AUDITING

SECTION 1

Introduction

Definition of Auditing

• Auditing is a form of attestation

• Attestation refers to a specialist communicating

• Auditing is also a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic events to ascertain

AUDITOR

Obtains and evaluates evidence

To ascertain correspondence between

Assertions about economic data

And established criteria

Communicate results

USERS

• Assertions are the representations of management as to the fairness of

• What are the established criteria?

• To evaluate fairness the auditor must gather evidence. What is the evidence?

• Evidence must be gathered objectively

• Auditing is a systematic process

• Evidence must be sufficient and competent

• Auditor does not guarantee accuracy

Planning System

Testing

Substantive

Testing

AuditReport

Test Internal

Controls

Test T/A’s

and Balances

• To be competent, evidence must be both valid and relevant

• The process of communicating the results is referred to as attestation

• What is the mechanism?

Generally Accepted Auditing Standards

• GAAS must be observed by the auditorThe General Standard

i. The examination should be performed and the report prepared by a person or persons having

The Examination Standards

i. The work should be adequately planned and properly executed using sufficient knowledge of the entity’s business as a basis. If assistants are employed, they should be properly supervised.

ii. A sufficient understanding of internal should be obtained to plan the audit. When control risk is assessed below maximum,

iii. Sufficient appropriate audit evidence should be obtained, by such means as

The Reporting Standards

i. The report should identify the financial statements and distinguish between the responsibilities of management and the responsibilities of the auditor.

ii. The report should describe the scope of the auditor’s examination.

iii. The report should contain either an expression of opinion on the financial statements or an assertion that an opinion cannot be expressed.

iii. Where an opinion is expressed, it should indicate whether the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows in accordance with an appropriate disclosed basis of accounting,

The report should provide adequate explanation with respect to any reservation contained in such opinion.

External vs. Internal Auditing

• External – conducted by auditors independent of management and representing third party users.

• Internal – serves management as opposed to third party users.

• Internal auditors are also engaged in evaluating the efficiency of operations

• Level to which the internal auditor reports is important

• The rule of thumb as to whom the internal auditor reports

Governmental Auditing

• Federal and Provincial Auditor Generals

• Canada Customs and Revenue Agency

• Government accounting and comprehensive auditing

Governmental Auditing and The Three E’s

• Economy

• Efficiency– An efficient operation produces the maximum output

for a given set of resources or inputs

• Effectiveness

Organizations That Affect Auditing

• A variety of professional groups

• In Canada

• In the U.S.

International Federation of Accountants

• About IFAC

• What We Do

• Structure and Governance

• Mission and Strategy

Establishment Of Standards

• In Canada the CICA has:

• In the U.S. the AICPA

• How about the FASB?

Organization Of The Profession

• Public accounting firms

• Four categories– Big 4– National– Regional Local

How Auditing Differs From Accounting

• Auditing and accounting are related but distinct from each other

• Accounting involves

• Auditing utilizes

Preparation offinancial statements

Evaluation offinancial statements

Auditing

Accounting

GAAP

Why Is Independent Auditing Necessary?

• Society has a perceived need for audits of publicly held companies

• Management wants to present the results of its stewardship in the most favourable light

• Stockholders are interested in the true financial position, results of operations, and cash flows

Requirements for an Effective Audit

1. The auditor must have a thorough understanding of the company and the industry

2. The auditor must have a comprehensive knowledge of GAAP

3. A solid grasp of the concepts of internal control structure and a careful review and evaluation of the underlying structure are necessary

4. The auditor must also be knowledgeable in the are of evidence gathering and evaluation

• The most effective means for assuring sound audit judgment are the training and experience of the auditor

• The competence of evidence

Communicating Audit Findings

• The audit report

– Introductory paragraph

– Management (or preparer) responsibility paragraph

– Auditor responsibility paragraph

– Opinion paragraph

Independent Auditors’ Report

To the Shareholders of ABC Inc

We have audited the accompanying financial statements of ABC Inc., which comprise the balance sheet as at December 31, 2010 and the statements of income, retained earnings and cash flow for the year then ended, and a summary of significant accounting policies and other explanatory information.

Management’s responsibility for the financial statementsManagement is responsible for the preparation and fair presentation of these financial statements in accordance with Canadian generally accepted accounting principles and for such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error; selecting and applying appropriate accounting policies; and making accounting estimates that are reasonable in the circumstances.

Auditors’ responsibilityOur responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement.An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditors’ judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditors consider internal control relevant to the entity’s preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the financial statements.We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.

OpinionIn our opinion, the financial statements present fairly, in all material respects, the financial position of ABC Inc. as at December 31, 2010 and its financial performance and cash flows for the year then ended in accordance with Canadian generally accepted accounting principles.

PricewaterhouseCoopers LLP (signed)Chartered AccountantsOne Lombard Place, Suite 2300, Winnipeg, ManitobaFebruary 22, 2011

• The standard report contains no exceptions

• Scope limitation

• GAAP departure

The Audit Process

Audit Planning

Interim Audit

Final Audit

Audit Report

Begin

PreliminariesEngagement LetterAudit Risk AnalysisAudit Fieldwork Planning

Testing Internal Controls

Inventory ObservationTesting T/A’s and Balances

Preliminary Arrangements

• The audit commences with preliminary arrangements being made with the client

• Preliminary arrangements are especially important in a new engagement rather than a continuing engagement

• The auditor may discover that they do not have the necessary skills

The Engagement Letter

• Summarizes the agreement of the parties formulated during the preliminaries

• A mutual understanding regarding the nature of the engagement

• So what is it in reality?

BORITZ, KAO, KADOUS & CO., Chartered AccountantsHalifax, Nova Scotia B3M 3J5

June 14, 200X

Mr. Rick Chulick, PresidentHillsburg Hardware Ltd.2146 Willow StreetHalifax, Nova ScotiaB3H 3F9

Dear Mr. Chulick:

Thank you for reappointing us as your auditors for the year ending December 31,200X. The purpose of this letter is to confirm our mutual understanding of the terms of our engagement.It will be the responsibility of J. E. Boritz to make sure that management receives quality service. J. E. Boritz will, as considered necessary, call upon other individuals with specialized knowledge, either in this office or elsewhere in our firm.

While auditing and reporting on your annual financial statements is to be the recurring basic service we provide, we would also like to assist you on issues as they arise throughout the year. Hence, we hope that you will call J. E. Boritz whenever you feel J.E. Boritz can be of assistance.

Audit of Financial StatementsThe purpose of our annual engagement to audit financial statements is to evaluate the fairness of

presentation of the statements in conformity with Canadian generally accepted accounting principles.Our audit will be conducted in accordance with Canadian generally accepted auditing standards.

Those standards require that we plan and perform an audit to obtain reasonable assurance that the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates by management, as well as evaluating the overall financial statement presentation.

It should be noted that an audit conducted in accordance with Canadian generally accepted auditing standards is based on selective tests. Because detailed examination is not performed on all transactions, there is a risk that material fraud or error may exist but not be detected.

The objective of our audit is the expression of an opinion on financial statements. Our ability to express that opinion, and the wording of our opinion, will be dependent on the facts and circumstances at the date of our report. If our audit report requires qualification, the reasons therefore will be discussed with you prior to its issuance.

Management's Responsibility We direct your attention to the fact that the financial statements are the responsibility of management. In this

regard, management has the responsibility for designing effective internal controls, for properly recording transactions in the accounting records, for making appropriate accounting estimates, for safeguarding assets, and for the overall accuracy of the financial statements.

Other Communications Arising from the Audit In connection with the planning and the performance of our audit, we will communicate to you, to the extent

that they come to our attention, fraud and significant deficiencies in the design or operation of the internal control structure that could adversely affect the Company's ability to record, process, summarize, and report financial data.

We may also have other comments for management on matters we have observed and possible ways to improve the efficiency of operations or other recommendations concerning the internal control structure. With respect to these other communications, it is our practice to discuss all comments, if appropriate, with the level of management responsible for the matters prior to their communication to you.

Coordination of the AuditOur audit is scheduled for performance and completion this year as follows:

Audit Performance Schedule Begin Complete

Planning August 1, 200X September 1, 200X

Interim September 1, 200X September 24, 200X

Year End February 1, 200Y February 16, 200Y

Report on Audit of Financial Statements March 10, 200Y

Assistance to be supplied by your personnel, including preparation of schedules and analyses of accounts, is described in a separate attachment. Timely completion of this work will facilitate the conclusion of our audit. We are, of course, available to assist you in other areas that might arise.

Fees Our fees are based on the amount of time required at various levels of responsibility, plus out-of-

pocket expenses (travel, printing, telephone, etc.), payable upon presentation of our invoices. We will notify you immediately of any circumstances we encounter which could significantly affect our initial estimate of total fees.

We appreciate the opportunity to be of service to you and believe this letter accurately summarizes the significant items of our engagement. If you agree with the terms of our engagement as described, please sign the copy of this letter in the space provided and return it to us.

Yours very truly,

J.E.BoritzBoritz, Kao, Kadous & Co.

Accepted By:Title: PresidentDate: June 21, 200X

Audit Risk Analysis

• The probability of rendering an unqualified opinion on F/S that are materially misstated

• Auditor needs a good understanding of internal control

• Management misrepresentation fraud

Audit Fieldwork Planning

• Preliminary audit programs need to be formulated

• Staffing the audit

• Pre-audit conference

• Two phases of the audit

Interim Audit

• Testing of client’s internal control

Final Audit

• Audit of transactions and balances

Continuous Auditing

• Sophisticated EDP applications

• Embedded audit modules

Problem 1:

Although the CICA Handbook standards provide general guidance, the application of theses standards is dependent upon particular circumstance. In practice, a professional accountant may encounter situations where CICA Handbook standards do not exist or may not apply. Since there is no substitute for the exercise of professional judgment in the determination of what constitutes fair presentation and good practice, it has been suggested that too much effort is being directed towards the development of standards. Discuss the issues raised in the above statements. (CICA Adapted)

Problem 2 (Chp. 1-13):

Daniel Charon is the loan officer of the Georgian Bay Bank. Georgian Bay Bank has a loan of $540,000 outstanding from Regional Delivery Service Ltd., a company specializing in the delivery of products of all types on behalf of smaller companies. Georgian Bay’s collateral on the loan consists of 20 small delivery trucks with an average original cost of $45,000.

Charon is concerned about the collectibility of the outstanding loan and whether the trucks still exist. He therefore engages Susan Virms , public accountant, to count the trucks, using registration information held by Charon. She is engaged because she spends most of her time auditing used automobile and truck dealerships and has extensive specialized knowledge about used trucks. Charon requests that Virms issue a report stating

1. Which of the 20 trucks is parked in Regional’s parking lot on the night of June 30.

2. The condition of each truck, using the categories of poor, good, and excellent.

3. The fair market value of each truck using the current “blue book” for trucks, which states the approximate wholesale prices of all used truck models based on the poor, good, and excellent categories.

Required:

a. Identify which aspects of this narrative fit each of the following parts of the definition of auditing:

(1) information.

(2) established criteria.

(3) accumulates and evaluates evidence.

(4) competent, independent person.

(5) report of results.

b. Identify the greatest difficulties Virms is likely to have doing this assurance engagement.

Problem 3:

Raymonde, the owner of a small company, asked Holmes, public accountant, to conduct an audit of the company records. Raymonde told Holmes that an audit is to be completed in time to submit audited financial statements to a bank as part of a loan application. Homes immediately accepted the engagement and agreed to provide an auditor’s report within three weeks. Raymonde agreed to pay Holmes a fixed fee plus a bonus if the loan was granted.

Holmes hired two accounting students to conduct the audit and spent several hours telling them what to do. Holmes told the students not to spend time reviewing the controls but instead to concentrate on proving the mathematical accuracy of the ledger accounts , and summarizing the data in the accounting records that support Raymonde’s financial statements. The students followed Holmes instructions and after two weeks gave Holmes the financial statements, which did not include footnotes. Holmes reviewed the statements and prepared an unqualified audit report. The report did not refer to generally accepted accounting principles.

Required:

Briefly each of the generally accepted auditing standards and indicate how the actions of Holmes resulted in a failure to comply with each standard.

Organize your answer as follows:

Brief description of GAAS Holmes Actions Resulting in Failure to Comply with GAAS

Problem 4:

For the following independent situations, assume you are the audit partner on the engagement.

1. During your examination of Debold Batteries Ltd., you conclude there is a possibility that inventory is materially overstated. The client refuses to allow you to expand the scope of your examination sufficiently to verify whether the balance is actually misstated.

2. You are auditing Woodcolt Linen Services, Inc., for the first time. Woodcolt has been in business for several years but has never had an audit before. After the audit is completed, you conclude that the current year balance sheet is stated correctly in accordance with GAAP. The client did not authorize you to do test work for any of the previous years.

3. You were engaged to examine Cutter Steel Corp.’s financial statements after the close of the corporation’s fiscal year. Because you were not engaged until after the balance sheet date, you were not able to physically observe inventory, which is very material. On the completion of your audit, you are satisfied that Cutter’s financial statements present fairly, including inventory about which you were able to satisfy yourself by the use of alternative procedures.

4. Four weeks after the year-end date, a major customer of Prince Construction Ltd. declared bankruptcy. Because the customer had confirmed the balance due to Prince at the balance sheet date, management refuses to charge off the account or otherwise disclose the information. The receivable represents approximately 10 percent of the accounts receivable and 20 percent of net income before taxes.

5. You complete the audit of Johnson Department Store ltd., and , in your opinion, the financial statements are fairly presented. On the last day of the examination, you discover that one of your supervisors assigned to the audit had a material investment in Johnson.

6. Auto Delivery Company Ltd., has a fleet of several delivery trucks. In the past, Auto Delivery has followed the policy of purchasing all equipment, In the current year, they decided to lease the trucks. This change in policy is fully disclosed in the footnotes.

Required: For each situation, state the type of auditors report that should be issued. If your decision depends on additional information, state the alternative reports you are considering and the additional information you need to make the decision.

Problem 5:

For the following independent situations, assume you are the audit partner on the engagement.

1. Kieko Corporation has prepared financial statements but has decided to exclude the cash flow statement. Management explains to you that the users of their financial statements find that particular statement confusing and prefer not to have it included.

2. Jet Stream Airlines, Inc. has been audited by your firm for ten years. In the past three years their financial condition has steadily declined. In the current year, for the first time, the current ratio is below 2:1, which is the minimal requirement specified in Jet Stream's major loan agreement. You now have reservations about the ability of Jet Stream to continue in operation for the next year.

3. Approximately 20 percent of the audit for Furtney Farms, Inc. was performed by a different public accounting firm, selected by you. You have reviewed its working papers and believe it did an excellent job on its portion of the audit. Nevertheless, you are unwilling to take complete responsibility for its work.

4. The controller of Fair City Hotels Company Ltd. Will not allow you to confirm the receivable balance for two of its major customers. The amount of the receivable is material in relation to Fair City’s financial statements. You are unable to satisfy yourself as to the receivable balance by alternative procedures.

5. In the last three months of the current year, Oil Refining Corp. decide to change direction and go significantly into the oil-drilling business. Management recognizes that this business is exceptionally risky and could jeopardize the success of its existing refining business, but there are significant potential rewards. During the short period of operation in drilling, the company has had three dry wells and no successes. The facts are adequately disclosed in the footnotes.

Required:

a. For each situation, identify which of the conditions requiring modification of or a deviation from an unqualified standard report is applicable.

b. State the level of materiality as immaterial, material, or material and pervasive. If you cannot decide the level of materiality, state the additional information needed to make the decision.

c. Given your answers in parts (a) and (b), identify the appropriate auditor’s report from the following: (1)Unqualified, (2)Qualified opinion only – except for, (3)Scope and opinion qualified, (4)Denial, or (5)Adverse.