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Overview
The easy way to master the art of auditing
Want to be an auditor and need to hone your investigating skills? Look no further. This friendly guide gives you an easy-to-understand explanation of auditing — from gathering financial statements and accounting information to analyzing a client's financial position. Packed with examples, it gives you everything you need to ace an auditing course and begin a career today.
- Auditing 101 — get a crash course in the world of auditing and a description of the types of tasks you'll be expected to perform during a typical day on the job
- It's risky business — find out
about audit risk and arm yourself with the know-how to collect the right type of evidence to support your decisions
Auditing is the process of investigating information that’s prepared by someone else — such as a company’s financial statements — to determine whether the information is fairly stated and free of material misstatement.Having a certified public accountant (CPA) perform an audit is a requirement of doing business for many companies because of regulatory- or compliance-related matters.
About The Author
Maire Loughran is a self-employed certified public accountant (CPA) who has prepared compilation, review, and audit reports for fifteen years. Additionally, she is a university professor of undergraduate- and graduate-level accounting classes.
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Because businesses generate so much paperwork, auditors can’t possibly sort through all of it. Instead you review a sample. You don’t include every type of client information in an auditing sample. Here are the types of evidence that you typically sample:
Tangible assets: If, for example, a business states that it owns 300 company cars.
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Generally accepted accounting principles (GAAP) define acceptable practices in the preparation of financial statements in the United States. Keep in mind that when you’re wearing your auditor hat, you can’t prepare the financial statements you audit; the financial statements are the responsibility of the client’s management.
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In addition to being thorough and unbiased when evaluating audit evidence, you also want to apply professional judgment by adopting an attitude of professional skepticism. When exercising professional skepticism, you keep an open and reasonably questioning mind without being overly suspicious. You don’t assume that management is dishonest, and you don’t assume that it’s honest.
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When you assess an auditing client’s cash control risk, remember that control risk is directly affected by the internal controls the company has set in place. Cash is a risky account because the money can easily be stolen if the business lacks good internal controls. Proper cash management is crucial for all businesses so that they can meet their short-term payment obligations.
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As an auditor, you must address all relevant events that take place after the balance sheet date but before you issue your report. For example, your audit client may be breathing a sigh of relief because a warehouse fire or a product liability lawsuit occurred after the balance sheet date. The client may assume an event like that doesn’t have to be included in this year’s audit report, but that’s not necessarily true.
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As an auditor you have to assess management’s financial statement presentation and disclosure. The financial statements (income statement, balance sheet, and statement of cash flows) and notes to the financial statements must contain all the necessary information a user needs to avoid being misled. Users of the financial statements are those who obtain the documents in order to make a decision, like whether to invest in a company or to loan it money.
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When auditing a company’s assets, don’t forget to take a look at asset control risk features the company has in place. During your audit you can perform tests of internal controls to limit the number of transaction you sample and test, or test every transaction. For many accounts with few transactions, it’s more efficient to forgo control testing in favor of looking at the complete population of transactions.
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When performing an audit, you look at revenue transactions. As the auditor you need to factor in any inherently risky circumstances that affect the revenue accounts. Generally, you look at four inherent risk factors for revenue:
Industry-related factors: You consider any external events that have an effect on revenue and cash flow.
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Making sure your audit client is current with all areas of human resources-related compliance is one way to judge the competency of employees when you’re deciding whether to limit audit procedures. So what personnel records does a company need to keep? The basic forms a business must keep on file are as follows:
Job applications: Title VII of the Civil Rights Act of 1964 requires covered employers (basically those having more than 15 employees) to retain job applications for a period of one year from the date an application or disciplinary action was made.
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If a potential auditing client’s records appear reliable and your firm can provide an impartial audit, you still need to make sure you can perform all the tasks the client needs. You also have to figure out what kinds of services to put in the contract.
Finding out what your client needs
While you interview the client, you can educate him about the nature of the services you provide.
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You have to judge a client’s accounting competence and integrity before accepting an auditing engagement. If the client lacks accounting skills and integrity, you should seriously consider not accepting the job. The process for sizing up a potential client can be involved. Just as you wouldn’t want to start a business with someone you don’t trust, you don’t want to accept an auditing engagement from a company whose management ethics seem a little shaky.
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When you find misstatements as you perform an audit, you’re responsible for making an assessment. You alone must determine whether the misstatement represents an error or fraud. Errors aren’t deliberate. Fraud takes place when you find evidence of intent to mislead.
Keep in mind that the dollar amount of the misstatement doesn’t make a difference when assigning a badge of fraud.
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When taking a new client, an auditor creates an engagement letter to solidify audit arrangements between the audit firm and the client. The letter serves as the contract, detailing the duties and obligations on either side of the table. Your CPA firm prepares the engagement letter.
Although you aren’t required to have a written agreement with an audit client (per SAS No.
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Auditing is the process of investigating information that’s prepared by someone else — such as a company’s financial statements — to determine whether the information is fairly stated and free of material misstatement.Having a certified public accountant (CPA) perform an audit is a requirement of doing business for many companies because of regulatory- or compliance-related matters.
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As an auditor you have to pay attention to all of a company’s assets. Prepaid expenses and deferred charges appear on a company’s balance sheet as other assets. Both categories apply to a situation where a client pays in advance for a good or service.
When you see the words expense and charge, you may wonder how the heck these items belong in an asset account.
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Depending on the method your audit client uses for value ending inventory, the amount transferred from the balance sheet inventory account to the income statement cost of goods sold can vary wildly. Your first question for your client in this stage of the audit is how it values ending inventory. You need this information when recalculating your client’s inventory valuation.
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Some accounts can accrue interest. As an auditor, you need to keep track of these accounts as well as cash and investment accounts. Keep in mind that all interest income from all bank accounts must be recorded on the income statement as revenue. Here are three examples of bank accounts that earn interest income:
Savings: Your client may have a savings account in order to set aside extra sources of cash that are earmarked for special purposes or to earn interest income.
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When performing an audit you have to account for all of your client’s assets. Not all assets are tangible objects or cash sitting in the bank. Many companies sell their own securities (stocks and bonds) to raise capital for operations and to expand. But businesses also frequently invest in securities issued by other companies, for both growth and income:
Growth securities are those a company anticipates being able to sell for more than it paid for them.
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As an auditor, you have to check the company’s intangible assets and that means understanding amortization. Amortization spreads the cost of an intangible asset over its expected useful life. Much like you use depreciation to calculate how much of a fixed asset’s value the client uses in a given year, you use amortization to make that calculation for certain intangible assets.
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The purpose of compliance audits is to see how well a company is following applicable rules, policies, and regulations. For example, as an internal auditor your job may be to see how well various departments in your company are abiding by the corporate bylaws (rules governing how the company operates) or by relevant government standards.
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A major auditing issue with accounts receivable is whether the amount reflected in the customer’s subsidiary ledger reconciles with the correct customer balance. When you audit accounts receivable, you often use confirmations to make sure the amounts reflected in accounts receivable are accurate.
Sending confirmations isn’t mandatory for each audit.
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When performing an audit of stockholder equity, you will want to verify the transactions with an independent registrar, who can confirm that all stockholders’ equity transactions are authorized by a company’s board of directors and are in accordance with its corporate charter. For example, the registrar keeps track of the number of shares outstanding to make sure the company doesn’t issue more shares than the charter allows.
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You can use several methods to determine the size of an audit sample. You can set the audit sample size based on tolerable and expected error or the previous year’s policy. You can use tables and software to set the sample size, or you can adjust the size based on your analysis.
Using tolerable and expected error
Tolerable error refers to the maximum number of client errors in a sample size that you’re prepared to accept and still conclude that you’ve achieved the audit objectives.
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At every step of an audit, you have to consider risks of misstatement and their associated controls. When you are auditing assets, be sure to focus is on identifying risks in the fixed-asset management process.
Generally, you look at two inherent fixed-asset risk factors: recording the correct cost basis, and working with complex (and, therefore, difficult to audit) accounting transactions.
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At every step of an audit, you have to consider risks and their associated controls. Normally, purchases don’t have a lot of inherent risk because the process doesn’t involve any complicated or contentious accounting issues. For example, valuation is clear-cut; it’s the bottom line total on the invoice. Cutoff is precise as well, because the company must include only purchases that are complete by the end of the fiscal year.
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Your first task when reviewing your audit client’s stockholder equity transactions is to double-check the terms of the corporate charter. The corporate charter contains pertinent facts about the corporation such as its name, address, and information about the type and number of stock shares it’s authorized to issue.
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If your audit client has material debt or equity transactions after the balance sheet date, you must disclose the debt or equity in your audit report as well. This type of subsequent event may include the following circumstances:
Borrowing new money, paying off debt, or changing the terms of existing debt: For example, the client issues new bonds or changes the date that a loan needs to be paid off.
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As an auditor, your primary objective is to make sure all your client’s legitimate obligations are properly recognized on its financial statements. Here are three tasks auditors must perform when examining long-term debt.
Review the board of directors meeting minutes: During your review, make sure that any new loan agreements or bond issuances are authorized.
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You can’t effectively or efficiently audit your client’s revenue transactions unless you understand how the client handles them. Each client you audit will probably approach each of the business processes in a slightly different fashion. However, all businesses have a flow to their revenue process. Interview the client, learn about the revenue flow, and apply your knowledge to the audit.
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While you work on your client’s audit, you gather sufficient appropriate evidence to come to a determination on whatever it is you’re auditing. The methods you use to gather audit evidence aren’t one-size-fits-all. Part of your obligation to exercise due professional care is to select the most appropriate method(s) for the type of client and auditing task at hand.
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The generally accepted auditing standards (GAAS) are the standards you use for auditing private companies. GAAS come in three categories: general standards, standards of fieldwork, and standards of reporting.
Keep in mind that the GAAS are the minimum standards you use for auditing private companies. Additionally, the Public Company Accounting Oversight Board (PCAOB) has adopted these standards for public (traded on the open market) companies.
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If your audit client manufactures items, it doesn’t have a merchandise inventory. Manufacturers have three other types of inventory you need to know how to handle as an auditor. These three types are as follows.
Raw materials: Everything a manufacturer buys to make a product is classified as raw materials. If the company manufactures blue jeans, typical raw materials include denim, thread, zippers, and buttons.
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Auditing purchased assets is relatively easy, because you can test most management assertions by looking at the purchase source documents. But what about assets that aren’t purchased? Here are three examples of nonpurchased assets and explanations of how your client should add them to the balance sheet:
Self-constructed assets: These are assets that the company doesn’t buy from a vendor but makes itself in-house.
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From an auditing standpoint, cash is an important account because cash transactions affect all other business and financial processes. Businesses acquire cash by selling goods or services, disposing of fixed assets, or acquiring debt or equity. The same businesses put their cash to use through purchasing, paying employees, and buying inventory.
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Your audit client’s expenses are all the costs it incurs while keeping its business open. Most likely, these costs are a combination of expenses you find very familiar, such as telephone and utilities, and industry-driven costs that you have to become familiar with. For example, a scientific research company may have expenses for tools and supplies with exotic names such as photoelectric colorimeter.
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As an auditor you have to assess the purchasing procedures your client uses. An important part of the purchasing process is — no surprise! — paying for the purchase. Businesses and individuals alike have only two ways to pay for expenses:
Cash purchases: Cash changes hands at the same time that the goods or services do.
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Auditors choose from several types of sampling when performing an audit. Attribute sampling means that an item being sampled either will or won’t possess certain qualities, or attributes. An auditor selects a certain number of records to estimate how many times a certain feature will show up in a population. When using attribute sampling, the sampling unit is a single record or document.
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When using classical variables sampling, auditors treat each individual item in the population as a sampling unit. This method is most like the statistics classes you had to take in high school and college. You use this method to evaluate your entire population based on your sample data. You can use three common types of classical variables sampling estimators: mean-per-unit, ratio, and difference.
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Auditors use monetary unit sampling, also called probability-proportional-to-size or dollar-unit sampling, to determine the accuracy of financial accounts. With monetary unit sampling, each dollar in a transaction is a separate sampling unit. A transaction for $40, for example, contains 40 sampling units. Auditors usually use monetary unit sampling to sample and test accounts receivable, loans receivable, and inventory.
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To perform an audit, you have to know how your client handles inventory. Knowledge about different inventory systems helps you to plan and execute an effective and efficient audit. Two major types of inventory systems exist: periodic and perpetual. Usually, if a retail business uses electronic cash registers (ECRs) to read the product bar codes, it uses the perpetual method.
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For many audits, looking at 10 percent of the records that a company has produced during the past year may be just right. But that number isn’t always going to work. Your job as an auditor is to choose records for your sample that accurately represent a certain population. A sampling unit is the item in the population that the auditor actually examines.
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Audit evidence documents give you the substantiation for your professional audit opinion. When performing an audit, you must assess the nature, competence, sufficiency, and evaluation of the audit evidence to determine its accuracy. After all your audit depends on the veracity of the evidence.
The nature of the audit evidence
The nature of audit evidence refers to the form of the evidence you’re looking at during the audit.
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During your risk-assessment procedures before you begin an audit, you interview members of the company and observe how they do their jobs to make your assessment of control risk. Company management is ultimately responsible for the financial statements. The internal controls set in place by the company have the goal of producing accurate and effective reporting.
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When assessing purchasing control risk, auditors assume that control risk is directly affected by purchasing internal controls set in place by the business. The purchases process has control risk associated with two broad issues: orders placed with fictitious vendors and orders placed for personal use.
If good controls aren’t in place regarding the various approval processes, employees could set up fictitious companies with whom they place nonexistent orders.
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Detection risk occurs when you don’t use the right audit procedures or you don’t use them correctly. You assess inherent and control risk and then solve your audit risk equation by assigning detection risk to reduce your audit risk to an acceptable level. Keep in mind that you can never completely eliminate detection risk because you’ll most likely never look at each and every transaction.
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You initially evaluate going-concern when deciding to accept a company as an audit client. You reevaluate the client’s ability to continue as a going-concern as you wrap up the audit. The term going-concern means that your audit client will continue to operate indefinitely; a benchmark for indefinitely is at least 12 months past the balance sheet date.
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At every step of an audit, you have to consider risks and their associated controls. At this inventory stage, your focus is on identifying risks that exist in the inventory management process and the internal controls the company has established to offset those risks.
Generally, you look at three inherent inventory management risk factors:
Susceptibility to theft: All inventory, regardless of its nature, can potentially be stolen by either employees or customers.
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Auditors must determine risks when working with clients. One type of risk to be aware of is inherent risk. While assessing this level of risk, you ignore whether the client has internal controls in place (such as a secondary review of financial statements) in order to help mitigate the inherent risk. You consider the strength of the internal controls when assessing the client’s control risk.
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During an audit, you have to assess your client’s control risk. This audit procedure involves evaluating control risk, which means you need to find out as much as you can about your client’s internal control procedures. Auditing those procedures involves several steps:
Consider external factors: Uncover as much as you can about environmental and external influences that may affect the company, such as the state of the economy, changes in technology, the potential effect of any laws and regulations, and changes in generally accepted accounting principles (GAAP) that relate to the client’s type of business.
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When you assess a client’s inventory management control risk during your audit, remember that the business’s internal controls directly affect that risk. The inventory management process has control risk associated with one major issue: making sure all inventory on the balance sheet actually exists.
A business must have in place proper segregation of duties so that no single individual handles all or most aspects of the inventory transaction authorization, preparation, and payment.
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Becoming an auditor is a process that spans quite a few years of your life. First comes the awesome educational requirement. Then you have to pass the Uniform CPA Examination. Depending on the state in which you take the CPA exam, you may have to fulfill an experience requirement before you can apply for your CPA license.
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When you are performing an audit, it’s a good idea to discuss how your client may be perpetrating fraud with your team members. Brainstorming is a very useful tool, as one member of the team may have an idea regarding client actions that you hadn’t considered, or lead you to consider some information you’ve obtained in a different way.
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Your audit client will prepare bank reconciliations, which compare and adjust its cash balance per its bank statements with its book cash balances. When you audit the bank reconciliations, you must make sure your client adjusts for three things:
Deposits in transit, which are deposits the company makes that haven’t appeared on the bank statement yet.
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There are a few different ways that your audit client might use to figure depreciation. In addition to understanding depreciation accounting methods, when doing an audit, you need to know the following numbers before you start checking depreciation calculations:
The asset’s cost
How long the company anticipates being able to use the asset
The asset’s value after the company is done using it
Under GAAP, fixed assets are depreciated using one of four methods: straight-line, units of production, declining balance, and sum-of-the-years’ digits.
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As an auditor, to make sure you don’t have any conflict-of-interest problems, you have to look at any third-party transactions your potential client may have been part of. If your potential client has material interests in other clients your firm represents, you have to walk away from the engagement. Usually, however, related-party transactions aren’t cause to turn down an engagement — you just need to make sure they’re properly accounted for and disclosed in the financial statements.
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As you perform your audit, you have to determine how important a contingent liability is to the audit. A contingent liability can come in three categories, and the category it falls into gives you guidance on whether it needs to be disclosed in the notes to the financial statements:
Probable: This category means that the future event will likely occur.
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Intangible assets differ from the other assets on your audit client’s balance sheet because they don’t have a physical presence and aren’t financial instruments like cash. However, like fixed assets, their expense is moved to the income statement over their useful life through amortization.
Here are some common intangible assets you’ll see during your audits:
Copyrights: When a client owns a copyright, no one else can use its printed work (such as a book) or its recorded work (such as a musical score or a movie) without permission.
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Although you can never guarantee that an audit is 100-percent accurate, the sample of records you choose is crucial to helping you achieve as much accuracy as possible. The choices you make when determining which records to review can help you reduce (but never eliminate) your sampling risk. A number of factors contribute to risk:
You’re looking at the records of a company you know only from the outside.
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In the normal course of doing business, an audit client will rid itself of unneeded fixed assets by selling them, trading them in as partial payments on new fixed assets, or junking them (throwing away assets that are totally worn out). Whatever the circumstance, you need to make sure the client has completely removed the asset’s cost and its accumulated depreciation from the balance sheet.
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If payroll fraud exists, it is likely to occur in one of three ways: During an audit you can use the following methods to detect all three circumstances of payroll error and fraud: through paying fictitious employees, employees who haven’t worked or employees who no longer work for the company. To find these types of errors when performing an audit take the following precautions:
Review payroll registers: A department manager needs to review and approve the payroll register, a summary of who’s getting paid and how much, prior to being forwarded to the payroll department.
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Auditors refer to financial statement information that’s not 100 percent correct as a misstatement. You’ll probably never see a set of financial statements that’s completely accurate. But misstatements aren’t the issue in an audit — whether they’re material is what matters.
With respect to materiality, everything is relative.
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Three circumstances may preclude you from issuing an unqualified report when you complete your audit. For example, if your client limits what actions you can take and what records you can look at, and you can’t get enough competent evidence about one or more facets of its financial statements, you may deem that these particular areas aren’t fully audited.
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From the initial client interview all the way down to issuing the audit report, as an auditor you have to keep a record of all the work you do. This information is kept in the audit file and shows the basis for the conclusions you reach. Here you learn about the types of documents that go into an audit file, as well as who ultimately owns that file.
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As you do your investigative work getting to know your audit client, following your risk assessment procedures, and assessing the risk of material misstatement, you must extensively document everything you do. You use this documentation to provide a clear audit trail of what steps you took so you have written substantiation for the various levels of risk you’ve assessed for the financial statement accounts and transactions.
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When deciding whether to accept an auditing engagement, you must judge your independence and objectivity. If your audit firm lacks independence or objectivity, you can’t accept the engagement. Independence and objectivity are closely related attributes that you need as an auditor. You and your firm have to be independent in both fact and appearance.
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At every step of an audit, you have to consider risks and their associated controls. Generally, you look at three inherent human resources risk factors: the supply and demand of competent employees, existing labor contracts, and regulatory compliance.
In addition, a huge human resources risk involves payroll controls — or lack of them.
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At every step of an audit, you have to consider risks and their associated controls. It’s important to consider risks and controls to make sure your audit effectively and efficiently guides you toward issuing the correct audit opinion.
Although employees may have a fairly difficult time accessing investments such as stocks, notes, and bonds and converting them into cash for their personal use, the same can’t be said for cash bank accounts.
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All auditors must know what a contingent liability is and how to handle it, but suppose your audit client doesn’t tell you it has contingent liabilities? What can you do to protect the good name of your CPA firm by finding all reportable contingent liabilities and producing a correct audit report? Here are the steps you should take to ensure due diligence regarding contingent liabilities.
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When performing an audit, you use risk assessment procedures to assess the risk that material misstatement exists. This step is very important because the whole point of a financial statement audit is finding out if the financial statements are materially correct.
A client’s contribution to audit risk — the risk of a material misstatement existing in the financial records due to errors and fraud — influences your firm’s plans regarding what audit evidence is necessary and which personnel will be assigned to the job.
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When you are performing an audit, to judge the reliability of a client’s internal control procedures, you first have to be aware of the five components that make up internal controls. For each client, you need to understand each component to plan your audit. Your understanding of these components lets you grasp the design of internal controls relevant to the preparation of financial statements and lets you see whether each internal control is actually in operation.
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If an audit engagement is high-risk, you have to sit back, evaluate how the company does business, and think about how material misstatements may slip through the cracks. You then design an extended audit to provide as much assurance as possible that you’ll detect those misstatements. Here are some prime examples of high-risk items:
The company has changed accounting principles.
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Part of your job as a staff associate in an auditing firm is to document your findings in working papers (also known as workpapers) and schedules. Workpapers summarize your audit actions, such as planning the audit. Schedules show what steps you take to reach a conclusion. For example, to support your conclusion that cash is correctly stated on the balance sheet, you may prepare a schedule showing all bank reconciliations affirming that they reconcile without discrepancy to the balance sheet.
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Knowing what a contingent liability is and how to handle it is great, but suppose the client doesn’t tell you it has contingent liabilities? To protect the good name of your CPA firm you need to find all reportable contingent liabilities. Here are two steps you can take to ensure due diligence regarding contingent liabilities.
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You’ll hear auditors referring to the triangle of fraud. That’s because in most fraudulent acts, three circumstances lead to the commission of fraud: the incentive to commit fraud, the opportunity to carry out the fraudulent act, and the ability to rationalize or justify the fraud.
Identifying incentive
Management usually perpetrate fraud differently from nonmanagement employees, For nonmanagement employees, incentive takes place when an employee has an overriding reason to steal from the company.
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Here’s something every auditor should remember: Just because a client comes to you and wants you to audit its financial statements, you don’t have to accept the engagement. After all, you’re not selling shirts in a department store; you’re expressing an opinion on the fairness of the financial statements under audit.
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When you are auditing stockholder equity, you want to look at the capital stock accounts. Capital stock includes all paid-in capital. The board of directors has to approve all capital stock transactions, including the type of stock issued, the total number of shares that can be outstanding at any one time, and the declaration of dividends.
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During your audit, you shouldn’t have to deal with much activity going on in the retained earnings account, so you generally audit all the transactions rather than sample and test. Inherently this is just not a high activity account like revenue and expenses. Three common items affect retained earnings: net income or loss, dividends, and prior-period adjustments.
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When performing due diligence in an audit, you have to address all relevant events that take place after the balance sheet date but before you issue your report. These are called subsequent events and auditors classify such events as Type I or Type II.
To identify Type I or Type II events, you have to do some investigative work by checking with the following people:
Company management: This is your best source of information.
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After completing your risk assessment procedures and deciding if any misstatements are material, you need to evaluate your findings. You must decide if you can use normal audit procedures (for a low-risk assessment) or if you have to use extended procedures (for a high-risk assessment).
After looking at major financial statement accounts or classes of transactions, if you decide the risk of material misstatement is relatively low, you design your audit procedures accordingly.
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Making sure the company books its payroll accruals properly is fairly easy. By the time you conduct your audit, all employees whose unpaid payroll transactions should have been accrued have been paid. All you have to do is get payroll records for the first pay period of the new year and pro-rate them.
The concept of accruals is easier to understand when you consider how you personally get paid.
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During your audit, you need to test management financial statement assertions. When you test cash disbursements during an audit, your first job is to figure out how your audit client pays its invoices. For cash disbursement transactions you need to test five assertions: occurrence, completeness, authorization, accuracy, and cutoff.
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During your audit of stockholder equity, you want to make sure your client’s dividends are correct. Making money is the whole reason that investors purchase stock, and dividends are one way that investors receive income from their investments. The two most common forms are cash and stock:
Cash dividends: Shareholders of record receive money in the form of a cash or electronic transfer based on how many shares of stock they own.
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One way auditors test employee payroll-related items is to make sure the related employer expenses are properly accounted for on the books. It’s the auditor’s responsibility during the audit to sample and test employer payroll taxes, accrued employer payroll taxes, and employer benefit expenses to make sure the income statement and balance sheet are materially correct.
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As an auditor you have to test security investments such as your client’s stocks and bonds. Testing investments during an audit is no different from testing any other financial account, such as cash. You must make sure that the amounts shown as investment assets aren’t materially misstated and that all income and changes in an investment’s value are properly recorded.
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During an audit, testing payroll transactions includes sniffing out employees paid who shouldn’t have been and making sure valid employees are paid the correct amount. Auditors also need to make sure the payroll transactions are reflected in the correct financial statement accounts.
During your audit, you need to test management financial statement assertions.
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You can choose your audit sample without using any type of specific statistical sampling method. The basic premise of statistical and nonstatistical sampling is the same. However, when performing an audit, be aware of these differences that do exist. They impact how you determine the sample size and select the items to sample.
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Even a very small company produces voluminous records; no auditor could ever audit all the records available and still get the audit done in time for the data obtained to be relevant. Sampling allows you to choose a small but pertinent and representative group of records that will give you an accurate picture of the company.
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As you are performing due diligence in your audits, you take subsequent events into account. There are three Type II events that you should investigate to determine whether you need to disclose in the financial statements: the purchase or sale of a business segment, the sale of a large amount of stock or the issuance of bond, and events that create catastrophic losses for your client.
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Every profession has its own lexicon. To communicate with your audit peers and supervisors, you must know key auditing phrases. Knowing these buzzwords is also helpful if you’re a business owner, because auditors sometimes forget to switch from audit-geek talk to regular language when speaking with you.
Audit evidence: Facts gathered during the audit procedures that provide a reasonable basis for forming an opinion regarding the financial statements under audit.
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When you perform an audit of a company, you have to account for that company’s tangible assets. You can find your audit client’s property, plant, and equipment in the asset section of its balance sheet. Here are some common types of property, plant, and equipment:
Buildings: These are the structures your client owns and does business in.
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Some auditing clients don’t follow Generally Accepted Accounting Principles (GAAP). Some companies — usually smaller, private ones — may use a cash or tax basis instead. Companies that are highly regulated by the local, state, or federal government may need to use a basis required by the regulatory agency. Here’s how you handle each situation:
Tax basis: A client that uses the tax method prepares its financial statements to mirror what goes on its tax return.
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Companies, like individuals, have long-term debt. To perform an audit, you need to understand the forms a company’s long-term debt can take and the debt-related issues you need to consider when conducting your audit. Your audit clients use three debt vehicles — mortgages, notes, and bonds — to finance the acquisition of their assets.
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When you are performing an audit, you are responsible for assessing management assertions about classes of transactions. Five management assertions are related to classes of transactions. Four of them closely mirror the assertions represented in the financial statement presentation and disclosure. However, the way the assertions relate to transactions differs slightly from the way they relate to presentations and disclosure:
Occurrence: This means that all the transactions in the accounting records actually took place.
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While you’re interviewing the audit client, find out about its sources of cash and how often it makes bank deposits. If an audit client — especially a retail client or one receiving a preponderance of customer payments through the mail — has lax controls regarding the frequency of bank depositing, you likely need to perform more sampling and testing of deposited items.
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After you finish auditing all your client’s business and financial processes, you must perform due diligence before you issue your audit report. Due diligence means that you hunt for any issues that weren’t addressed during the audit of the financial statements — issues that may have an impact on the way people interpret those financial statements.
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Auditors of privately owned businesses must follow a code of conduct. As an auditor, you abide by your state’s code of conduct, but you also follow the code of conduct established by the American Institute of Certified Public Accountants (AICPA) — the national professional organization for all certified public accountants (CPAs).
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The standard of professional conduct for the audit of all publicly traded companies comes from the Public Company Accounting Oversight Board (PCAOB). The Audit Standards Board (ASB) used to be the one-stop shop for all standards for nongovernmental audits. However, when the U.S. Congress passed the Sarbanes-Oxley Act of 2002 (SOX), the authority over audits of public companies shifted to the newly formed PCAOB.
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Stockholders’ equity represents the claim that the corporation’s shareholders have to the company’s net assets. As an auditor you have to account for net assets. Stockholders’ equity has three common components: paid-in capital, treasury stock, and retained earnings.
Three types of business entities exist: corporations, sole proprietorships, and flow-through entities such as partnerships.
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After you test inventory and verify that your audit client is following its standards, you’re ready to start testing management assertions. For inventory transactions you test these five management assertions during your audit:
Occurrence: Occurrence tests if the inventory transactions actually took place. To test occurrence, you should take a sample of additions to inventory (purchases) and vouch them to purchase requisitions and receiving reports.
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During your audit, you need to test management financial statement assertions for fixed and intangible asset transactions. The six assertions that you must attend to when auditing — occurrence, ownership, completeness, authorization, accuracy, and cutoff — are outlined here
Occurrence: Occurrence tests whether the fixed-asset transactions actually took place.
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Part of an auditor’s job for a client can include verifying company documents. Attestation is a subset of assurance services that focuses on whether your engagement’s subject matter complies with the applicable criteria for measurement and disclosure. Most attestation engagements have three parties:
Practitioner: The CPA engaged to issue a written communication that expresses a conclusion about a client subject matter or assertion.
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Audit evidence consists of the documents you use during an audit to substantiate your audit opinion. While working on an audit, you encounter many different types of evidence (written, oral, and so on). Documents can be prepared by employees of the client or by outside parties. To properly evaluate the strength of evidence you gather, you have to understand the four concepts of evidence:
Nature: The form of the evidence — for example, oral, visual, or written.
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When you assess a client’s payroll control risk during your audit, remember that the control risk is directly impacted by payroll internal controls set in place by the business. A company can introduce errors and fraud in its payroll mainly in three ways. When auditing your company’s payroll, keep the following in mind:
Paying fictitious employees: Causing checks to be issued to fictitious or “ghost” employees is outright fraud, and it can be the work of multiple employees working together (called collusion) or one employee (if controls are weak).
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If for some reason, you can’t issue an unqualified report when you complete your audit, you still need to create a report. Three reporting options are available to auditors: the qualified report, the disclaimer report and the adverse report:
Qualified report: You issue a qualified report if you have a scope limitation or a material departure from GAAP but the rest of the financial statement assertions were audited to your satisfaction while applying generally accepted auditing standards (GAAS) and were not materially misstated.
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After you pass the CPA exam, you’ll probably be itching to get into the job market to start making some money! Chances are good that with a CPA license in hand, you can choose to do external auditing.
If you choose to become an independent auditor you have no special relationship with or financial interest in the client that would cause you to disregard evidence and facts when evaluating your client.
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You can use sampling to test the strength of a client’s internal controls, but you also use sampling to test account balances. The full name for this process in auditing lingo is sampling for substantive tests of details of account balances. In non-auditing talk, this means the auditor uses sampling to see if the dollar amount on the financial statements for each account is accurate.
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When you perform an audit, you check a company’s revenue recognition, which has to reconcile with generally accepted accounting principles (GAAP). This means, in most cases, that the straight-out accrual method is applied: A company records revenue when it’s earned and realizable.
The type of business dictates how to apply revenue recognition.
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When you audit a company, your main goal is to provide assurance to the users of the company’s financial statements that those documents are free of material misstatement. You use the audit risk model, which consists of inherent, control, and detection risk, to help you determine your auditing procedures for accounts or transactions shown on your client’s financial statements.
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The goal of a financial statement audit is for you (the auditor) to form an opinion regarding whether those statements are or aren’t free from error. To do so, you use your best professional judgment when assessing your client’s information and assertions. Although every company is different, and each audit you work on will vary, you can follow some common procedures.
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Auditors issue an unqualified report after they gather sufficient competent evidence and conduct the audit according to generally accepted auditing standards (GAAS) using financial statements that the client prepares using GAAP.
An unqualified report for a private company follows a standard format with three paragraphs: introduction, scope, and opinion.
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The primary reason auditors observe their client taking the physical inventory is to make sure the inventory reflected on the balance sheet actually exists and that the balance sheet includes all inventory owned by the company. This includes all raw materials, supplies, inventory in transit when using Free on Board (FOB) shipping point, inventory the company may have on consignment with another business, and inventory stored off the premises.
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As an auditor you have to analyze your client’s account balances. Management assertions address the correctness of balance sheet account balances at year-end. These account balances include the company’s assets, liabilities, and equity. Here’s a refresher on the balance sheet accounts:
Assets are resources the company owns.
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Revenue is important to the audit because it’s one of the two major business processes. (Purchasing is the other.) It’s also the major account in which you look for instances of financial misstatements. However, ferreting out common instances that lead to material revenue misstatements is fairly easy.
Because most financial statements under audit have to comply with generally accepted accounting principles (GAAP), auditing revenue is a two-part process:
Sample and test the income statement revenue accounts: Revenue accounts on the income statement reflect all income earned during the period, regardless if cash changes hands.
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When you audit publicly traded companies, federal regulations dictate that you must audit internal controls that affect financial reporting. But what about audits of privately owned companies? Do you always have to audit your client’s internal controls? Not exactly.
In every audit, you must get at least a preliminary understanding of the client’s internal controls that affect each business and financial process.
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The types of auditing clients you may encounter and the reasons they require audits are, of course, expansive. As a new auditor, you may not be qualified to conduct some of these audits discussed here, because they require specific skills. Here is a short list of clients and types of audits you may be called on to perform:
Publicly run companies: Public companies sell their shares of stock to investors and must be audited by independent auditors.