Lecture #3: Assurance Frameworks, Analytical Procedures

Last class

• What is right or wrong

• What is required to become an audit professional

• Midterm question

o We do we need a code of conducts

o Ranking of alternatives for an ethical dilemma

What is an assurance engagement?

• An assurance engagement is…

o an engagement where, pursuant to an accountability relationship between

two or more parties, a practitioner is engaged to issue a written communication expressing a conclusion concerning a subject matter for which the accountable party is responsible.

• Not always F/S!

Accountability Relationship

• An accountability relationship …is a prerequisite for an assurance engagement.

• exists when:

o (the accountable party) is answerable to and/or is responsible to another party

(the user) for a subject matter

Someone is accountable to someone else about something

You are responsible for someone about something

What can you provide assurance on?

• Environmental impact

o Pollution – don’t go over a threshold

• Grants and contribution (charity)

o Use of funds – permissible use of the fund

• Composition of products

o Content – acceptable level of health content

• Efficiently of operations

o Assessment – seeing how efficient they are at their work

Assurance Concepts

• How does the practitioner form a conclusion?

o Bench marks

• Conditions that….

o Complex

o Remoteness

o Consequences

USERS

• There are three underlying conditions that affect demand by users for information.

Identify and discuss these concerns.

Levels of Assurance

• Two distinct levels of assurance - a high level and a moderate level.

o No way of having absolute assurance

• What are some evidence for high assurance

o Independent conformation

o Inspection, observation

o Inquiry and analysis

What is a Review?

• In a review engagement, practitioner = moderate level of assurance

o Design test to give out a moderate assurance

Moderate assurance – Reviews

• When do you use a review?

•

Compilations

• Level of Assurance?

o No assurance

o Directory note (not sure)

True or False (midterm questions)

• “Not all engagements performed by practitioners are assurance engagements…”

o True

o Accountability relationship needs to exist in all assurance engagement

GENERAL STANDARDS

• Before undertaking an assurance engagement, need to have reason to believe that that

engagement can be completed in accordance with the relevant standards

o Missing information

o Unclear opening balance

• Why is that?

o You need to be able to reach a conclusion with high assurance

Gen stds cont…

• SM is or will be within the collective professional expertise of the practitioner and

other persons performing the assurance engagement.

Use of Specialists

Limited procedure

• Checks only certain accounts

Engagement Letter

• Reasons for it

o What auditors are going to do and managements responsibilities

o Helps flush out areas of mis-understandment and areas of confusion

o Who as access to the records

o Responsibility for internal controls

o Auditor’s potential liabilities

General Standard

• Two responsibilities under the Gen Std

o Due care

Imposing responsibility on everybody (including specialist)

o Objective state of mind

Remain unbiased in carrying out resp in forming conclusion

Independence

• The assurance engagement should be performed with due care and with an objective

state of mind.

Performance/Examination Stds

• The practitioner should identify or develop criteria that are suitable for evaluating the

subject matter.

• What are criteria?

Characteristics of Criteria

• Suitable criteria for conclusions

o Relevance

Contribute to the finds,

o Reliability

Achieved consistent result

o Neutrality

Free from bias that would case misuse of information

o Understandability

What the subject matter signify

o Completeness

All the information

Criteria

• Significance?

o You can’t give assurance without criteria as guidelines

• Sources?

o Laws and regulations

• Absence?

o Consider the affect that it can have on your report

Developing Criteria… 10 minutes

• Lib-Inc. manufactures injection moulding equipment

• 6 manufacturing centres, 1 distribution centre in Southern Ontario

• Head office is Ottawa, responsible for plant layouts

• Injection moulding machines, operators are key to business

• Each shop employs 25-35 people

• Key ingredient is plastic

• Your firm has been engaged to perform an operational audit of the equipment layout in

plants for a company.

• Required: What are some specific criteria, stated in the form of questions that might be

used to evaluate plant layouts? How would you develop your criteria?

• Criteria

o Capacity: Number of employees per machine

o Is layout of the material facilitate production

Is it close to the machines

o Is the equipment place so that waste is disposed easier

o Is equipment operating at X% of level of X amount of year

o Is safety of employee endangered by the layout of equipment

o Traveling time from moving goods to one machine to another

o What has Ottawa has done in terms of their contribution to the layout

PERFORMANCE STANDARDS

• Responsibilities: The work should be adequately planned and

• The practitioner should ensure any other persons performing the assurance engagement

are properly supervised.

Performance Standards (midterm question)

• Need a general strategy and a detailed approach to the execution of the engagement.

• Factors including:

• objective of the engagement;

• criteria to be used in the engagement;

• planned level of assurance;

• possible sources of evidence;

• preliminary judgments about materiality and

• expertise required, including the nature and extent of specialist involvement.

• Planning and supervision continue as the engagement progresses.

• Nature, extent, timing vary ( exp and nature of engmt)

• Plans may need to be changed as the engagement progresses.

• I.e.: pharm in NB

Sufficient, Appropriate audit evidence

• Assurance is obtained through obtaining sufficient, appropriate audit evidence

• The concepts of sufficiency and appropriateness of evidence are interrelated.

• Sufficiency –measure quantity

• Appropriateness – measure of quality

REPORTING STANDARDS

• Management provides assertions to auditors regarding the economic actions and events

of the company. Explain what is meant by the term “assertions” and what they are.

• The assertion evaluates, using suitable criteria, the subject matter for which the

accountable party is responsible

Assertions (F/S)

• Management asserts financial statements are correct with regard to

o existence or occurrence of assets, liabilities or transactions,

o completeness of information in the financial statements,

o rights and obligations at a point in time,

o appropriate valuation or allocation,

o presentation, and disclosure.

o “Five assertions revisited”

Reporting Assurance

• Traditional Format

• Suggestions

Reservations…

• A reservation should be expressed when the practitioner:

• is unable to obtain sufficient appropriate evidence to evaluate one or more aspects of

the subject matter's conformity with the criteria;

• Qualified conclusion (opinion):

o Denial

o Adverse

Alternative Theories of the Role of the Auditor

• Information Hypothesis

o Reduce information risk

• Monitoring Hypothesis

o Absent of audit, management would just steal everything (be dishonest)

• Insurance Hypothesis

o If something goes wrong, they can sue us

Discussion - Analytical Procedures

• What are Analytical Procedures?

• Why do auditors need to use them?

• What are the advantages and disadvantages of utilizing analytical procedures?

Analytical procedures

• What are they?

o Understanding plausible relationship between expected and actual

o Are our accounts balances reasonable?

Analytical Procedures – Examples

• Do analytical procedures provide Relevant/Reliable Evidence?

o Not just by itself

It would just be an review

o Less reliable than that other one

o Used in collaboration

o It is low cost

Question

• During which phases of the audit are analytical procedures conducted?

o Throughout the entire audit

Planning phase, to evaluate materiality

Analytical Procedures Done throughout the Audit

• Planning – understand clients industry and business, going concerns, possible

misstatements, reduce detailed tests

• Testing – possible misstatements, reduce possible tests

• Completion – assess going concern, indicate possible misstamtements

Four General Types of Analytical Procedures

• Compare client data with industry data

• Compare client data with client data

• Compare client date with client expect result

• Compare client data with auditor expect result

Analytical Procedures

• You are assigned to the audit of Lib-Inc – your current role is to “perform analytical

procedures relating to profitability and liquidity”. You are meeting with the Comptroller of Lib-Inc.

• Given the following information how would you write up your Note to File?

Compare client data with client determined expected results

• Most companies prepare budgets

o When did you prepare the budget

o Has the budget been revised

Compare client data with auditor determined expected results

• How does an auditor do this?

Crazy Eddie

• Wow.

• Thoughts?

• Themes?

• Risk factors

o All family

High chance of collusion

o Pressure to preform and profitability when you go public

o Eddie’s personality

Aggressive management

Untrustworthy of outsiders

o Auditor (firm)change (frequent)

o Outdated inventory system

o Aggressive culture of the company

o Completive industry

• Red flags?

• Fraud mechanics?

• Business Model

• Audit Criticisms?

o Independence

o Made it too easy for them to move the inventory

o Undereducated and unsupervised

Needed to put more senior auditors

o They didn’t know what questions to ask or who to ask

• Penalty?

o Sam – 2 years in jail

o Eddie – 7 years

Crazy Eddie Q1

• Compute key ratios and other financial measures for Crazy Eddie during the period

1984-1987

• Identify and briefly explain the red flags in Crazy Eddie’s financial statements that

suggested the firm posed a higher than normal level of audit risk

Crazy Eddie – Q2

• Identify specific audit procedures that might have led to the detection of the following

irregularities perpetrated by Crazy Eddie personnel:

o A) the falsification of inventory count sheets

o B) the bogus debit memos for accounts payable

Conformation of A/P

Why is there a debit memo

Are there any subsequent payment

o C) the recording of transhipping transactions as retail sales

Review the documentation on who the sale was for

Test the control of the organization

• Test the transshipping sales to see if tis not miss recorded

o D) inclusion of consigned merchandise in year-end inventory

Review the inventory control sheet

Crazy Eddie – Q3

• The retail consumer electronics industry was undergoing rapid and dramatic changes

during the 1980’s. Discuss how changes in an audit client’s industry should affect audit planning decisions. Relate this discussion to Crazy Eddie.

o Auditor needs to be updated and knowledgeable of the industry and how its

changing

Crazy Eddie - Q4

• Explain what is implied by the term lowballing in an audit context. How can this practice

potentially affect the quality of independent audit services?

o Putting a low offer in order to get contracts

Crazy Eddie – Q5

• Assume that you were a member of the Crazy Eddie audit team in 1986. You were

assigned to test the client’s year-end inventory cutoff procedures. You selected 30 invoices entered in the accounting records near year-end: 15 in the few days prior ro the client’s fiscal year-end and 15 in the first few days of the New Year. Assume that client personnel were unable to locate 10 of these invoices. How should you and your superiors have responded to this situation? Explain.

o Extend your test

Show me another 100 if u can’t find the 10

o Why is it that we can’t find the 10?

Crazy Eddie – Q6

• Should companies be allowed to hire individuals who formerly served as their

independent auditors? Discuss the pros and cons of this practice.

ZZZZ Best

• Background

• Risk factors

o Very competitive

o Too good to be true

o Aggressive management

o IPO

o Internal control

• Financial

• Fraud

• Audit Criticisms

• Penalty

Zzzz Best

• EW never issues an audit opinion on F/S of Zzzz Best, but did issue a review report on

the company’s quarterly F/S for the three months ended July 31, 1986. How does a review differ from an audit, particularly in terms of the level of assurance implied by the auditor’s report?

Zzzz Best

• In testimony before Congress, George Greenspan reported that one method he used to

audit the insurance restoration contracts was to verify that his client actually received a payment on those jobs. How can such apparently reliable evidence lead an auditor to improper conclusions?

o Just because your getting money does not mean it was received from your job

This is just moving of money

• Did the confidentiality agreement that Minkow required EW to sign improperly limit the

scope of the Zzzz Best audit? Why or why not? Discuss general circumstances under which confidentiality concerns on the part of a client may properly affect audit planning decisions. At which point do client imposed audit scope limitations affect the type of audit opinion issued?

o Yes they did

• What procedures do professional standards require auditors to perform when reviewing

a client’s pre-audit but post year end earnings press release?

o Auditors does not have to do anything