AUDITINGCHAPTER 2

Standards, Materiality, & RiskByDavid N. Ricchiute

GBW Ch. 2 8th ed2

TOPICS

Audit & Attestation standardsAuditing conceptsAudit riskMateriality in financial statement audit

GBW Ch. 2 8th ed3

EARLY DEVELOPMENT OF STANDARDS

1941 Accounting Series Release (ASR)#21 SEC requires audit report Audit conducted in accordance with

generally accepted standards

1948 AICPA approves generally accepted auditing standards (GAAS)

GBW Ch. 2 8th ed4

RECENT DEVELOPMENT OF STANDARDS

1970s practitioners criticized GAAS as not sufficiently specific1986 Attestation standards developed Umbrella for engagement standards GAAS applies exclusively to financial

statement audits

GBW Ch. 2 8th ed5

COMPARING GAAS & ATTESTATION

Attestation GAAS

Broad range of engagementsincluding audit

Financial statement audit

Umbrella for all attest services

Audit one of many attest engagements

GBW Ch. 2 8th ed6

GENERAL STANDARDSAttestation GAAS

Adequate technical training Adequate technical training

Adequate knowledgeAssertion can be evaluated by reasonable criteria & consistently measured or estimated

Independence in mental attitude

Independence in mental attitude

Due professional care Due professional care

GBW Ch. 2 8th ed7

FIELDWORK STANDARDS

Attestation GAAS

Adequately planned & supervised

Adequately planned & supervised

Understanding internal control

Sufficient evidence Sufficient competent evidential matter

GBW Ch. 2 8th ed8

REPORTING STANDARDSAttestation GAAS

Assertion identified

Conclusion about conformity with established criteriaState significant reservations

Conclusion about conformity with GAAPConsistent use of GAAPAdequate informative disclosures

Limited use to parties agreeing on procedures

Opinion on statements as a whole

GBW Ch. 2 8th ed9

STANDARDS FOR PUBLIC COMPANY ENGAGEMENTS

Sarbanes-Oxley Act of 2002 Creates Public Company Accounting

Oversight Board (PCAOB) Delegates authority to PCAOB to

Oversee, regulate accounting and auditing professions

Develop accounting, auditing standards or Accept accounting standards from FASB Accept auditing standards from AICPA

GBW Ch. 2 8th ed10

AUDITING CONCEPTS

IndependenceDue careEvidenceReporting

GBW Ch. 2 8th ed11

INDEPENDENCE EXPLAINED

In fact State of mind Attitude of impartiality

In appearance Free of overt interest in client

GBW Ch. 2 8th ed12

CONSULTING & PUBLIC COMPANY ENGAGEMENTS 2000

… consulting & other services may shorten the distance between the auditor & management. Independence—if not in fact, then certainly in appearance—becomes a more elusive proposition. … In this dual role, the auditor, who guards the integrity of the numbers, now both oversees & answers to management.

Arthur Levitt, Jr., “Renewing the Covenant with Investors” Speech at NYU Center for Law & Business, 5/10/00.

GBW Ch. 2 8th ed13

SEC PUBLIC COMPANIES INDEPENDENCE REFORMS 2000

Engagement team model of independence Team & immediate family prohibited from

investments in clients

Increased restrictions for IT and internal audit consultingRequired disclosure audit/nonaudit fees in proxy statement

GBW Ch. 2 8th ed14

SARBANES-OXLEY, & INDEPENDENCE 2002

Establishes PCAOBAddresses accountability for corporate & criminal fraudLimits audit firm’s consulting services to public company clientsClient board of directors to approve consulting services provided by auditor

GBW Ch. 2 8th ed15

SERVICES PROHIBITED BY SARBANES-OXLEY

For public companies:Bookkeeping, other accounting servicesInformation systems design, implementationValuation or appraisal servicesActuarial servicesInternal audit outsourcing servicesManagement functions, human resourcesBroker, dealer, investment advisorLegal, expert servicesOther services to be determined

GBW Ch. 2 8th ed16

SEC, INDEPENDENCE, & PUBLIC COMPANIES 2003

Further independence regulations Rotate engagement partner 5-7 years Restrict firm’s independence for 1

year when client hires member of audit team

Violates independence if auditor’s compensation based on selling service other than attest

Require auditor report certain matters to client’s audit committee Critical accounting policies

GBW Ch. 2 8th ed17

DUE CARE EXPLAINED

Care when providing professional servicesAdequate training for professional services

GBW Ch. 2 8th ed18

DUE CARE IN LAW

Every man who offers his service to another & is employed assumes the duty to exercise such skill as he possesses with reasonable care & diligence. …if one offers his service, he is understood as holding himself out to the public as possessing the degree of skill commonly possessed by others in the same employment & if his pretensions are unfounded, he commits a species of fraud upon every man who employs him . . .

Cooley on Torts

GBW Ch. 2 8th ed19

DUE CARE & WORLDCOM 2002

2nd largest long-distance carrier restated financial statements for 5 quarters Network access fees capitalized instead of

expensed Overstated net income by $11 billion Overstated balance sheet by $75 billion Not GAAP

Auditor knew but did not challenge

GBW Ch. 2 8th ed20

DUE CARE &PRUDENT PRACTITIONER

Foresee unreasonable risk to othersAttend to extra risksConsider unusual circumstances or relationshipsIdentify unfamiliar situation & take precautionsResolve doubtKeep currentReview work of assistants

GBW Ch. 2 8th ed21

DUE CARE OPERATIONALIZED

Auditor obtains knowledge of business to understand events, transactions, practices with significant effect on financial statementsPlan audit to limit audit risk to low levelAssess possible errors on balance sheet

GBW Ch. 2 8th ed22

EVIDENCE EXPLAINED

Underlying accounting data Journals, ledgers,

reconciliations, accounting manuals

Corroborating information Receiving reports, invoices,

contracts, representations from 3rd parties

GBW Ch. 2 8th ed23

EVIDENCE

Basis for all decisions Evidential matter Planning & supervision Internal control

GBW Ch. 2 8th ed24

EVIDENCE: SUFFICIENCY & COMPETENCE

Sufficiency Quantity useful evidence collected at

reasonable cost

Competence Validity: varies with source Relevance: related to assertion

GBW Ch. 2 8th ed25

EVIDENCE HIERARCHY

Independent sources more reliable than management

Banks, debtors

Evidence obtained directly more persuasive than indirect evidence from management

Physical examination, observation, computation, inspection

Effective internal control systems produce more reliable evidence

GBW Ch. 2 8th ed26

PLANNING & SUPERVISION EXPLAINED

Planning Developing objectives & strategy

Supervision Directing assistants toward objectives Determining when objectives are met

GBW Ch. 2 8th ed27

INTERNAL CONTROL

Policies & procedures of management & board of directorsProvides reasonable assurance their objectives will be achievedAuditor must understand client’s internal controls To plan audit To design audit tests

GBW Ch. 2 8th ed28

REPORTING EXPLAINED

Report states conclusion Attestation report

Whether management’s assertion conforms with stated criteria

Audit report Whether financial statements conform

to GAAP

GBW Ch. 2 8th ed29

AUDIT REPORT CONCLUSION

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the company . . ., & the results of its operations and its cash flows . . ., in conformity with generally accepted accounting principles.

GBW Ch. 2 8th ed30

STRATEGY FOR RISK

Risk of omissions or misstatementsDesign engagement to control material omissions or misstatementsProvide reasonable not absolute assurance of detecting omissions or misstatements

GBW Ch. 2 8th ed31

ATTESTATION RISK

Probability that attester may unknowingly fail to modify a written conclusion about an assertion that is materially misstated

D. N. Ricchiute, Auditing, 8th ed.

GBW Ch. 2 8th ed32

AUDIT RISK

Probability that auditor may unknowingly fail to modify opinion on financial statements that are materially misstated

D. N. Ricchiute, Auditing, 8th ed.

GBW Ch. 2 8th ed33

COMPONENTS OF AUDIT RISK

Client sources of risk Inherent risk Control risk

Auditor source of risk Detection risk

GBW Ch. 2 8th ed34

COMPONENTS OF AUDIT RISK DEFINED

Inherent risk Risk that errors will occur

Control risk Risk that internal controls won’t prevent,

detect, correct errors

Detection risk Risk that audit procedures won’t find

errors

GBW Ch. 2 8th ed35

INHERENT RISK SOURCES

Risk that errors will occurBusinessIndustryManagement’s predisposition to manage earningsAggressive use of GAAPSpecific accounts Liquid assets vs. nonliquid assets

GBW Ch. 2 8th ed36

CONTROL RISK SOURCES

Risk that internal controls won’t prevent, detect, correct errorsOutdated technologyOutdated softwareLack of respect for controls by top management

GBW Ch. 2 8th ed37

DETECTION RISK SOURCES

Likelihood that errors could occur and not be detected by audit proceduresNature of audit proceduresExtent of audit proceduresTiming of audit proceduresAuditor’s judgment

GBW Ch. 2 8th ed38

AUDIT RISK MODEL:SAS No. 47

AR = IR x CR x DR

DR = AR IR x CR

GBW Ch. 2 8th ed39

AUDITOR’S BUSINESS RISKThe probability that a practitioner

might incur damages despite issuing an appropriate report Ex.: litigation

Factors affecting auditor’s business risk Aggressive financial reporting Management integrity or reputation Conflicts of interest & regulatory

problems Industry characteristics

GBW Ch. 2 8th ed40

AUDITOR’S RESPONSE TO BUSINESS RISK

If business risk is higher, adjust audit risk assessment Set audit risk lower Decrease acceptable level of detection risk Increase evidence Drop client

If assurance levels all same, do not adjust audit risk

GBW Ch. 2 8th ed41

AUDIT FAILURE DEFINED

Failing to perform procedures that would reduce audit risk to a relatively low level Ex.: SunbeamSunbeam’s auditor a) identified

reserves not in compliance with GAAP; b) proposed adjustments which management rejected; c) accepted reserves as stated after incorrectly applying materiality analysis

GBW Ch. 2 8th ed42

MATERIALITY

The magnitude or an omission or misstatement of accounting information that, in the judgment of a reasonable person relying on the information, would have been changed or influenced by the omission or misstatement.1

Statement of Financial Accounting Standards No. 2, “Qualitative

Characteristics of Accounting Information,” Stamford: FASB, 1980, par

132.

GBW Ch. 2 8th ed43

MATERIALITY IN PRACTICE

Preliminary estimate of materiality for planning guides audit effort, evidence collection SAS No. 22, “Planning & Supervision”

GBW Ch. 2 8th ed44

AUDIT RISK, MATERIALITY, AUDIT EFFORT

Inverse relationship between audit risk and materiality Low audit risk suggests it would take

larger amounts to be material

Inverse relationship between materiality and audit effort (hours worked) Higher materiality threshold suggests

less audit effort

GBW Ch. 2 8th ed45

QUANTITATIVE MATERIALITY CRITERIA

Effect on Net income Total assets Total revenue

GBW Ch. 2 8th ed46

SAS 99 ON MATERIALITY

Auditors should Not rely solely on quantitative

materiality criteria Judge materiality of misstatements

both individually & in aggregate Recognize that intentional but

immaterial misstatements are inappropriate & may be unlawful

GBW Ch. 2 8th ed47

QUALITATIVE MATERIALITY CONSIDERATIONS

Misstatement may not be immaterial if: Affects debt compliance requirements Masks change in earnings Conceals unlawful transaction Prompts undue expectations Hides failure to meet analysts’ expectations Associated with an estimate Affects management’s compensation

GBW Ch. 2 8th ed48

ALLOCATING PRELIMINARY MATERIALITY ESTIMATES

On the basis of Relative magnitude of financial

statement accounts Relative variability of financial

statement accounts Professional judgment