Auditing - Lecture 2
Part I. Fundamentals of audit: CPA


Content
nCPA
nAssurance and other services
nAudit process and auditor reports
nRecommended reading
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CPA - profession
nUse of the title certified public accountant (CPA) is regulated by national laws in every
individual country through national authorized licensing departments. Although regulations for
becoming a CPA usually differ from country to country however to become a CPA three major
requirements must be met:
qeducational requirement
quniform CPA examination requirement
qexperience requirement
nTo maintain the right to practice as independent auditors in most countries, CPAs must meet
defined continuing education and licensing requirements. Therefore, it is common for accountants to
be CPAs who do not practice as independent auditors.
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CPA – firm (types)
nBig-4 – Deloitte, PwC, EY, KPMG - have offices throughout the United States and throughout the
world. The Big Four firms audit nearly all of the largest companies worldwide.
nNational firms - RSM McGladrey, Grant Thornton, BDO Seidman, CBIZ/Mayer Hoffman McCann - these
firms are large but considerably smaller than the Big-4. National firms perform the same services
as the Big-4 and compete directly with them for clients. Each national firm is affiliated with
firms in other countries and therefore has an international capability.
nRegional and local large firms - Crowe Horwath, BKD , Moss Adams Holthouse Carlin & Van Trigt  -
some have only one office and serve clients primarily within commuting distances, others have
several offices in some some country or region and serve a larger radius of clients. Many of these
firms also have internat. affiliations.
nLocal small firms - more than 95 percent of all CPA firms have fewer than 25 professionals in a
single-office firm. They perform audits primarily for smaller businesses and not-for-profit
entities, although some have one or two clients with public ownership.
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CPA – firm (services)
nActivities of CPA firms:
qAccounting and bookkeeping services - many small clients with limited accounting staff rely on CPA
firms to prepare their financial statements. Accounting and bookkeeping are the major source of
revenue for most large CPA firms.
qTax services - CPA firms prepare corporate and individual tax returns for both audit and nonaudit
clients. For many small firms, such services are far more important to their practice than
auditing, as most of their revenue may be generated from tax services.
qManagement consulting services - Most CPA firms provide certain services that enable their clients
to operate their businesses more effectively. These services range from simple suggestions for
improving the client’s accounting system to advice in risk management, mergers and acquisitions due
diligence, business valuations, and actuarial benefit consulting.
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Assurance and other services - framework
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nAll auditor services standards have as their basis the IFAC Code of Ethics and International
Standards on Quality Control (ISCQ)
qIFAC Code of Ethics – contains 3 parts (A – Framework which applies to all professional
accountants, B - Framework which applies to accountants in public practice, C - Framework which
applies to employed accountants). It declares such fundamental principles as independence of audit
and review engagements, integrity of client, objectivity, professional competence and due care,
confidentiality, professional behavior of CPA professionals and firms. It also defines basic
threats and safeguards for CPA professions and firms.
qInternational Standards on Quality Control (ISCQ) – sets a requirement for CPA firm to establish
and maintain a system of quality control to provide it with reasonable assurance that: (a) the firm
and its personnel comply with professional standards and applicable legal and regulatory
requirements; and (b) reports issued by the firm are appropriate in the circumstances.
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Assurance and other services - framework
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nEngagement standards:
qInternational Standards on Auditing (ISAs) - are to be applied, as appropriate, in the audit of
historical financial information.
qInternational Standards on Review Engagements (ISREs) - are to be applied in the review of
historical fin. information.
qInternational Standards on Assurance Engagements (ISAEs) - are to be applied in assurance
engagements dealing with subject matters other than historical financial information.
qInternational Standards on Related Services (ISRSs) - are to be applied to compilation
engagements, engagements to apply agreed upon procedures to information, and other related services
engagements as specified by the IAASB.
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Assurance and other services - AE
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nAssurance engagement (AE) - an engagement in which a practitioner (professional accountant or
auditor) expresses a conclusion (in report form) that is designed to enhance the degree of
confidence users have about the evaluation of the subject matter against identified criteria
(common examples of AEL: financial statement audits and reviews and opinions on the effectiveness
of internal controls).
nElements of AE – there are 5 elements: (1) three-party relationship involving (a practitioner, a
responsible party, intended users); (2) a subject matter; (3) suitable criteria; (4) evidence; (5)
assurance report.
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Assurance and other services - AE
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nAssurance engagements (AE) and other related services
qAudit and review of historical financial information – objective of audit is to enable the auditor
to express an opinion whether the financial statements are prepared, in all material respects, in
accordance with an identified financial reporting framework. The expression of a conclusion by an
auditor is designed to enhance the degree of confidence intended users can have about historical
financial statements. A review of financial statements is similar to an audit in the way it
requires terms of an engagement, planning, consideration of work performed by others,
documentation, and paying attention to subsequent events.
qRelated services – a related service engagement is generally an examination of historical
financial statements to develop a conclusion based on the criteria, but no audit opinion. In some
instances, this kind of engagement could also be linked to information in other historical
financial statements.
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Audit process (phase I)
nPhase I. Client acceptance – objectives are to determine both acceptance of a client and
acceptance by a client, to decide on acquiring a new client or continuation of relationship with an
existing one and the type and amount of staff required. Procedures:
qEvaluate the client’s background and reasons for the audit
qDetermine whether the auditor is able to meet the ethical requirements
qregarding the client
qDetermine need for other professionals
qCommunicate with predecessor auditor
qPrepare client proposal
qSelect staff to perform the audit
qObtain an engagement letter
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Audit process (phase II)
nPhase II. Planning – objectives are to determine the amount and type of evidence and review
required to give the auditor assurance that there is no material misstatement of the financial
statements. Procedures:
qPerform audit procedures to understand the entity and its environment, including the entity’s
internal controls
qAssess the risks of material misstatements of the financial statements
qDetermine materiality
qPerform tests of controls (ToC) providing evidence on quality of internal controls and based on
them financial statements
qPrepare the planning memorandum and audit program, containing the auditor’s response to the
identified risks
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Audit process (phase III)
nPhase III. Testing and evidence – objective is to test for evidence supporting internal controls
and the fairness of the financial statements. Procedures:
qSubstantive tests of transactions
qAnalytical procedures
qTests of details of balances
qSearch for unrecorded liabilities
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Audit process (phase IV)
nPhase IV. Evaluating and evidence – objective is to complete the audit procedures and issue an
opinion. Procedures:
qEvaluate governance evidence
qPerform procedures to identify subsequent events
qReview financial statements and other report material
qPerform wrap-up procedures
qPrepare Matters for Attention of Partners
qReport to the board of directors
qPrepare Audit report
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Standard unqualified audit report
nStandard unqualified audit report - the most common type of audit report. It is used for more than
90 percent of all audit reports. US GAAS and ISA prescribe the use of three-paragraph form:
introduction, scope, and opinion, where the final paragraph – opinion - states the auditor’s
conclusion based on the results of the audit examination. This paragraph is so important that the
entire audit report is frequently referred to as “the auditor’s opinion”. The opinion paragraph is
stated as an opinion rather than as statement of absolute fact or a guarantee. The intent is to
indicate that the conclusions are based on professional judgment.
nConditions for standard unqualified audit report:
qcompleteness - all statements (balance sheet, income statement, statement of change in equity and
retained earnings, and statement of cash flows) are included in the financial statements.
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Standard unqualified audit report
qcompliance – US GAAS/SAS or ISA have been followed in all respects. This also means that adequate
disclosures have been included in the footnotes and other parts of the financial statements.
qpervasiveness of evidence – sufficient appropriate evidence has been accumulated and presented in
auditor’s report.
qthere are no circumstances requiring the addition of an explanatory paragraph or modification of
the wording of the report.
nThe standard unqualified audit report is sometimes called a clean opinion because there are no
circumstances requiring a qualification or modification of the auditor’s opinion. The standard
unqualified report is the most common audit opinion. Sometimes circumstances beyond the client’s or
auditor’s control prevent the issuance of a clean opinion. However, in most cases, companies make
the appropriate changes to their accounting records to avoid a qualification or modification by the
auditor.
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Extended and/or modified unqualified audit report
nAn auditor’s report is considered to be modified in the two different situations:
qmatters that do not affect the auditor’s opinion (which would mean adding of matter paragraph =>
issue of unqualified audit report with explanatory notes and/or modified wording)
qmatters that do affect the auditor’s opinion (instances that call for either: (a) qualified
opinion, (b) disclaimer of opinion, or (c) adverse opinion).
nCauses of addition of an explanatory paragraph or a modification in the wording of the standard
unqualified report:
qLack of consistent application of US GAAP or IFRS
qSubstantial doubt about going concern
qAuditor agrees with a departure from promulgated accounting principles
qEmphasis of a matter
qReports involving other auditors or experts
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Departures from unqualified audit report
nConditions requiring departures (matters that do affect the auditor’s opinion):
qScope of the audit has been restricted (scope limitation)
qFinancial statements have not been prepared in US GAAP or IFRS (US GAAP/IFRS limitation)
qAuditor is not independent (independence limitation)
nMateriality (extra condition) - materiality is an essential consideration in determining the
appropriate type of report for a given set of circumstances. For example, if a misstatement is
immaterial relative to the financial statements, it is appropriate to issue an unqualified report.
The situation is totally different when the amounts are of such significance that the financial
statements are materially affected as a whole. In these circumstances, it is necessary to issue a
disclaimer of opinion or an adverse opinion, depending on whether a scope limitation or GAAP
departure is involved. In situations of lesser materiality, a qualified opinion is appropriate.
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Decision-making process about type of audit report
nMaking decision about type of audit reports:
qDeciding whether any condition exists requiring a departure from a standard unqualified report
qDeciding about materiality level for each condition
qDeciding about the appropriate type of report for the condition, given the determined materiality
level
qWriting of audit report
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Qualified audit report (opinion)
nQualified opinion report - can result from a limitation on the scope of the audit or failure to
follow US GAAP or IFRS. A qualified opinion report can be used only when the auditor concludes that
the overall financial statements are fairly stated (a disclaimer or an adverse report must be used
if the auditor believes that the condition being reported on is highly material) Therefore, the
qualified opinion is considered the least severe type of departure from an unqualified report.
nA qualified report can take the form of a qualification of both the scope and the opinion or of
the opinion alone. A scope and opinion qualification can be issued only when the auditor has been
unable to accumulate all of the evidence required by generally accepted auditing standards.
Therefore, this type of qualification is used when the auditor’s scope has been restricted by the
client or when circumstances exist that prevent the auditor from conducting a complete audit. The
use of a qualification of the opinion alone is restricted to situations in which the financial
statements are not stated in accordance with US GAAP/IFRS.
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Adverse audit report (opinion)
nAn adverse opinion - is used only when the auditor believes that the overall financial statements
are so materially misstated or misleading that they do not present fairly the financial position or
results of operations and cash flows in conformity with US GAAP/IFRS. The adverse opinion report
can arise only when the auditor has knowledge, after an adequate investigation, of the absence of
conformity. This is uncommon and thus the adverse opinion is rarely used.
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Disclaimer
nA disclaimer of opinion - is issued when the auditor has been unable to satisfy himself or herself
that the overall financial statements are fairly presented. The necessity for disclaiming an
opinion may arise because of a severe limitation on the scope of the audit or a nonindependent
relationship under the Code of Professional Conduct (AISPA or IFAC) between the auditor and the
client. Either of these situations prevents the auditor from expressing an opinion on the financial
statements as a whole. The auditor also has the option to issue a disclaimer of opinion for a going
concern problem.
nThe disclaimer is distinguished from an adverse opinion in that it can arise only from a lack of
knowledge by the auditor, whereas to express an adverse opinion, the auditor must have knowledge
that the financial statements are not fairly stated. Both disclaimers and adverse opinions are used
only when the condition is highly material.
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Recommended reading
nArens et al. (2015) – chosen chapters will be uploaded to IS
qCh. 1 (1.4, 1.7), 2 (2.1-2.2, 2.9), 3 (whole)
nHayes et al. (2014) – chosen chapters will be uploaded to IS
qCh. 1 (1.8-1.9), 2 (2.3), 4 (whole)
nISQC
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