. ENGAGEMENT LETTERS • Drafted by auditor for CEO’s 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 GBW 8th ed., Ch. 7

  12. PROPOSED ADJUSTING JOURNAL ENTRIES (AJE) • SAS 88 “Audit Adjustments” • Management’s responsibility to record material proposed adjustments • Management must confirm responsibility for adjustments at year end in representation letter • Auditor informs audit committee of management’s responsibilities for adjustments GBW 8th ed., Ch. 7

  13. UNDERSTANDING CLIENT’S BUSINESS • Auditor considers effects of client business & strategies on • Risks • Strategies to overcome risk • Transactions, events as products of management’s strategies GBW 8th ed., Ch. 7

  14. CLIENT STRATEGY TEMPLATE-Strategies • Growth strategy • Financial goals & operating priorities GBW 8th ed., Ch. 7

  15. CLIENT STRATEGY TEMPLATE-Characteristics • Characteristics of business • Major business units • Markets • Products • Customers • Competitors • Strategic alliances & joint ventures • Potential adverse influences GBW 8th ed., Ch. 7

  16. BUSINESS: Units, Markets, Products, Customers • Demonstrate value of product • R&D to develop new products GBW 8th ed., Ch. 7

  17. FINANCIAL GOALS, OPERATING PRIORITIES: Merck • Remain in top quartile • Maximize revenue growth • Preserve profitability of core business • Achieve full potential GBW 8th ed., Ch. 7

  18. ERRORS VS. FRAUD • Errors • Unintentional misstatements or omissions in financial statements • Fraud • Fraudulent financial reporting: intentional misstatement or omission • Misappropriation of assets: theft GBW 8th ed., Ch. 7

  19. PLANNING • Risk of misstatement from fraud • First quarter planning • Second quarter planning GBW 8th ed., Ch. 7

  20. RISK OF FRAUD: Auditor’s Responsibility • Discuss risk with staff • Obtain pertinent information • Identify & assess risks • Plan according to assessment • Evaluate evidence GBW 8th ed., Ch. 7

  21. 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 GBW 8th ed., Ch. 7

  22. IDENTIFYING, ASSESSING RISK OF FRAUD • Fraud triangle • Incentives, pressures to commit fraud • Opportunities to commit fraud • Management’s rationalizations for committing fraud GBW 8th ed., Ch. 7

  23. FIRST-QUARTER PLANNING • Review prior-year audit work • Review 1st quarter results • Prepare preliminary audit time budget • Consider adverse influences GBW 8th ed., Ch. 7

  24. SECOND-QUARTER PLANNING • Review 2nd quarter results • Finalize budget • Perform analytical procedures • Prepare preliminary planning memo • Coordinate staff with client • Prepare interim audit programs GBW 8th ed., Ch. 7

  25. INTERIM AUDIT WORK: Controls & Programs • Understand internal control • Perform tests of controls • Assess control risk • Prepare preliminary audit programs GBW 8th ed., Ch. 7

  26. YEAR-END AUDIT WORK • Coordinate with client • Finalize audit program • Perform substantive tests, analytical procedures • Evaluate audit test results • Material errors, fraud • Subsequent events GBW 8th ed., Ch. 7

  27. YEAR-END AUDIT DOCUMENTATION • Management, legal representations • Audit documentation review • Staff work reviewed • Audit reports GBW 8th ed., Ch. 7

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