CHAPTER 6
Material Vs Immaterial Misstatements
OBJECTIVE OF CONDUCTING AN AUDIT OF
FINANCIAL STATEMENTS
The purpose of an audit is to provide
financial statement users with an opinion by the
auditor on whether the financial statements are
presented fairly, in all material respects, in
accordance with the applicable financial
accounting framework.
Auditors accumulate evidence in order to
reach conclusions about whether the financial
statements are fairly stated and to determine the
effectiveness of internal control, after which they
issue the appropriate audit report.
AUDITORS RESPONSIBILITIES
The overall objectives of the auditor are:
(a) To obtain reasonable assurance about
whether the financial statements as a whole are
free from material misstatement, whether due to
fraud or error, thereby enabling the auditor to
express an opinion whether the financial
statements are prepared, in all material respects,
in accordance with an applicable financial
reporting framework; and
(b) To report on the financial statements, and
communicate as required by auditing standards,
in accordance with the auditors findings.
Misstatements are usually considered
material if the combined uncorrected errors and
fraud in the financial statements would likely
have changed or influenced the decisions of a
reasonable person using the statements.
Although it is difficult to quantify a measure of
materiality, auditors are responsible for obtaining
reasonable assurance that this materiality
threshold has been satisfied.
Reasonable Assurance
Assurance is a measure of the level of
certainty that the auditor has obtained at the
completion of the audit. Auditing standards
indicate reasonable assurance is a high, but not
absolute, level of assurance that the financial
statements are free of material misstatements.
The concept of reasonable, but not absolute,
assurance indicates that the auditor is not an
insurer or guarantor of the correctness of the
financial statements. Thus, an audit that is
conducted in accordance with auditing
standards may fail to detect a material
misstatement.
Errors Vs Fraud
Auditing standards distinguish between
two types of misstatements: errors and fraud.
Either type of misstatement can be material or
immaterial. An error is an unintentional
misstatement of the financial statements,
whereas fraud is intentional. Two examples of
errors are a mistake in extending price times
quantity on a sales invoice and overlooking older
raw materials in determining the lower of cost or
market for inventory.
For fraud, there is a distinction between
misappropriation of assets, often called
defalcation or employee fraud, and fraudulent
financial reporting, often called management
fraud. An example of misappropriation of assets
is a clerk taking cash at the time a sale is made
and not entering the sale in the cash register.
Professional Skepticism
Auditing standards require that an audit
be designed to provide reasonable assurance of
detecting both material errors and fraud in the
financial statements. To accomplish this, the
audit must be planned and performed with an
attitude of professional skepticism in all aspects
of the engagement. Professional skepticism is
an attitude that includes a questioning mind and
a critical assessment of audit evidence.
Auditors Responsibilities for Detecting
Material Errors
Auditors spend a great portion of their
time planning and performing audits to detect
unintentional mistakes made by management
and employees. Auditors find a variety of errors
resulting from such things as mistakes in
calculations, omissions, misunderstanding and
misapplication of accounting standards, and
incorrect summarizations and descriptions.
Auditors Responsibilities for Detecting
Material Fraud
Auditing standards make no distinction
between the auditors responsibilities for
searching for errors and fraud. In either case, the
auditor must obtain reasonable assurance about
whether the statements are free of material
misstatements.
Fraud Resulting from Fraudulent Financial
Reporting Versus Misappropriation of Assets
Both fraudulent financial reporting and
misappropriation of assets are potentially
harmful to financial statement users, but there is
an important difference between them.
Fraudulent financial reporting harms users by
providing them incorrect financial statement
information for their decision making. When
assets are misappropriated, stockholders,
creditors, and others are harmed because
assets are no longer available to their rightful
owners.
Usually, but not always, theft of assets is
perpetrated by employees and not by
management, and the amounts are often
immaterial. However, there are well-known
examples of extremely material misappropriation
of assets by employees and management,
similar to the Adelphia fraud described in the
shaded box at the top of this page.
There is an important distinction between
the theft of assets and misstatements arising
from the theft of assets. Consider the following
three situations:
1. Assets were taken and the theft was covered
by misstating assets. For example, cash
collected from a customer was stolen before it
was recorded as a cash receipt, and the account
receivable for the customers account was not
credited. The misstatement has not been
discovered.
2. Assets were taken and the theft was covered
by understating revenues or overstating
expenses. For example, cash from a cash sale
was stolen, and the transaction was not recorded.
Or, an unauthorized disbursement to an
employee was recorded as a miscellaneous
expense. The misstatement has not been
discovered.
3. Assets were taken, but the misappropriation
was discovered. The income statement and
related footnotes clearly describe the
misappropriation.
In all three situations, there has been a
misappropriation of assets, but the financial
statements are misstated only in situations 1 and
2. In situation 1, the balance sheet is misstated,
whereas in situation 2, revenues or expenses
are misstated.
Auditors Responsibilities for Discovering
Illegal Acts
Illegal acts are defined as violations of
laws or government regulations other than fraud.
Two examples of illegal acts are a violation of
federal tax laws and a violation of the federal
environmental protection laws.
Direct-Effect Illegal Acts
Certain violations of laws and regulations
have a direct financial effect on specific account
balances in the financial statements. For
example, a violation of federal tax laws directly
affects income tax expense and income taxes
payable.
Indirect-Effect Illegal Acts
Most illegal acts affect the financial
statements only indirectly. For example, if the
company violates environmental protection laws,
financial statements are affected only if there is
a fine or sanction. Potential material fines and
sanctions indirectly affect financial statements
by creating the need to disclose a contingent
liability for the potential amount that might
ultimately be paid.
Evidence Accumulation When There Is No
Reason to Believe Indirect-Effect
Illegal Acts Exist
Many audit procedures normally
performed on audits to search for errors and
fraud may also uncover illegal acts. Examples
include reading the minutes of the board of
directors and inquiring of the clients attorneys
about litigation. The auditor should also inquire
of management about policies they have
established to prevent illegal acts and whether
management knows of any laws or regulations
that the company has violated.
necessary to determine whether the suspected
illegal act actually exists:
1. The auditor should first inquire of
management at a level above those likely to be
involved in the potential illegal act.
2. The auditor should consult with the clients
legal counsel or other specialist who is
knowledgeable about the potential illegal act.
3. The auditor should consider accumulating
additional evidence to determine whether there
actually is an illegal act.
Actions When the Auditor Knows of an Illegal
Act
The first course of action when an illegal
act has been identified is to consider the effects
on the financial statements, including the
adequacy of disclosures. These effects may be
complex and difficult to resolve.
FINANCIAL STATEMENT CYCLES
Audits are performed by dividing the
financial statements into smaller segments or
components. The division makes the audit more
manageable and aids in the assignment of tasks
to different members of the audit team.

Evidence Accumulation and Other Actions

When There Is Reason to Believe
Direct- or Indirect-Effect Illegal Acts May
Exist
The auditor may find indications of
possible illegal acts in a variety of ways. For
example, the minutes may indicate that an
investigation by a government agency is in
process or the auditor may have identified
unusually large payments to consultants or
government officials.
When the auditor believes that an illegal
act may have occurred, several actions are
Cycle Approach to Segmenting an Audit
A common way to divide an audit is to
keep closely related types (or classes) of
transactions and account balances in the same
segment. This is called the cycle approach.
MANAGEMENT ASSERTIONS
Management assertions are implied or
expressed representations by management
about classes of transactions and the related
accounts and disclosures in the financial
statements. In most cases they are implied.
Management assertions are directly related to
the financial reporting framework used by the
company (usually U.S. GAAP or IFRS), as they
are part of the criteria that management uses to
record and disclose accounting information in
financial statements.
International auditing standards and U.S.
GAAS classify assertions into three categories:
1. Assertions about classes of transactions and
events for the period under audit
2. Assertions about account balances at period
end
3. Assertions about presentation and disclosure
(Table 6-2) Management Assertions for Each
Category of Assertions
Assertions about Classes of Transactions
and Events
Occurrence Transactions and events that
have been recorded have occurred and pertain
to the entity.
Completeness All transactions and events
that should have been recorded have been
recorded.
Accuracy Amounts and other data relating to
recorded transactions and events have been
recorded appropriately.
Classification Transactions and events have
been recorded in the proper accounts.
Cutoff Transactions and events have been
recorded in the correct accounting period.
Assertions about Account Balances
Existence Assets, liabilities, and equity
interests exist.
Completeness All assets, liabilities, and
equity interests that should have been recorded
have been recorded.
Valuation and allocation Assets, liabilities,
and equity interests are included in the financial
statements at appropriate amounts and any
resulting valuation adjustments are appropriately
recorded.
Assertions about Presentation and
Disclosure
Occurrence and rights and obligations
Disclosed events and transactions have
occurred and pertain to the entity.
Completeness All disclosures that should
have been included in the financial statements
have been included.
Accuracy and valuation Financial and other
information are disclosed appropriately and at
appropriate amounts.
Classification and understandability Financial
and other information is appropriately presented
and described and disclosures are clearly
expressed.
CHAPTER 7
NATURE OF EVIDENCE
Evidence was defined as any information
used by the auditor to determine whether the
information being audited is stated in
accordance with the established criteria. The
information varies greatly in the extent to which
it persuades the auditor whether financial
statements are fairly stated. Evidence includes
information that is highly persuasive, such as the
auditors count of marketable securities, and less
persuasive information, such as responses to
questions of client employees.
Audit Evidence Contrasted with Legal and
Scientific Evidence
Evidence is also used extensively by scientists,
lawyers, and historians. In legal cases, there are
well-defined rules of evidence enforced by the
judge for the protection of the innocent. Similarly,
gathering evidence is a large part of what
auditors do.

AUDIT EVIDENCE DECISIONS
A major decision facing every auditor is
determining the appropriate types and amounts
of evidence needed to be satisfied that the
clients financial statements are fairly stated.
There are four decisions about what evidence to
gather and how much of it to accumulate:
1. Which audit procedures to use
2. What sample size to select for a given
procedure
3. Which items to select from the population
4. When to perform the procedures
Audit Procedures
An audit procedure is the detailed
instruction that explains the audit evidence to be
obtained during the audit. It is common to spell
out these procedures in sufficiently specific
terms so an auditor may follow these instructions
during the audit.
Sample Size
Once an audit procedure is selected,
auditors can vary the sample size from one to all
the items in the population being tested.
Items to Select
After determining the sample size for an
audit procedure, the auditor must decide which
items in the population to test.
Timing
An audit of financial statements usually
covers a period such as a year. Normally an
audit is not completed until several weeks or
months after the end of the period. The timing of
audit procedures can therefore vary from early in
the accounting period to long after it has ended.
Audit Program
The list of audit procedures for an audit
area or an entire audit is called an audit
program. The audit program always includes a
list of the audit procedures, and it usually
includes sample sizes, items to select, and the
timing of the tests. Normally, there is an audit
program, including several audit procedures, for
each component of the audit. Therefore, there
will be an audit program for accounts receivable,
one for sales, and so on.
Reliability, and therefore
appropriateness, depends on the following six
characteristics of reliable evidence:
1. Independence of provider.
Evidence obtained from a source outside
the entity is more reliable than that obtained from
within. Documents that originate from outside the
clients organization, such as an insurance policy,
are considered more reliable than are those that
originate within the company and have never left
the clients organization, such as a purchase
requisition.
2. Effectiveness of clients internal controls.
When a clients internal controls are
effective, evidence obtained is more reliable than
when they are weak.
3. Auditors direct knowledge.
Evidence obtained directly by the auditor
through physical examination, observation,
recalculation, and inspection is more reliable
than information obtained indirectly.
4. Qualifications of individuals providing the
information.
Although the source of information is
independent, the evidence will not be reliable
unless the individual providing it is qualified to do
so.
5. Degree of objectivity.
Objective evidence is more reliable than
evidence that requires considerable judgment to
determine whether it is correct.
6. Timeliness.
The timeliness of audit evidence can
refer either to when it is accumulated or to the
period covered by the audit. Evidence is usually
more reliable for balance sheet accounts when it
is obtained as close to the balance sheet date as
possible.
TYPES OF AUDIT EVIDENCE
In deciding which audit procedures to use,
the auditor can choose from eight broad
categories of evidence, which are called types of
evidence. Every audit procedure obtains one or
more of the following types of evidence:
1. Physical Examination
Physical examination is the inspection or
count by the auditor of a tangible asset. This type
of evidence is most often associated with
inventory and cash, but it is also applicable to the
verification of securities, notes receivable, and
tangible fixed assets. There is a distinction in
auditing between the physical examination of
assets, such as market able securities and cash,
and the examination of documents, such as
cancelled checks and sales documents.
2. Confirmation
Confirmation describes the receipt of a
direct written response from a third party
verifying the accuracy of information that was
requested by the auditor. The response may be
in electronic or paper form. The request is made
to the client, and the client asks the third party to
respond directly to the auditor.
3. Documentation
Documentation is the auditors inspection
of the clients documents and records to
substantiate the information that is, or should be,
included in the financial statements. The
documents examined by the auditor are the
records used by the client to provide information
for conducting its business in an organized
manner, and may be in paper form, electronic
form, or other media.
4. Analytical Procedures
Analytical procedures use comparisons
and relationships to assess whether account
balances or other data appear reasonable
compared to the auditors expectations.
Analytical procedures are used extensively in
practice, and are required during the planning
and completion phases on all audits.
5. Inquiries of the Client
Inquiry is the obtaining of written or oral
information from the client in response to
questions from the auditor. Although
considerable evidence is obtained from the client
through inquiry, it usually cannot be regarded as
conclusive because it is not from an independent
source and may be biased in the clients favor.
6. Recalculation
Recalculation involves rechecking a
sample of calculations made by the client.
Rechecking client calculations consists of testing
the clients arithmetical accuracy and includes
such procedures as extending sales invoices
and inventory, adding journals and subsidiary
records, and checking the calculation of
depreciation expense and prepaid expenses. A
considerable portion of auditors recalculation is
done by computer assisted audit software.
7. Re-performance
Re-performance is the auditors
independent tests of client accounting
procedures or controls that were originally done
as part of the entitys accounting and internal
control system. Whereas recalculation involves
rechecking a computation, re-performance
involves checking other procedures.
8. Observation
Observation is the use of the senses to
assess client activities. Throughout the
engagement with a client, auditors have many
opportunities to use their sensessight, hearing,
touch, and smellto evaluate a wide range of
items.
AUDIT DOCUMENTATION
Auditing standards state that audit
documentation is the principal record of
auditing procedures applied, evidence obtained,
and conclusions reached by the auditor in the
engagement. Audit documentation should
include all the information the auditor considers
necessary to adequately conduct the audit and
to provide support for the audit report. Audit
documentation may also be referred to as
working papers, although audit documentation is
often maintained in computerized files.
Purposes of Audit Documentation
The overall objective of audit
documentation is to aid the auditor in providing
reasonable assurance that an adequate audit
was conducted in accordance with auditing
standards. More specifically, audit
documentation, as it pertains to the current
years audit, provides:
A Basis for Planning the Audit. If the auditor
is to plan an audit adequately, the necessary
reference information must be available in the
audit files.
A Record of the Evidence Accumulated and
the Results of the Tests. Audit documentation
is the primary means of documenting that an
adequate audit was conducted in accordance
with auditing standards.
Data for Determining the Proper Type of
Audit Report. Audit documentation provides an
important source of information to assist the
auditor in deciding whether sufficient appropriate
evidence was accumulated to justify the audit
report in a given set of circumstances.
A Basis for Review by Supervisors and
Partners. The audit files are the primary frame
of reference used by supervisory personnel to
review the work of assistants.
Supporting Schedules
The largest portion of audit
documentation includes the detailed supporting
schedules prepared by the client or the auditors
in support of specific amounts on the financial
statements.
Here are the major types of supporting
schedules:
Analysis. An analysis is designed to show the
activity in a general ledger account during the
entire period under audit, tying together the
beginning and ending balances. This type of
schedule is normally used for accounts such as
marketable securities; notes receivable;
allowance for doubtful accounts; property, plant,
and equipment; long-term debt; and all equity
accounts.
Trial balance or list. This type of schedule
consists of the details that make up a year-end
balance of a general ledger account. It differs
from an analysis in that it includes only those
items making up the end-of-the-period balance.
Reconciliation of amounts. A reconciliation
supports a specific amount and is normally
expected to tie the amount recorded in the
clients records to another source of information.
Tests of reasonableness. A test of
reasonableness schedule, as the name implies,
contains information that enables the auditor to
evaluate whether the clients balance appears to
include a misstatement considering the
circumstances in the engagement.
Summary of procedures. Another type of
schedule summarizes the results of a specific
audit procedure. A summary schedule
documents the extent of testing, the
misstatements found, and the auditors
conclusion based on the testing.
Examination of supporting documents. A
number of special-purpose schedules are
designed to show detailed tests performed, such
documents examined during tests of controls
and substantive tests of transactions.
Informational. This type of schedule contains
information as opposed to audit evidence. These
schedules include information for tax returns and
SEC Form 10-K and data such as time budgets
and the clients working hours, which are helpful
in administration of the engagement.
Outside documentation. Much of the content
of the audit files consists of outside
documentation gathered by auditors, such as
confirmation replies and copies of client
agreements.
CHAPTER 8
PLANNING
The first generally accepted auditing
standard of field work requires adequate
planning. The auditor must adequately plan the
work and must properly supervise any assistants.
There are three main reasons why the
auditor should properly plan engagements:
to enable the auditor to obtain sufficient
appropriate evidence for the circumstances, to
help keep audit costs reasonable, and to avoid
misunderstandings with the client.
Obtaining sufficient appropriate evidence
is essential if the CPA firm is to minimize legal
liability and maintain a good reputation in the
business community. Keeping costs reasonable
helps the firm remain competitive. Avoiding
misunderstandings with the client is necessary
for good client relations and for facilitating high-
quality work at reasonable cost.