THE FUNDAMENTAL

CONCEPTS OF AUDIT
CHAPTER 2

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 CHAPTER 2 LEARNING OBJECTIVES
• 2.1 Distinguish Fraud and Error, Recognize specific fraud
risk areas and develop procedures to detect fraud
• 2.2 Audit risk model: Understand audit risk model for
planning, Planned detection risk, Inherent risk, Control risk,
Acceptable audit risk
• 2.3 Describe information about Management assertions and
Audit evidence
• 2.4 Develop responses to identified professional Skepticism
and Professional Judgement

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 MANAGEMENT FRAUD AND
AUDIT RISK

"IT TAKES 20 YEARS TO BUILD A REPUTATION AND FIVE MINUTES TO

RUIN IT. IF YOU THINK ABOUT THAT, YOU'LL DO THINGS
DIFFERENTLY."
- - WARREN BUFFET, BILLIONAIRE INVESTOR

©2002 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

 I. ERRORS, FRAUD, AND ILLEGAL
ACTS

A. Errors
B. Management Fraud
C. Consideration of Fraud in a Financial Statement Audit
D. Reasons Auditors Fail to Detect Fraud
E. Auditor Responsibility for Detecting Errors, Frauds, and Illegal Acts
©2002 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
 ERRORS

Errors are
unintentional
misstatements or
omissions of
amounts or
disclosures in
financial
statements.

McGraw-Hill/Irwin ©2002 by the McGraw-Hill Companies, Inc. All rights reserved.

 MANAGEMENT FRAUD

Management fraud is
intentional
misstatements or
omissions of
amounts or
disclosures in
financial statements

©2002 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

 CONSIDERATION OF FRAUD IN A
FINANCIAL STATEMENT AUDIT

SAS 99 requires auditors to understand fraud, assess fraud risks, design

audits to provide reasonable assurance of detecting material
management/employee fraud that could have a material effect on the
financial statements, and report the findings to management, directors,
users of financial statements (sometimes), and outside agencies (under
certain conditions).

©2002 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

 REASONS AUDITORS FAIL TO DETECT FRAUD

Over reliance on client representations.

Lack of awareness or failure to recognize that an observed condition may
indicate a material fraud.
Lack of experience.
Personal relationships with clients.

©2002 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

 3-9
EXHIBIT 3.1
MANAGEMENT FRAUD OVERVIEW
 3-10
FINANCIAL STATEMENTS:
ERRORS, FRAUDS AND ILLEGAL ACTS
• Errors are unintentional misstatements or omissions of amounts or disclosures in
financial statements.
• Management Fraud is intentional misstatements or omissions of amounts or
disclosures in financial statements.
• Direct-effect illegal acts are violations of laws or government regulations by the
company or its management or employees that produce direct and material effects
on dollar amounts in financial statements.
• "Illegal acts" (far-removed) are violations of laws and regulations that are far removed
from financial statement effects (for example, violations relating to insider securities
trading, occupational health and safety, food and drug administration, environmental
protection, and equal employment opportunity).
 AUDITOR RESPONSIBILITY FOR DETECTING
ERRORS, FRAUDS, AND ILLEGAL ACTS
Responsible for Must Communicate Findings?
Detection?

Material Immaterial Material Immaterial

Yes
Errors Yes No (Audit No
Committee)

Yes Yes
Fraud Yes No (Audit (One level
Committee) above)

Yes
Illegal Yes No Yes (One level
Acts (Direct Effect) (Audit above)
Committee)
©2002 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
 TYPES OF FRAUD
Fraudulent Financial Reporting—An intentional misstatement
or omission of amounts or disclosures with the intent to deceive
users.
• Most cases involve an attempt to overstate income, but can also
understate income.
• Earnings management involves fraud to meet earnings goals.
• Income smoothing is a form of earnings management that shifts
income from year to year to reduce fluctuations.
Misappropriation of Assets—Fraud that involves theft of an
entity’s assets. Normally perpetrated by lower level employees,
but can involve upper management.

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FRAUD TRIANGLE AND IDENTIFY CONDITIONS FOR FRAUD
CONDITIONS FOR FRAUD
Three conditions for fraud are referred to as the fraud triangle:
1. Incentives/Pressures—Management or other employees have
incentives or pressures to commit fraud.
2. Opportunities—Circumstances provide opportunities for
management or employees to commit fraud.
3. Attitudes/Rationalization—An attitude, character, or set of ethical
values exists that allows management or employees to commit a
dishonest act, or they are in an environment that imposes sufficient
pressure that causes them to rationalize committing a dishonest
act.
The fraud triangle is illustrated in Figure 2-1.
Risk factors for fraudulent financial reporting are shown in Table 2-
1.

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 CONDITIONS FOR FRAUD (CONT.)

Commonly cited fraud risk conditions are shown in Figure 2-2.

The characteristics of fraud perpetrators are detailed in Figure 2-3.
Risk Factors for Misappropriation of Assets—The same three
conditions apply to misappropriation of assts.
However, in assessing risk factors, greater emphasis is placed on
individual incentives and opportunities for theft.
Examples of fraud risk factors for each of the three conditions for
misappropriation of assets are provided in Table 2-2.

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Copyright ©2012 Pearson Education, Inc. 2-19
 SPECIFIC FRAUD RISK AREAS
Revenue and Accounts Receivable Fraud Risks—The
Committee of Sponsoring Organizations (COSO) found that more
than half of financial statement frauds involve revenue and
accounts receivable, and related cash.
Three main types of revenue manipulation are:
1. Fictitious revenues
2. Premature revenue recognition
3. Manipulation of adjustments to revenue
Warning Signs of Revenue Fraud—Two of the most useful are:
• Analytical procedures
• Documentary discrepancies

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 SPECIFIC FRAUD RISK AREAS (CONT.)

Revenue and Accounts Receivable Fraud Risks (cont.)

Misappropriation of Receipts Involving Revenue—Rarely as material as fraudulent
financial reporting, but is costly because it is a direct loss of assets (cash). Usually
involve one of the following:
• Failure to Record a Sale—One of the most difficult types of fraud to detect.
• Theft of Cash Receipts After a Sale Is Recorded—To hide the theft, the
perpetrator must reduce the customer’s account in one of three ways:
1. Record a sales return or allowance.
2. Write off the customer’s account.
3. Apply the payment from another customer to the customer’s account.

Warning Signs of Misappropriation of Revenues and Cash Receipts—Analytical

procedures and comparisons are helpful. An example of the effects of fictitious
receivables on accounting ratios are shown in Table 2-4.

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Copyright ©2012 Pearson Education, Inc. 2-22
 SPECIFIC FRAUD RISK AREAS (CONT.)
Inventory Fraud Risks—Fictitious inventory has been at the center of
several major cases of fraudulent financial reporting.
• Auditors are required to verify the existence of physical inventories, but
audit testing is done on a sample basis.
• If inventory is stored in several locations, it is relatively easy for the
client to move inventory to the sample testing site.
Warning Signs of Inventory Fraud—Analytical procedures, especially
gross profit margin percentage and inventory turnover, are effective.
The effects of fictitious inventory on inventory turnover based on the
Crazy Eddie case are shown in Table 2-5.

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Copyright ©2012 Pearson Education, Inc. 2-24
 SPECIFIC FRAUD RISK AREAS (CONT.)
Purchases and Accounts Payable Fraud Risks—Companies may
deliberately attempt to understate accounts payable and overstate income.
Misappropriation in the Acquisition and Payment Cycle—The most
common fraud in the acquisition area is for payments to be issued to fictitious
vendors and depositing the cash in fictitious accounts.
Other Areas of Fraud Risk
• Fixed Assets—Companies may capitalize repairs to increase the amount of
assets on the balance sheet.
• Intangible Assets—The values of intangible assets, especially goodwill, are
based on estimates and are susceptible to manipulation.
• Payroll Expense—Rarely an area for fraudulent financial reporting, but
often an area of misappropriation by payment to fictitious employees or
overstatement of payroll hours.

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 OBJECTIVE 2.2
Audit Risk Model.

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 3-27

THE AUDIT RISK MODEL (ARM)

• Audit risk (AR) is the risk (likelihood) that the auditor may
unknowingly fail to modify the opinion on financial
statements that are materially misstated (e.g., an unqualified
opinion on misstated financial statements.)
• The AUDIT RISK MODEL decomposes overall audit risk into
three components: inherent risk (IR), control risk (CR), and
detection risk (DR):
AR = IR x CR x DR
(IR x CR = Risk of Material Misstatement (RMM))
 3-28
EXHIBIT 3.4
INHERENT, CONTROL AND DETECTION RISK

Internal Controls

Accounting
Events, Financial
Information
Statements
Transactions System Substantive
Procedures

INHERENT RISK
The likelihood that, CONTROL RISK
in the absence of The likelihood that an error DETECTION RISK AUDIT RISK
internal controls, or fraud will not get caught by the The likelihood that The likelihood that
an error or fraud client’s internal controls. an error or fraud an error or fraud will occur,
will enter the accounting will not be caught and not get caught
information system by the auditor’s by either the internal controls
procedures. or auditor’s procedures.
Risk of Material Misstatement (RMM)
 3-29

ARM CONCEPTS
• The auditor cannot affect inherent risk or control risk. The
auditor can only ASSESS them.
• The auditor can only affect detection risk—generally by
examining more evidence.
• Detection risk is inversely related to control risk and
inherent risk.
• Detection risk is inversely related to competence and
reliability of evidence.
 3-30

INHERENT RISK
• Inherent Risk (IR) is the likelihood that, in the absence of internal
controls, a material misstatement could occur. In other words, it is a
measure of the susceptibility of an account to misstatement.
• Factors affecting account inherent risk include:
• Dollar size of the account
• Liquidity
• Volume of transactions
• Complexity of the transactions
• New accounting pronouncements
• Subjective estimates
 3-31
OTHER FACTORS AFFECTING
OVERALL INHERENT RISK
• Competition
• Economy
• Nature of Industry
• Management Style
• Leverage
 3-32
INHERENT RISK:
GENERAL CATEGORIES OF ERRORS AND
FRAUDS
• Invalid transactions are recorded.
• Valid transactions are omitted from the accounts.
• Unauthorized transactions are executed and
recorded.
• Transaction amounts are inaccurate.
• Transactions are classified in the wrong accounts.
• Transaction accounting and posting is incorrect.
• Transactions are recorded in the wrong period.
 3-33

INHERENT RISK:
GENERAL CATEGORIES OF ERRORS AND FRAUDS
Error Examples Fraud Examples

Invalid transactions are recorded A computer malfunction causes a sales transaction to Fictitious sales are recorded and charged to
be recorded twice nonexistent customers
Valid transactions are omitted from the Shipments to customers are never recorded because Shipments are made to an employee’s friend
accounts of problems in the company’s information processing and purposely never recorded
system
Unauthorized transactions are executed A customer’s order is not approved for credit yet the Unauthorized purchases are made and
and recorded goods are shipped, billed, and charged to the shipped to an employee’s house
customer without requiring payment in advance

Transaction amounts are inaccurate An employee calculates depreciation incorrectly A company “short ships” a shipment to a
customer and bills the customer for the full
amount ordered
Transactions are classified in the wrong Sales to a subsidiary company are recorded as sales A loan to the company’s CEO (not permitted
accounts to outsiders instead of intercompany sales or the under Sarbanes-Oxley) is classified as an
amount is charged to the wrong customer account account receivable to conceal the transaction
receivable record
Transaction accounting and posting are Sales are posted in total to the accounts receivable Capital leases are accounted for as operating
incorrect control account, but some are not posted to individual leases in order to keep related liabilities off
customer account records the balance sheet

Transactions are recorded in the wrong The company fails to record a shipment that was sent Shipments made in January (of the next
period by a supplier FOB shipping point in December, but fiscal year) are backdated and recorded as
the shipment was not received (or recorded) until sales in December
January
 3-34

CONTROL RISK
• Control Risk (CR) is the likelihood that a material
misstatement would not be caught by the client’s internal
controls.
• Factors affecting control risk include:
• The environment in which the company operates (its “control
environment”).
• The existence (or lack thereof) and effectiveness of control
procedures.
• Monitoring activities (audit committee, internal audit function, etc.).
 3-35

DETECTION RISK
• Detection risk (DR) is the risk that a material
misstatement would not be caught by audit procedures.
• Factors affecting detection risk include:
• Nature, timing, and extent of audit procedures
• Sampling risk
• Risk of choosing an unrepresentative sample.
• Nonsampling risk
• Risk that the auditor may reach inappropriate conclusions based upon
available evidence.
 3-36
Detection Risk and the Nature, Timing, and
Extent of Audit Procedures

Lower Detection Risk Higher Detection Risk

Nature More effective tests. Less effective tests.

Timing Testing performed at Testing can be performed
year-end. at Interim.
Extent More tests. Fewer tests.
 3-37

EXAMPLE OF THE AUDIT RISK MODEL

• AR =.05 (set by firm) • Low

• IR =.90 (nature of account) • High
• CR =.70 (assessed by auditor) • Medium High
• DR =.08 [.05/(.90 X .70)] • Low
=.08
EXHIBIT 3.8 3-38
MATRIX APPROACH TO DETECTION RISK
DETERMINATION

Control Risk

Low Moderate High

Inherent Low High Moderate to High Moderate

Risk Detection Risk Detection Risk Detection Risk

Moderate Moderate to High Moderate Low to

Detection Risk Detection Risk Moderate
Detection Risk

High Moderate Low to Moderate Low

Detection Risk Detection Risk Detection Risk
 3-39

MORE EXAMPLES
AR IR CR DR?

.05 1.0 .50 .10

.05 .50 .05 2.0?

Low Moderate Moderate Low

Very Low Low High Medium

 3-40

MATERIALITY
• Materiality refers to an amount (or transaction) that
would influence the decisions of users (i.e., an amount
(or event) that would make a difference). The emphasis
is on user, rather than management or the audit team.
• Materiality Criteria:
Quantitative Criteria: Qualitative Criteria
• Absolute size • Nature of the item or issue
• Relative size • Circumstances
• Cumulative effects • Uncertainty
• Ultimately, materiality is a matter of professional judgment.
EXHIBIT 3.9 3-41
MATERIALITY TABLE
Larger of Client
Total Revenues or Total Assets is …

Over But not Over Planning Factor X Excess Over

Materiality
$0 $30 thousand $0 + .0593 X $0
30 thousand 100 thousand 1,780 + .0312 X 30 thousand
100 thousand 300 thousand 3,960 + .0215 X 100 thousand
300 thousand 1 million 8,260 + .0145 X 300 thousand
1 million 3 million 18,400 + .00995 X 1 million
3 million 10 million 38,300 + .00674 X 3 million
10 million 30 million 85,500 + .00461 X 10 million
30 million 100 million 178,000 + .00312 X 30 million
100 million 300 million 396,000 + .00215 X 100 million
300 million 1 billion 826,000 + .00145 X 300 million
1 billion 3 billion 1,840,000 + .000995 X 1 billion
3 billion 10 billion 3,830,000 + .000674 X 3 billion
10 billion 30 billion 8,550,000 + .000461 X 10 billion
30 billion 100 billion 17,800,000 + .000312 X 30 billion
100 billion 300 billion 39,600,000 + .000215 X 100 billion
300 billion ... 82,600,000 + .000148 X 300 billion
Source: AICPA Audit Sampling Guide, AICPA (New York, New York), 2001.
 3-42

GENERAL AUDIT PROCEDURES

• Inspection of records and documents
• Vouching
• Tracing
• Scanning

• Inspection of tangible assets

• Observation
• Inquiry
• Confirmation
• Recalculation
• Reperformance
• Analytical Procedures
 3-43

VOUCHING/TRACING
Q: Did all Summary Listing
recorded sales [Sales Journal]
actually occur?
Tracing
Vouching
(Completeness)
(Existence or Occurrence)

Q: Were all sales

Source Documents recorded?
[Shipping documents]
 3-44

AUDIT PROGRAMS
• A list of the audit procedures the auditors
need to perform to gather sufficient
appropriate evidence on which to base their
opinion on the financial statements.
• Each audit program is based, in part, on the
output of Audit Risk Model.
• Generally one for each major cycle or group of
related accounts.
• Revenue and collection (Chapter 7)
• Acquisition and expenditure (Chapter 8)
• Production (Chapter 9)
• Financing and investing (Chapter 10)
• Signed off as procedures are performed.
 OBJECTIVE 2-2
Identify the four audit evidence
decisions that are needed to create
an audit program.

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 AUDIT EVIDENCE DECISIONS
The auditor must make four major decisions
regarding what evidence to gather and how much 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?
An audit program includes all of the above
information for a given audit.

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 OBJECTIVE 2-3
Specify the characteristics that determine
the persuasiveness of evidence.

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 PERSUASIVENESS OF EVIDENCE

Audit standards require that the auditor accumulate

sufficient appropriate evidence to support the opinion
issued.
The two determinants of the persuasiveness of evidence
are appropriateness and sufficiency.
Appropriateness of evidence depends on:
• Relevance of evidence
• Reliability of evidence

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 PERSUASIVENESS OF EVIDENCE (CONT.)
Relevance of evidence means that the evidence must
pertain to or be relevant to the audit objective that is
being tested.
Reliability of evidence refers to the degree to which evidence is
believable or worthy of trust. Reliability depends on the following
characteristics:
1. Independence of provider
2. Effectiveness of client’s internal controls
3. Auditor’s direct knowledge
4. Qualifications of individuals providing the information
5. Degree of objectivity
6. Timeliness

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 PERSUASIVENESS OF EVIDENCE (CONT.)
Sufficiency of evidence refers to the quantity of evidence obtained.
The sample size that is considered sufficient is affected by two
factors:
• The auditor’s expectation of misstatements
• The effectiveness of the client’s internal controls
Combined Effect—The persuasiveness of the evidence can be
evaluated only after considering the combination of
appropriateness and sufficiency.

In making decisions about audit evidence, both persuasiveness and

cost must be considered. The relationships among evidence
decisions and persuasiveness are illustrated in Table 2-2.

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Copyright ©2012 Pearson Education, Inc. 2-51
 OBJECTIVE 2-4
Identify and apply the eight types of
evidence used in auditing.

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 TYPES OF AUDIT EVIDENCE
Every audit procedure obtains one or more of the following
types of evidence:
1. Physical examination
2. Confirmation
3. Inspection
4. Analytical procedures
5. Inquiries of the client
6. Recalculation
7. Reperformance
8. Observation
Relationships among auditing standards, types of evidence, and the four
audit evidence decisions are shown in Figure 2-1.

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Copyright ©2012 Pearson Education, Inc. 2-54
 TYPES OF AUDIT EVIDENCE (CONT.)
1. Physical Examination—The inspection or count of a tangible asset by the auditor.
2. Confirmation—The receipt of a direct written response from a third party
verifying the accuracy of information that was requested by the auditor.
Information often confirmed is detailed in Table 2-3.
3. Inspection—The auditor’s examination of the client’s documents and records to
substantiate the information in the financial statements.
• Documents can be internal (prepared by the client’s organization) or external
(prepared or handled by someone outside the organization who is a party to
the transaction).
• Using documents to support recorded transactions (occurrence) is called
vouching.
• Testing from source documents to recorded amounts (completeness
objective) is called tracing.

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Copyright ©2012 Pearson Education, Inc. 2-56
 TYPES OF AUDIT EVIDENCE (CONT.)
4. Analytical Procedures—The evaluation of financial information through analysis of
plausible relationships among financial and nonfinancial data and are required
during planning and completion phases of all audits. Purposes of analytical
procedures include:
• Understand the Client’s Industry and Business—Used in planning to gain
knowledge about the client.
• Assess the Entity’s Ability to Continue as a Going Concern—Many ratios can be
an indicator of potential financial problems.
• Indicate the Presence of Possible Misstatements in the Financial Statements—
The presence of unusual fluctuations noted in comparing current and prior
years could signal misstatements.
• Provide Evidence Supporting an Account Balance—If reliable relationships
exist, substantive analytical procedures can be used to support account
balances.

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 TYPES OF AUDIT EVIDENCE (CONT.)

5. Inquiry—Obtaining written or oral information from the client in

response to auditor questions. Usually not considered conclusive
unless it is corroborated.
6. Recalculation—Rechecking a sample of calculations made by the
client.
7. Reperformance—The auditor’s test of client accounting procedures
or controls.
8. Observation—Watching a process or procedure being performed by
others.

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 TYPES OF AUDIT EVIDENCE (CONT.)

Appropriateness of Types of Evidence—Table 2-4 details the criteria to

determine appropriateness. Conclusions from the criteria:
• The effectiveness of a client’s internal controls has significant
influence on the reliability of most types of audit evidence,
especially internal documentation and analytical procedures.
• Physical examination and recalculation involve the auditor’s
direct knowledge and are likely to be highly reliable.
• Inquiry alone is usually not sufficient to provide appropriate
evidence to satisfy any audit objective.

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Copyright ©2012 Pearson Education, Inc. 2-60
 TYPES OF AUDIT EVIDENCE (CONT.)
Cost of Types of Evidence:
• Most expensive:
• Physical examination
• Confirmation
• Moderately costly:
• Inspection
• Analytical procedures
• Reperformance
• Least expensive:
• Observation
• Inquiries of the client
• Recalculation
Terms used in audit procedures are defined in Table 2-5.
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 OBJECTIVE 2-5
Know the types of analytical procedures
and their purposes.

Copyright © 2012 Pearson Education, Inc. 2-64

 ANALYTICAL PROCEDURES
Purposes of Analytical Procedures During the Audit Engagement:
1. Analytical procedures are required in the planning phase as
part of risk assessment to understand the client’s business
and industry.
2. Analytical procedures are often done during the testing phase
of the audit as substantive tests in support of an account
balance.
3. Analytical procedures are required during the completion
phase of the audit, serving as a final review for material
misstatements.

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 ANALYTICAL PROCEDURES (CONT.)

Types of Analytical Procedures—Auditors compare client data with:

1. Industry data
2. Similar prior-period data
3. Client-determined expected results
4. Auditor-determined expected results

Internal comparisons and relationships are detailed in Table 2-6.

An example of a substantive analytical procedure is included in Figure 2-2.

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 OBJECTIVE 2-6
Compute common financial ratios.

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 COMMON FINANCIAL RATIOS
Financial ratios fall into several categories:
• Short-Term Debt-Paying Ability:
• Cash ratio
• Quick ratio
• Current ratio
• Liquidity Activity Ratios:
• Accounts receivable turnover
• Days to collect receivables
• Inventory turnover
• Days to sell inventory

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 COMMON FINANCIAL RATIOS (CONT.)

• Ability to Meet Long-Term Debt Obligations:

• Debt to equity
• Times interest earned
• Profitability Ratios:
• Earnings per share
• Gross profit percentage
• Profit margin
• Return on assets
• Return on common equity

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 OBJECTIVE 2-8
Prepare organized audit documentation.

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 AUDIT DOCUMENTATION
Audit documentation is the record of the audit procedures
performed, relevant audit evidence, and conclusions the auditor
reached.
Purposes of Audit Documentation:
• Basis for planning the audit
• Record of the evidence accumulated and the results of the tests
• Data for determining the proper type of audit report
• Basis for review by supervisors and partners
Ownership of the Audit Files: All audit files are the property of
the auditor.

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 AUDIT DOCUMENTATION (CONT.)

Confidentiality of Audit Files:

The AICPA Code of Professional Conduct states that a member in public
practice shall not disclose any confidential client information without the
specific consent of the client.
Requirements for Retention of Audit Documentation:
• Auditing standards require records of private companies be retained
for a minimum of five years.
• Sarbanes-Oxley Act requires auditors of public companies to maintain
audit files for a minimum of seven years.

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 AUDIT DOCUMENTATION (CONT.)

The contents and organization of a typical set of audit files is illustrated in

Figure 2-3. The type of audit documentation and the way it is arranged in the
files is logical although firms may vary in their approaches.
Permanent Files: Contain data of a historical or continuing nature. These
provide a convenient source of information that is used from year to year:
• Copies of company documents such as articles of incorporation, bylaws, bond
indentures, and long-term contracts
• Analyses of accounts from previous years that have continuing importance
• Information related to understanding internal controls and assessing control
risk
• Results of analytical procedures from prior years’ audits for comparison

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 AUDIT DOCUMENTATION (CONT.)
Current Files: Includes all documentation for the current year audit including:
• Audit Program
• Working Trial Balance—Each line in the trial balance is supported by a lead
schedule. A typical lead schedule for Cash is included in Figure 2-4.
• Adjusting Entries—Auditors propose adjusting entries for material
misstatements. An adjusting entry to Cash is illustrated in Figure 2-4.
• Supporting Schedules—Major types:
• Analysis
• Trial balance or list
• Reconciliation of amounts
• Substantive analytical procedures
• Summary of procedures
• Examination of supporting documentation
• Informational
• Outside documentation
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 AUDIT DOCUMENTATION (CONT.)
Preparation of Audit Documentation—Audit documentation should be in
sufficient detail to provide a clear understanding of the work performed,
evidence obtained, and conclusions reached.
Documentation should have these characteristics:
• Identified with the client’s name, period covered, description of the
contents, initials of the preparer, date of preparation, and an index
code.
• Files should be indexed and cross-referenced to aid in organization.
• Documentation should clearly indicate the audit work performed
through memos, initialing the procedures in the audit program, or tick
marks on the schedules.
• Include sufficient information to fulfill the audit objectives.
• Conclusions reached about the segment of the audit should be clearly
stated.

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Copyright © 2012 Pearson Education, Inc. 2-82
 OBJECTIVE 2-3
Understand the auditor’s
responsibility for assessing the risk
of fraud and detecting material
misstatements due to fraud.

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 ASSESSING THE RISK OF FRAUD

Professional Skepticism—Auditing standards require that the

audit be planned and performed with an attitude of professional
skepticism.
This involves two components:
• Questioning mind
• Critical evaluation of audit evidence

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 ASSESSING THE RISK OF FRAUD (CONT.)

Sources of Information to Assess Fraud Risks (Figure 2-4)

1. Communication Among Audit Team
1. How and where the entity’s financial statements might be susceptible to
material misstatement due to fraud.
2. How management could perpetrate and conceal fraudulent financial
reporting.
3. How anyone might misappropriate assets of the entity
4. How the auditor might respond to the susceptibility of material
misstatements due to fraud.
2. Inquiries of Management
3. Risk Factors
4. Analytical Procedures—See horizontal analysis in Figure 2-5.
5. Other Information

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 ASSESSING THE RISK OF FRAUD (CONT.)

Identified Risks of Material Misstatement Due to Fraud

Auditors evaluate all of the sources of information to assess the risk of
material misstatement due to fraud as part of audit planning.
This assessment continues throughout the audit because the auditor may
learn new information while performing audit procedures.
Auditing standards require that the auditor presume there is a risk of fraud
in revenue recognition. If the auditor concludes that this assumption does
not apply, it must be documented in the working papers.

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