Chapter 5: Professional Auditing Standards and Opinion Formulation Process

Chapter 5: Professional Auditing

Standards and Opinion Formulation
Process
Professional Auditing Standards
- Auditors in the U.S. follow auditing guidance by
o AICPA standards for auditors of private U.S. companies
o PCAOB standards for auditors of publicly traded firms on U.S. stock exchange
o IAASB standards for auditors of publicly traded firms on non-U.S. stock exchange
- Auditing standards apply to the auditor’s task of developing and communicating an
opinion on financial statements and, as part of an integrated audit, on client’s internal
control over financial reporting

Auditing Standards Issued by AICPA, IAASB, and PCAOB

- AICPA and IAASB standards jointly coordinate the format and organization of their
standards
o Introduction
o Objective
o Definitions
o Requirements (how auditor will reach objectives, “auditor should/must”)
o Application and other explanatory material
- PCAOB standards are organized by topical areas that follow the flow of the audit opinion
formulation process
o Different numbering convention from AICPA and IAASB to help avoid confusion
between its standards and those of other standards setters

Comparison of auditing standards

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Chapter 5: Professional Auditing Standards and Opinion Formulation Process

Principles Underlying the Auditing Standards

PCAOB Guidance – Five Topical Categories of Standards
1. General auditing standards: Standards on broad auditing principles, concepts, activities
and communications; auditors have to
 Exercise professional care including professional skepticism
 Obtain reasonable assurance about whether financial statements are free of
material misstatement or whether material weakness exists
 Maintain an independence in mental attitude
 Have the appropriate professional qualifications
2. Audit procedures: Standards for planning and performing audit procedures and for
obtaining audit evidence
3. Auditor reporting: Standards for auditors’ reports
4. Matters relating to filings under federal securities law: Standards on auditor
responsibilities relating to SEC filings for securities offerings and reviews of interim
financial information
5. Other matters associated with audits: Other work performed in conjunction with audit

AICPA Guidance: Principles Governing an Audit

Purpose of an audit and premise upon which audit is conducted
1. The purpose of an audit is to enhance the degree of confidence that users can place in
the financial statement  Achieved when an auditor expresses an opinion on the
financial statements
2. An audit is based on the premise that management has responsibility to prepare the
financial statements, maintain IC over financial reporting and provide the auditor with
relevant information and access to personnel
Responsibilities
3. Auditors are responsible for having the appropriate competence and capabilities to
perform audit, should comply with ethical requirements, and maintain professional
skepticism throughout the audit
Performance
4. The auditor needs to obtain reasonable assurance as to whether the financial
statements are free from material misstatement
5. Obtaining reasonable assurance requires the auditor to plan and supervise the work,
determine materiality levels, identify risks of material misstatement, and design and
implement appropriate audit responses to the assessed risks
6. An audit has inherent limitations such that the auditor isn’t able to obtain absolute
assurance
Reporting
7. The auditor expresses an opinion as to whether financial statements are free from
material misstatements or states that an opinion cannot be expressed

IAASB Guidance: Objectives of an Audit

- In conducting an audit, overall objectives of the auditor are:
o To obtain reasonable assurance, enabling auditor to express opinion in accordance
with applicable financial reporting framework
o To report on financial statements, and communicate as required by the ISAs in
accordance with auditor’s findings
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Chapter 5: Professional Auditing Standards and Opinion Formulation Process

Overview of Audit Opinion Formulation Process

- An important starting point is the client’s responsibilities related to internal control and
the financial statements
- If controls over input, process, and output activities are effective, there is a higher
likelihood that financial statements are free form material misstatement

Overview: Client’s preparation of financial statements and management report on internal

control

Activities within each phase of the process

 The steps and activities are the same for integrated and financial statement only audit

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Chapter 5: Professional Auditing Standards and Opinion Formulation Process

Audit Opinion Formulation Process: Accounting Cycles

- Accounting cycle (process): The grouping of similar transactions linked by procedures
and controls that affect related accounts
o Provides a convenient way to break the audit up into manageable sections of related
accounts
- Individual auditors/teams are typically assigned to audit a particular cycle
o Focus on the flow of transactions within that cycle, including how transactions are
initiated, authorized, recorded, and reported
o Identification of points in that cycle where material misstatement could occur and
controls that have been designed/implemented to mitigate those risks

Audit Opinion Formulation Process: Financial Statement Assertions

- Within each cycle, the audit is designed around management’s assertions inherent in
the financial statements, such as
o Existence (physically present)
o Completeness (fully recorded)
o Rights and obligations (rights or title)
o Valuation (properly at cost with applicable allowances)
o Presentation and disclosure (appropriate classification and description)
- Relevant assertions: Those assertions that have a meaningful bearing on whether a
financial statement account is fairly stated
o Certain assertions are more relevant than others for a particular cycle (e.g. valuation
is important for inventory, but not particularly relevant for a cash account unless
currency translation is involved)

Existence or Occurrence Assertions

- Existence: Whether all assets and liabilities recorded in financial statements exist
- Occurrence: Whether all transactions recorded in financial statements have occurred
- Most relevant for accounts where auditor is concerned that management has an
incentive to overstate the ending balance  Revenue and assets (e.g. inventory, fixed
assets)

Completeness Assertion
- Completeness: Whether all transactions and accounts that should be included in
financial statements are actually included
- Most relevant for accounts for which auditor is concerned that management has
incentive to understate the ending balance  Expenses and liabilities (e.g. A/P)

Rights and Obligations Assertion

- Rights and obligations: Whether recorded assets are the rights of the organization
- Most relevant for accounts where auditor is concerned that management may have
incentive to improperly claim that they have a right to a revenue or asset (e.g. financial
performance-based executive compensation)  Assets and liabilities
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Valuation or Allocation Assertion

- Valuation or allocation: Whether accounts have been included in the financial
statements at appropriate amounts
- Most relevant for accounts where auditor is concerned that management may have
incentive to improperly value revenues, expenses, assets and liabilities  Everything!

Presentation and Disclosure Assertion

- Presentation and disclosure: Whether components of financial statements are properly
classified, described and disclosed
- Relevant as management might inaccurately disclose information about obligations (e.g.
they say that a long-term liability will not mature within a year, but the auditor is
concerned that it will)
- The auditor will test the disclosure assertion by examining the footnotes to financial
statements for the long-term liability balance and the relevance and appropriateness of
management’s disclosures

Audit Opinion Formulation Process: Audit Evidence and Audit

Procedures
- Audit evidence: Information obtained by the auditor to support the audit opinion
- Three categories of audit procedures
1) Risk assessment procedures to obtain information for identifying and assessing the
risks of material misstatement  Used for planning the audit
2) Tests of controls to evaluate the operating effectiveness of ICs in preventing, or
detecting and correcting, material misstatements
3) Substantive procedures to detect material misstatements in account balances
- Audit procedures need to be designed and performed to obtain sufficient appropriate
audit evidence that supports the auditor’s opinion
- Audit programs summarize various procedures performed by auditor in a document

Audit Opinion Formulation Process: Audit Documentation

- Audit documentation (working papers, workpapers) is prepared by the auditor to
provide evidence that the audit was planned and performed in accordance with auditing
standards  “Not documented, not done!”
o Should clearly show evidence of supervisory review, particularly in those areas with
the greatest potential for improprieties (e.g. inventory, revenue recognition)
o Should indicate what tests were performed and by whom, the audit evidence
examined, any significant judgements made, and the conclusions reached
- Purposes of audit documentation:
o Assisting the engagement team (ET) in planning and performing audit
o Assisting members of the ET responsible for supervising and reviewing audit work
o Retaining a record of matters of continuing significance to future audits
o Enabling internal/external inspections of completed audits
o Assisting auditors in understanding the work performed in prior years as an aid in
planning and performing current engagement

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Five Phases of Audit Opinion Formulation Process

Phase 1 – Making Client Acceptance and Continuance Decisions
- Client portfolio is ever-changing (voluntarily or involuntarily)
- Procedures in assessing the client include
o Inquiry of client and audit firm personnel on potential independence issues
o Background checks on management to assess integrity
o Review of questionable accounting policies
o Review regulatory filings and inquire about IC deficiencies
o Analyze client and industry financial statements to assess business failure probability
o Assess background and experience of potential client’s accounting personnel

Phase 2 – Performing Risk Assessment

- More time consuming for new clients
- Identifying the risks of material misstatement is essential to planning an audit
o A starting point for risk assessment is the identification of significant accounts,
disclosures, and relevant assertions
o Auditor establishes a materiality level for financial statements overall and for specific
accounts and disclosures

Examples of sources of risk of material misstatement

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Chapter 5: Professional Auditing Standards and Opinion Formulation Process

- Inherent risk: Susceptibility of an assertion about a class of transaction, account balance,

or disclosure to a misstatement that could be material before consideration of any
related controls
- Control risk: Risk that a misstatement will not be prevented, or detected and corrected,
on a timely basis by the organization’s internal control
- Risk assessment procedures include
o Inquiries of management and others in the entity who may have information on risks
o Planning analytical procedures
o Observation and inspection of documentation
- The quality of internal control directly affects the risk of material misstatement
- The auditor assesses the internal control design
o Effectiveness: Can reasonably prevent or detect material misstatements
o Implementation: Are operated as designed by persons possessing the necessary
authority and competence

Responding to identified risks

- Once risk assessment is completed, the auditor needs to select specific audit procedures
(strategy) to respond to identified risks
o Controls reliance audit: If the auditor wants to rely on controls as part of basis for
audit opinion; includes tests of controls and substantive procedures
o Substantive audit: When it is not sufficient/effective to rely on controls; includes
substantive procedures and doesn’t include test of controls
- Overall responses to identified risks
o Assembling an audit team with expertise to address identified risks of material
misstatement
o Emphasizing the need of professional skepticism
o Providing the level of supervision appropriate for the assessed risk
o Incorporating elements of unpredictability in the selection and timing of audit
procedures to be performed

Phase 3 – Obtaining Evidence About Internal Control

- Only relevant for integrated audits and controls reliance audits
- Auditor test controls that are most important in reducing risk to determine whether they
are operating effectively to address risk of material misstatement
- The auditor should select controls that are most important to the organization’s ability
to adequately address the risk of material misstatement
o Select both entity-wide and transaction controls, where effective entity-wide
controls may reduce the number of control activities selected for testing
o The auditor should explicitly link controls and assertions

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Chapter 5: Professional Auditing Standards and Opinion Formulation Process

- Tests of controls vary according to the process tested and the type of control in place;
they can be ordered by rigorousness
o Inquiry
o Observation
o Inspecting relevant documentation
o Reperforming a control
- The results of the tests are considered before finalizing the decisions about substantive
procedures, and there are two outcomes for a financial statement audit
1) Control deficiencies are identified: Assess severity of deficiencies to conclude how
control should be changed and document the implications for substantive
procedures
2) No control deficiencies are identified: Assess whether control is still appropriate,
determine extent to which control provide evidence on accuracy of accounting
balances, determine planned substantive procedures
 Results of tests allow the auditor to determine how much assurance about the reliability
of account balances can be obtained from effective operation of controls
- In case of an integrated audit: If control deficiencies are found and they are considered
to be severe, the report on internal control should include a description of the material
weakness and include an opinion indicating that IC over financial reporting is not
effective

Types of controls and tests of controls

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Chapter 5: Professional Auditing Standards and Opinion Formulation Process

Summary of audit decisions prior to determining substantive procedures

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Chapter 5: Professional Auditing Standards and Opinion Formulation Process

Phase 4 – Obtaining Substantive Evidence About Accounts, Disclosures, and

Assertions
- The auditor performs substantive procedures for relevant assertions of each significant
account and disclosure, regardless of the assessed level of control risk
o Can include both substantive analytical procedures (optional) and tests of details of
account balance (necessary)
- In determining appropriate substantive procedures, auditor considers
o The source of potential misstatement
o The extent and type of potential misstatement

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Chapter 5: Professional Auditing Standards and Opinion Formulation Process

- Typical accounts checked include revenue, cash receipts, current provision for
uncollectible accounts, write-offs, and adjustments
- Analyses for related accounts will incorporate the following:
o Assertions affected by highly subjective estimates usually require direct tests of
account balances
o Nonstandard and large adjusting entries should be reviewed and tested using
appropriate substantive procedures
o The size of the account (materiality) influences, but does not dictate, the substantive
procedures that should be performed
o The extent and results of control testing performed by management and by the
auditor will influence the substantive procedures to be performed
o The evidence the auditor has from risk assessment procedures and tests of ICs
influences substantive procedures to be performed
o The existence of other corroborating tests of the account balance affects substantive
procedures to be performed
- Side agreements are made between the organization and its customer (including
agreements made outside of publicly known contracts) and must be taken into account
by the auditor during this phase

Phase 5 – Completing the Audit and Making Reporting Decisions

- In this phase, the auditor
o Completes various review and communication activities
o Makes a decision about what type(s) of opinion(s) to issue
- In an integrated audit, the auditor issues an opinion on IC and financial statements
 Can be done separately or together, but if the reports are issued separately, each has
to refer to the other
- The report should
o Describe material weakness but not discuss actions being taken by management to
remediate these weaknesses
o Does not discuss whether control weaknesses were first identified by management
or by the auditor
o Recognizes the integrated nature of the audit (if the case) in that auditors consider
identified material weaknesses when planning the financial statement audit

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