The goal of this paper is to compare and contrast audit procedures and reporting within a business context. This paper provides answers to the following questions:
- Discuss the different audit reports. Under what circumstance is each report used?
- Outline the auditor’s code of professional conduct and independence in relation to the audit reports.
- What specific information would be examined during an audit that would require analytical procedures?
- Include test examples of the cash and collection cycle.
This paper also includes a comparison of the Explanatory Report to the Standard Report. In comparing these two reports, specific procedures and steps will be identified, keeping in mind that theoretical application and the actual application differ from one another. Auditing is a very complex process of checks, designed to ensure information is correct as identified. In many ways, auditing is a numbers-based analysis. It is important to be able to audit the procedures of the past to recommend future improvements for success.
Several types of Auditor’s Reports exist. These include standard (unqualified), explanatory, qualified, disclaimer, and adverse. The Standard Auditor’s Report is unqualified. Unqualified means that in the auditor’s opinion, there are no special circumstances to report and the financial statements are presented fairly without material misstatements. Auditors may issue reports showing their opinions are something other than unqualified. These include explanatory, qualified, disclaimer, and adverse.
Explanatory reports have an explanatory paragraph added to the standard unqualified report. The explanatory paragraph follows the opinion paragraph. “Four situations require the addition of the explanatory paragraph: 1) Reference to the audit of internal control for public companies 2) Substantial doubt to the ability of the entity to continue as going concern 3) Lack of consistency due to accounting changes, and 4) A need for additional emphasis (Messier, Glover, & Prawitt, 2012, p. 616).”
Qualified reports are used for a departure from Generally Accepted Accounting Principles (GAAP). “The report describes the nature and impact of the departure. This could be because of faulty accounting. A qualified report means the financial statements are presented fairly except for this departure GAAP (Messier, Glover, & Prawitt, 2012, p. 619-620).” In qualified reports misstatements may exist but they are not material misstatements. If material misstatements exist, then an Adverse Report would be used instead.
Disclaimer reports are used when an auditor withholds his opinion on the financial statements. An auditor may withhold his opinion either because of insufficient appropriate evidence to form an opinion or because of lack of independence. The auditor must be independent, meaning they have no connection with the client personally or financially. If the auditor cannot maintain professional independence, then he/she cannot provide an unbiased opinion. “In the disclaimer, the auditor states the reason why he/she was unable to provide an opinion and explicitly states that no opinion is expressed (Messier, Glover, & Prawitt, 2012, p. 619-620).”
An Adverse Report is issued when the financial statements do not present fairly due to a departure from GAAP that causes a material effect on the financial statements overall. “In an adverse report the auditor explains the nature and size of the misstatement and states the opinion that the financial statements do not present fairly in accordance with GAAP (Messier, Glover, & Prawitt, 2012, p. 619-620).”
Auditor’s Code of Professional Conduct and Independence
The Principles of Professional Conduct Responsibilities are shown below. They are also listed on the AICPA website.
In carrying out their responsibilities as professionals, members should exercise sensitive professional and moral judgments in all their activities.
The public interest: Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism. Integrity: To maintain and broaden public confidence, members should perform all professional responsibilities with the highest sense of integrity.
Objectivity and independence: A member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. A member in public practice should be independent in fact and appearance when providing auditing and other attestation services.
Due care: A member should observe the profession’s technical and ethical standards, strive continually to improve competence and the quality of services, and discharge professional responsibility to the best of the member’s ability.
Scope and nature of services: A member in public practice should observe the Principles of the Code of Professional Conduct in determining the scope and nature of services to be provided (Messier, Glover, & Prawitt, 2012, p. 652).
Regarding the subject of auditor ethics, independence has become a frequently discussed topic. With the complexity of the issue at hand, the AICPA has devoted multiple pages of interpretations and rulings regarding independence. Also the SEC and the now defunct ISB contain rulings about independence issues (Messier, Glover, & Prawitt, 2012, p. 654).
In the Rothenburg Construction Company case, Jay Rich, CPA, held 10 percent of the stock in Rothenburg Construction Company. Therefore, Mr. Rich could not maintain professional independence while conducting the audit. The objectivity and independence clause of the “Principles of Professional Conduct Responsibilities” would have been violated if Mr. Rich had conducted the audit. He cannot conduct an audit for a company for which he holds part of the stock.
Specific Information during an Audit Requiring Analytical Procedures
Material misstatements discovered during audits can be more difficult to recognize in audits concerning fraud than in audits concerning errors. One solution for detecting fraud is the use of analytical procedures. Analytical procedures are “evaluations of financial information made through analysis of plausible relationships among both financial and nonfinancial data (Messier, Glover, & Prawitt, 2012, p. 121).”
Auditors must realize the possibility for financial fraud exists and act with professional skepticism. Auditors can evaluate financial statement accounts by using analytical procedures. Non-financial data can be gathered using inquiries and observation. This data can be compared to the results obtained from analytical procedures. Results of evaluations must be communicated clearly and concisely to others. These efforts should be supported during both the planning and performance stage of the audit with brainstorming meetings between the engagement team members. Results of evaluations must be communicated clearly and concisely to others. Auditors must understand the Fraud Risk Triangle and know that with enough pressure, and the opportunity, even an honest person can rationalize unethical behavior. Managers often are involved in fraud because they have the opportunity access accounting records and the incentive to make profit. Auditors can use the confirmation process to obtain evidence from third parties about financial assertions made by management.
Upon completion of an audit, the auditor should be able to ascertain whether the accumulated audit procedures may cause the financial statements to be materially misstated. Based on the understanding of the entity and its environment, the auditor should assess the risk of material misstatement at the assertion level and determine necessary auditing procedures based on the risk assessment results.
Test Examples of the Cash and Collection Cycle
The cash and collection cycle is the process of ensuring that employees and management properly control customer billing and cash receipts. When auditing a cash a collection cycle, the auditor should be looking for fraud. However, according to Dyck (2011), it is more likely that the financial statements would be materially misstated due to unintentional bias than due to fraud (Budescu, Peecher, & Solomon, 2012, p. 26). If fraud is suspected the usual audit procedures may be extended to include the following:
- Extended bank reconciliation procedures.
- Proof of cash.
- Tests for kiting (Messier, Glover, & Prawitt, 2012, p. 552).
Extended Bank Reconciliation Procedures
If the auditor suspects some type of fraud has been committed, then the auditor would examine the bank reconciliations of two consecutive months to ensure that all reconciling items were handled properly. The deposits would be traced to the bank statement to verify that they were deposited in the bank. Deposits in transit would be traced to the following month’s cash receipts journal to verify that they were recorded. Checks listed as outstanding on the bank reconciliation would be traced to the cash disbursements journal, and the canceled or substitute checks returned in the next month’s bank statement would be examined for propriety. Other reconciling items such as bank charges, NSF checks, and collections of notes by the bank similarly would be traced to the accounting records for proper treatment (Messier, Glover, & Prawitt, 2012, pp. 553-554).
Proof of Cash
The primary purposes of the proof of cash are:
( 1) to ensure that all cash receipts recorded in the entity’s cash receipts journal were deposited in the entity’s bank account
( 2) to ensure that all cash disbursements recorded in the entity’s cash disbursements journal have cleared the entity’s bank account, and
( 3) to ensure that no bank transactions have been omitted from the entity’s accounting records (Messier, Glover, & Prawitt, 2012, p. 554).
“The reader should note that a proof of cash will not detect a theft of cash when the cash was stolen before it was recorded in the entity’s books (Messier, Glover, & Prawitt, 2012, p. 554).” The auditor may suspect that cash was stolen without being recorded in the entity’s books, when during the audit test for the completeness assertion it appears that not all cash receipt transactions were recorded (Messier, Glover, & Prawitt, 2012, p. 554).
Tests for Kiting
One type of fraudulent scheme that has been around for years is called check kiting. The account holder usually has two accounts and transfers non-existent funds from one account into another one. A kiting scheme generates non-existent revenue and produces questionable account balances. Since this type of bank fraud is common, The Office of the Comptroller of the Currency (OCC) has recently issued an advisory letter to banks on how to identify and combat check kiting. Normally, when people cash checks, the funds supporting the check are actually in the account. However, clearing a check usually takes between one to five days. “During this clearing time, the bank gives the person cashing the check a short-term loan until the money is actually received from the financial institution that originally issued the check. There is a window of time during which the bank that cashed the check does not actually have the money. It is during this window when the bank that issued the check is unaware that the check was issued. The check-kiting scheme takes advantage of this transit vulnerability. Check kiting is a crime prohibited by federal law 18 USC § 1344 (Summerford & Gober, 2003).” It states that whoever knowingly executes, or attempts to execute, a scheme or artifice—
(1) to defraud a financial institution; or
(2) to obtain any of the moneys, funds, credits, assets, securities, or other property owned by, or under the custody or control of, a financial institution, by means of false or fraudulent pretenses, representations, or promises;
shall be fined not more than $1,000,000 or imprisoned not more than 30 years, or both.
Thus, individuals who perpetrate a check kite are frequently prosecuted and sent to prison. But that often does not help the banks, which are left with the loss after the check kite collapses (Summerford & Gober, 2003).”
One approach commonly used by auditors to test for kiting is the preparation of an interbank transfer schedule. To test for kiting, an auditor will check to see if the money recorded as transfers was really in the account at the time of transfer. Kiting can be detected by tracing the check to the cash disbursements and cash receipts journals and to the end-of-the-month bank reconciliation (Messier, Glover, & Prawitt, 2012, p. 554). Another method of testing for kiting is to put a hold on the account the money was transferred into for a few days while waiting to see what day the money in the other account actually becomes available.
Auditing assignments involve examining work papers and checking boxes to trace amounts on bank reconciliations, cutoff bank statements, standard bank confirmations, and proof of cash statements. However, the key issue may not be to just “check the box” but to develop more tools for evaluating and controlling audit failures. Kleinman & Palmon (2014) suggested that we do systematic research to determine how audit quality is effected by national culture, legal systems, accounting standards, auditing standards, and auditing enforcement regimes (Kleinman, Lin, & Palmon, 2014, p. 79).
“PricewaterhouseCoopers (2003) and Albrecht and Sack (2000) state that future accountants must learn to solve complex, unstructured problems and communicate their solutions clearly and concisely (Green, 2013. p. 168).” Accountants must be able to perform inventory audits with accuracy and completeness at the forefront of their audit actions. Also they must be mindful of the potential for inventory losses due to fraud, theft, damages, and obsolescence. They must realize that inventory valuation methods such as LIFO, FIFO, and Standard Cost must be considered when getting the true value of inventory. Review and observation are the main ways of testing control activities within the organization. Auditors must verify that the inventory actually does exist as well as its physical location. Auditors can perform these verification procedures through the use of substantive tests.
The main difference between the Explanatory Report and the Standard Report is that the explanatory report has an explanatory paragraph added to the standard unqualified report. The explanatory paragraph follows the opinion paragraph. The following four situations require the addition of the explanatory paragraph:
1) Reference to the audit of internal control for public companies
2) Substantial doubt to the ability of the entity to continue as going concern
3) Lack of consistency due to accounting changes, and
4) A need for additional emphasis (Messier, Glover, & Prawitt, 2012, p. 616).
We will look at each one of the situations above separately. We will discuss how each one is simply a deviation of the Standard Report. Both the Standard Report and the Explanatory Report are considered to be Unqualified/Unmodified Opinions (Messier, Glover, & Prawitt, 2012, p. 616). The Explanatory Report is like that Standard Report in that there are no modifications to the wording of any paragraphs. The Introductory, Scope, and Opinion paragraphs remain the same. The only difference is that the Explanatory Report has an additional paragraph added after the Opinion paragraph (Messier, Glover, & Prawitt, 2012, p. 616). Some differences exist in the terminology between the Public Company Accounting Oversight Board (PCAOB) and the Accounting Standards Board (ASB) standards relating to these additional paragraphs (Messier, Glover, & Prawitt, 2012, p. 616).
While the PCAOB standards refer to all such paragraphs simply as “ explanatory paragraphs,” the ASB’s standards, which apply to audits of all entities except for public companies, refer to explanatory paragraphs as either “ emphasis- of- matter” or “ other- matter” paragraphs. An emphasis- of- matter paragraph refers to a matter that has been appropriately presented or disclosed in the financial statements. An emphasis- of- matter paragraph is used when the auditor has substantial doubt about an entity’s ability to continue as a going concern, when there is a lack of consistency in the financial statements, or when the auditor wishes to emphasize a particular matter, if such items have been appropriately disclosed in the financial statements. An emphasis- of- matter paragraph would also be used under ASB standards when the financial statements have been prepared in accordance with a special purpose framework other tha(n) GAAP. An other- matter paragraph refers to a matter other than those presented or disclosed in the financial statements but that, in the auditor’s judgment, is relevant to users’ understanding of the audit, the auditor’s responsibilities, or the auditor’s report. For example, an other- matter paragraph is used when the auditor’s opinion on prior period financial statements differs from the opinion the auditor previously expressed or when the distribution of the auditor’s report is to be restricted to particular users. Like the explanatory paragraph in a report for a public company, emphasis- of- matter or other- matter paragraphs are placed after the opinion paragraph, but under the section heading “ Emphasis of Matter” or “ Other Matter.” While the term explanatory paragraph has a slightly more general meaning than the term emphasis- of- matter paragraph, we use these terms interchange-ably throughout the text for simplicity (Messier, Glover, & Prawitt, 2012, pp. 616-617).
Reference to the Audit of Internal Control for Public Companies
Internal Control over Financial Reporting (ICFR) means controls that address risks to financial reporting. Generally Accepted Auditing Principles (GAAP) help to reduce these risks (http://www.thecaq.org/reports-and-publications/guidetoicfr/guide-to-internal-control-over-financial-reporting). When financial reporting risks are minimized, investors can have confidence in financial reporting. When beginning an auditing engagement, auditors look at the characteristics of the company, the environment, and the scope of the company’s operations. They also look at public policies and current news in the accounting and auditing industry.
Public companies have specific reporting requirements mandated to them by the Securities and Exchange Commission (SEC) and the Sarbanes-Oxley Act (SOX). These requirements are necessary to fairly present to investors the financial positions of the companies in which they are investing. These companies are publicly-traded on the stock exchange. Using a system of Internal Control over Financial Reporting (ICFR), the managers at these companies are responsible for providing reasonable assurance of the reliability of financial statements. These rules were adopted in June 2003 to implement Section 404 of SOX. The management must also annually evaluate whether ICFR is effective and disclose the results to investors (http://www.sec.gov/rules/interp/2007/33-8810.pdf).
Management is required to conclude and state in its report that ICFR is ineffective when there are one or more material weaknesses. Companies should provide disclosure to investors so that they can understand the cause for the control deficiency. In this way, the potential impact of each particular material weakness can be seen. Auditors should distinguish material weaknesses that may have a profound impact on ICFR versus those that will have a lesser impact. This type of information will be more useful to investors (http://www.sec.gov/rules/interp/2007/33-8810.pdf).
Management should evaluate the following situations indicating whether or not an ICFR defienciency exists. If it exists, then it should be determined if the risk is a material risk.
- Identification of fraud, whether or not material, on the part of senior management
- Restatement of previously issued financial statements to reflect the correction of a material misstatement
- Identification of a material misstatement of the financial statements in the current period in circumstances that indicate the misstatement would not have been detected by the company’s ICFR; and
- Ineffective oversight of the company’s external financial reporting and internal control over financial reporting by the company’s audit committee
Substantial Doubt to the Ability of the Entity to Continue as Going Concern
A basic assumption that underlies financial reporting is that an entity will continue as a going concern. “Going concern” means “stay in business.” Auditing standards state that the auditor has a responsibility to evaluate whether there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited. When the auditor concludes that there is substantial doubt about an entity’s ability to continue as a going concern, the auditor should consider the possible effects on the financial statements and the related disclosures. If management has adequately disclosed the entity’s financial problems, the audit report typically will express an unqualified/ unmodified opinion but will include an emphasis- of- matter paragraph to emphasize the auditor’s doubt about the entity’s ability to continue as a going concern. In rare cases of extreme and immediate financial distress, the auditor may disclaim an opinion on the entity. If the entity’s disclosures with respect to its ability to continue as a going concern are inadequate, a departure from GAAP exists, resulting in a qualified or an adverse opinion report covering the comparative financial statements (Messier, Glover, & Prawitt, 2012, p. 617).
Shown below is an example of an Unqualified/ Unmodified Financial Statement Audit Report with an Emphasis- of- Matter Paragraph for Going- Concern Problems:
[ Standard introductory, management’s responsibility, auditor’s responsibility, scope, and opinion paragraphs]
Emphasis of Matter The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 6 to the financial statements, the Company has suffered recurring losses from operations and has a net capital deficiency that raises substantial doubt about its ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 6. The financial statements do not include any adjustments that might result from the outcome of this uncertainty (Messier, Glover, & Prawitt, 2012, p. 617).
Lack of Consistency Due to Accounting Changes
A fundamental principle of accounting is that it should result in financial statements that are consistent and comparable across periods. The auditor’s standard unqualified audit report implies that the comparability of the financial statements is not materially affected by inconsistent use of accounting principles. FASB ASC Topic 250, “ Accounting Changes and Error Corrections,” governs the accounting for changes in accounting principles. From the auditor’s perspective, accounting changes can be categorized into ( 1) changes that affect both comparability and consistency in the application of accounting principles and ( 2) changes that affect comparability but that do involve inconsistency in the application of accounting principles (Messier, Glover, & Prawitt, 2012, p. 617).
Changes Affecting Consistency
If a change in accounting principle or in the method of its application materially affects the comparability and the consistency of the financial statements, and the auditor concurs with the change, the auditor should discuss the change in an explanatory or emphasis of- matter paragraph to highlight the lack of consistency. Auditing standards ( AU 708) refer to the following accounting changes as affecting both comparability and consistency and requiring an explanatory or emphasis- of- matter paragraph: 1. Change in accounting principle. An example is a change from straight- line depreciation to an accelerated method for depreciating equipment. 2. Change in reporting entity. An example is the consolidation of a major subsidiary’s financial statements with the parent company’s financial statements in the previous year and accounting for the subsidiary on a cost or equity basis in the current year. 3. Correction of a misstatement in previously issued financial statements. This includes two situations: first, a change in the use of an accounting principle in prior years ( for example, replacement cost for inventory) to an acceptable accounting principle ( such as FIFO) in the current year and, second, adjustments to correct a material misstatement in previously issued financial statements (Messier, Glover, & Prawitt, 2012, p. 618).
An explanatory or emphasis- of- matter paragraph highlighting an accounting change that results in a lack of consistency would contain wording such as the following:
“ As discussed in Note 7 to the financial statements, the Company changed its method of computing depreciation on fixed assets from the straight- line to the double-declining balance method in 2013.” Note that adding an explanatory or emphasis- of- matter paragraph does not eliminate the auditor’s responsibility to evaluate the adequacy of the required financial statement disclosures relating to accounting changes and corrections of errors (Messier, Glover, & Prawitt, 2012, p. 618).
Changes Not Affecting Consistency
Other changes may affect comparability but not consistency in the use of accounting principles. These include 1. Change in accounting estimate. A change in the service life of a depreciable asset is an example of a change in estimate. 2. Change in classification and reclassification. If an item was included in operating expenses last year and in administrative expenses in the current year, this is a change in classification but not in accounting principle. 3. Change expected to have a material future effect. This would be a change in accounting principle that has an immaterial effect in the current year but is expected to have a material effect in future years. Changes that affect comparability but not consistency in the application of accounting principles are normally disclosed in the notes to the financial statements. Such changes do not require an explanatory/ emphasis- of- matter paragraph in the auditor’s report (Messier, Glover, & Prawitt, 2012, p. 618).
A Need for Additional Emphasis
Under certain circumstances an auditor may want to emphasize a specific matter regarding the financial statements even though he or she intends to express an unqualified or unmodified opinion. Such information is presented in an explanatory/ emphasis- of- matter paragraph. Two examples of situations that might cause the auditor to add explanatory language in an emphasis- of- matter paragraph are significant related- party transactions that are appropriately disclosed by the entity and important events occurring after the balance sheet date (Messier, Glover, & Prawitt, 2012, p. 619).
In this paper, different type of auditor’s reports were discussed. The reasons why certain audit report are chosen by auditors was examined. The auditor’s report provides or disclaims an opinion based on whether the entity’s financial statements and related disclosures are presented fairly and conform to GAAP standards. If it is the opinion of the auditor that the financial statements are presented unfairly or contain material misstatements, then an adverse auditor report is issued.
The paper also describes the Auditor’s Professional Code of Conduct and independence. In some circumstances an audit requires the use of analytical reports. This paper outlines specific information during an audit requiring these analytical procedures.
The paper discusses some test examples of the Cash and Collection cycle. The Cash and Collection cycle is a common target for fraud and theft. Analytical procedures can be helpful in detecting accounting theft or fraud.
Finally, this paper includes a comparison of the Explanatory Report to the Standard Report. In comparing, these two reports, specific procedures and steps were identified. In summary, the explanatory report contains important items of interest or concern about a company’s financial statements that an auditor deems necessary to disclose to the public.
In this paper, we explored the concepts of auditing and the application of auditing standards. These include auditing and assurance services, professional standards, audit planning, substantive testing, internal control evaluation, evidence, and procedures used by external auditors, and reports on financial statements.
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