Study Guide For Auditing

Hello and, welcome to the TAXATION course.

A student of today should be aware of what Philip Kotler Says, " Future is not Ahead of us, it has already happened". Future businesses and trades will face huge opportunities and challenges as well because; globalization, technologies and deregulation steps across borders have been changing at accelerating pace. Adopting accelerating changes therefore, becomes new millennium challenges for the upcoming managers – the students of today.

So, let get into the business! The first thing that I can tell you is the success of taking this course depends on the amount of time that we are going to spend behind study. Therefore, I would request you all to pay some additional time if possible behind study.

This Study guide gives you an smell of the lesson plan of the whole course. The course is divided into 10 lecture session. You will get 11 lecture classes in total. Of all the classes one lecture is dedicated for mid-term exam.

Obviously, this study guide is divided into ten sections. Each section covers one lecture. Even though you have to go through all the sections thoroughly for learning purpose, yet you need to focus on the areas and issues that are discussed in the real time lectures for exam purpose. I suggest that you take the following approach as you complete each study lesson:

1.     Read the study guide.

2.     Read the relevant areas of each section for exam purpose. Since the exam will consist of short multiple‐choice problems, the more problems you have studied or worked, the easier the exam will be for you.

3.     Read the assigned textbook chapter(s).

4.     Submitted written assignments must be written using Microsoft's Word® word processing program.

5.     Complete and send in the written assignment for the lesson. If you have trouble with some of the problems in the assignment (some of them are difficult), make an attempt at the answer and send in the assignment. Your lecturer will not count off if you have made an honest effort.

6.     I will send your assignment back to you along with the electronic file location (a URL) of the study guide suggested solutions. You should go over these solutions carefully. Not only will they give you the answers to problems you did not understand, they will also give you the correct understanding of the concept and the fact.

Good luck – the future managers! Take care!

A.   PREREQUISITES:

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To take this course and come out successful, students (all the batches) must have completed following Courses:

• Management and corporate accounting
• Management Economics
• Managerial corporate finance

In addition, students must have elementary knowledge of mathematics.

B.   MODULE AIMS:

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Auditing concerns external financial auditing, in which independent auditors will come from a CPA firm to audit a client company’s financial statements. We will concentrate on the process of gathering and evaluating evidence to determine whether the client’s financial statements are fairly presented in accordance with GAAP. We will also see how audit results are reported to readers of the client’s financial statements.

The primary objective of this course is to introduce the basic concepts underlying the audit process. An integrated approach will be taken with the primary emphasis on understanding why and how audits are performed.

The primary objective is to examine the process of gathering and evaluating evidence to determine whether a client company’s financial statements are fairly stated in accordance with GAAP, as well as many reporting issues. We also will examine a number of other issues pertaining to auditors, including accounting and review services, etc.

As we cover topics, we will also discuss how the auditor can minimize audit risk as well as audit risks and procedures relating to auditing in computerized environments. We will also stress ethical issues whenever possible.

C.   LEARNING OUTCOMES:

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These goals will help you meet the following performance objectives. At the conclusion of the course, you should be able to:

·         Describe the complete audit process based upon your knowledge of Accounting Information Systems.

·         Understand audit reports, as well as modifications including audit, attestation, review, and compilation reports.

·         Understand how a basic audit plan is developed.

·         Identify specific issues involving SEC (publicly-traded) audit clients.

·         Relate evidence-gathering to specific issues, including the audit risk model and qualities of evidence.

·         Develop a basic understanding of sampling in tests of transactions.

·         Appreciate, read and comprehend authoritative guidance for auditing.

·         Employ appropriate ethical conduct in your work, as well as understand issues relating to auditor ethics.

·         Research auditing issues on the Internet, as well as other appropriate media.

·         Maintain current competency in auditing after completing the course so that you can keep current with the profession.

·         Understand a basic audit plan.

·         Comprehend statistical sampling in substantive tests.

 What is the distinction between auditing and accounting? 

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Relationship between auditing and accounting:

Auditing and accounting are closely connected but both are separate activities. The directors of a company are responsible for establishing books of accounts that will accurately record financial information and that are used for preparing the annual financial statements. It is similarly the responsibility of the directors to adopt consistent and appropriate accounting policies in order to prepare and present the financial statements. The financial statements have to comply with national legislative requirements and International Financial Reporting Standards (IFRSs).

Accounting is the process of recording, classifying, summarizing and reporting financial information in a logical/systematic manner for the purpose of decision making. To provide relevant & reliable information, accountants must have a thorough understanding of the principles and rules that provide the basis for preparing the financial statements.

In auditing the financial statements, the concern is with determining whether the presented financial statements properly (true and fair) reflect the financial information that occurred during the accounting period. Since auditors are primarily concerned with the end result of this work i.e. do the financial statements show a true and fair view? In order to arrive at their conclusion the auditors must have a deep knowledge and understanding of accounting (including applicable accounting standards) and in practice, the directors will consult with the auditors as to appropriate accounting policies to follow.

Many financial statement users and members of the general public confuse auditing with accounting. The confusion results because most auditing is concerned with accounting information, and many auditors have considerable expertise in accounting matters. The confusion is increased by giving the title “Chartered Accountant” to individuals performing a major portion of the audit function.

 Purpose / Goal of Audit:

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Why is there a need for an audit?

The problem that has always existed at the time when the manager reports to the owners is that: whether the owners will believe the report or not? This is because the reports may:

• Contain errors
• Not disclose fraud
• Be inadvertently misleading
• Be deliberately misleading
• Fail to disclose relevant information
• Fail to conform to regulations
  
  

The solution to this problem of credibility in reports and accounts lies in appointing an independent person called an auditor to examine the financial statements and report on his findings.

A further point is that modern companies can be very large with multi-national activities. The preparation of the accounts of such groups is a very complex operation involving the bringing together and summarizing of accounts of subsidiaries with differing conventions, legal systems and accounting and control systems. The examination of such accounts by independent experts who are trained in the assessment of financial information is of benefit to those who control and operate such organizations as well as to owners and outsiders.

Many financial statements must conform to statutory or other requirements. The most notable is that all company accounts have to conform to the requirements of the Companies Ordinance 1984 but many other bodies (like: Charities, Building Societies, Financial Services business etc) have detailed accounting requirements as required by the relevant legislations. In addition all accounts should conform to the requirements of International Financial Reporting Standards (IFRSs).
It is essential that an audit of financial statements should be carried out to ensure that they conform to these requirements.

Audits are performed to ascertain the validity and reliability of information, and also provide an assessment of a system's internal control. The goal of an audit is to express an opinion on the person/organization/system etc. under evaluation based on work done on a test basis. Due to practical constraints, an audit seeks to provide only reasonable assurance that the statements are free from material error. Hence, statistical sampling is often adopted in audits.In the case of financial audits, a set of financial statements are said to be true and fair when they are free of material misstatements - a concept influenced by both quantitative and qualitative factors.

Traditionally audits were mainly associated with gaining information about financial systems and the financial records of a company or a business. However recently auditing has begun to include other information about the system, such as information about environmental performance. As a result there are now professions that conduct environmental audits.

Such systems must adhere to generally accepted standards set by governing bodies that regulate businesses. It simply provides assurance for third parties or external users that such statements present 'fairly' a company's financial condition and results of operations.

Types of Auditors:

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There are two types of auditors:

• Internal auditors generally directly report to the top management of the company. As employees of the organization, they may have an inside track on noticing fraud or certain other occurrences. Internal auditors are employees of a company hired to assess and evaluate its system of internal control. To maintain independence, they present their reports directly to the board of directors or to top management. They provide functional operation to the concern. Internal auditors are employees of the company so that they can easily find out the frauds and any mishappening.

• External auditors come from an outside accounting firm in order to evaluate the company's financial statements. Many external audits done fall into the category of the "big four," the mid-tier range, or affiliates of the big four. External auditors are independent staff assigned by an auditing firm to assess and evaluate financial statements of their clients or to perform other agreed upon evaluations. Most external auditors are employed by accounting firms for annual engagements. They are called upon from the out side of the company.

An External auditor is an audit professional who performs an audit on the financial statements of a company, government, individual, or any other legal entity or organization, and who is independent of the entity being audited. Users of these entities' financial information, such as investors, government agencies, and the general public, rely on the external auditor to present an unbiased andindependent evaluation on such entities. They are distinguished from internal auditors for two main reasons:

(1)   The internal auditor's primary responsibility is appraising an entity's risk management strategy and practices, management (including IT) control frameworks and governance processes, and

(2)   They do not express an opinion on the entity's financial statements.

Besides providing audit services, external auditors also provide different other kind of services. Most common of them are reviews of financial statements and compilation. In review auditors are generally required to tick and tie numbers to general ledger and make inquiries of management. In compilation auditors are required to take a look at financial statement to make sure they are free of obvious misstatements and errors.

The primary role of external auditors is to express an opinion on whether an entity's financial statements are free of material misstatements.

Some people confuse auditors with people who detect fraud but auditors have nothing to do with fraud detection exclusively. Auditors just want to make sure that company's financial statements are true and fair representation of its actual position. If they come across any fraud related information, it is their responsibility to bring it to the management's attention and consider withdrawing from the engagement if management does not take appropriate actions. Normally, external auditors review the entity's information technology control procedures when assessing its overall internal controls. They must also investigate any material issues raised by inquiries from professional or regulatory authorities, such as the local taxing authority. For public companies listed on stock exchanges in the United States, the Sarbanes-Oxley Act (SOX) has imposed stringent requirements on external auditors in their evaluation of internal controls and financial reporting.

The independence of external auditors is crucial to a correct and thorough appraisal of an entity's financial controls and statements. Any relationship between the external auditors and the entity, other than retention for the audit itself, must be disclosed in the external auditor's reports. These rules also prohibit the auditor from owning a stake in public clients and severely limits the types of non-audit services they can provide.

In the United States, certified public accountants are the only authorized non-governmental type of external auditors who may perform audits and attestations on an entity's financial statements and provide reports on such audits for public review. In the UK, Canada and other Commonwealth nations Chartered Accountants have served this role.

Who can be an auditor?

For appointment as auditor of:

• a Public Company or
• a Private Company which is a subsidiary of a Public Company.

a Private Company having paid up capital of three million rupees or more.

Major auditing firms:

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The four largest accounting firms in the world are collectively referred to as the Big Four. They are as follows:

• PricewaterhouseCoopers, also known as PwC
• Ernst & Young, also known as EY
• KPMG
• Deloitte Touche Tohmatsu, also known as Deloitte

There are many other audit firms competing with the big four for major audit engagements. Competition has intensified in response to independence issues and other legislative requirements introduced as a consequence of the Arthur Andersen Scandal. In the US and Australia, these firms are referred to as "mid-tier". Some of these include: BDO International, Moore Stephens LLP, Grant Thornton International, McGladrey & Pullen, Hall Chadwick, Dauby O'Connor & Zaleski, LLC, PKF, Pitcher Partners, Johnson Lambert & Co. LLP, Beard Miller Company, DFK International, Horwath International, and UHY firm.

In the UK the medium sized firms are also referred to as mid-tier. Many of these firms are international and increasingly are competing for work against the Big Four, especially following the recent large auditing scandals.

Auditing firms around the world:

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While the four major audit firms listed above provide audit services to the largest corporations in the United States of America, audit firms around the world are also in partnership with the Big Four. Since corporations held offices in other parts of the world, they tend to be audited by affiliates of the Big Four to maintain consistency and uniformity in their application of auditing standards.Types of Audits:

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Types of Audits can be discussed in many dimension.

Quality audits

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Quality audits are performed to verify the effectiveness of a quality management system. This is part of certifications such as ISO 9001. They are essential to verify existence of objective evidence of processes, to assess how successfully processes have been implemented, for judging the effectiveness of achieving any defined target levels, provide evidence concerning reduction and elimination of problem areas, and are a hands-on management tool for achieving continual improvement in an organization.

For the benefit of the organization, quality auditing should not only report non-conformances and corrective actions, but also highlight areas of good practice. In this way other departments may share information and amend their working practices as a result, also enhancing continual improvement.

 

Integrated audits:

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In the US, audits of publicly-listed companies are governed by rules laid down by the Public Company Accounting Oversight Board (PCAOB). Such an audit is called an Integrated Audit, and auditors have the additional responsibilities of expressing opinions on management's assessment of the firm's internal control, and on the effectiveness of internal control over financial reporting based on their (the auditors') own assessment.

Three types of audits are discussed in general, i.e.,

1. Financial statement audits
2. Operational audits
3. Compliance audits

 

Financial Statement Audits

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An audit of financial statements is conducted to determine whether the overall financial statements (the quantifiable information being verified) are stated in accordance with specified criteria. Normally, the criteria are the requirements of the applicable International Financial Reporting Standards (IFRSs). The financial statements most commonly comprises of the Balance Sheet, Income Statement, Statement of Changes in Equity, Cash Flow Statement, and Notes to the accounts. 

The assumption underlying an audit of financial statements is that these will be used by different groups for different purposes. Therefore, it is more efficient to have one auditor who will perform an audit and draw conclusions that can be relied upon by all users than to have each user perform his or her own audit. If a user believes that the general audit does not provide sufficient information for his or her purposes, the user has the option of obtaining more data. For example, a general audit of a business may provide sufficient financial information for a banker considering a loan to the company, but a corporation considering a merger with that business may also wish to know the replacement cost of fixed assets and other information relevant to the decision. The corporation may use its own auditors to get the additional information.

 

Operational Audits:

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An operational audit is a review of any part of an entity’s operating procedures and methods for the purpose of evaluating efficiency and effectiveness. At the completion of an operational audit, recommendations to management for improving operation are normally expected. An example of an operational audit is evaluating the efficiency and accuracy of processing payroll transactions in a newly installed computer system. Another example, where most accountants would feel less qualified is evaluating the efficiency, accuracy, and customer satisfaction in processing the distribution of letters and parcels by a courier company such as TCS.

Because of the many different areas in which operational effectiveness can be evaluated, it is impossible to characterize the conduct of a typical operational audit. In one organization, the auditor might evaluate the relevancy and sufficiency of the information used by management in making decisions to acquire new fixed assets, while in a different organization the auditor might evaluate the efficiency of the paper flow in processing sales.

In operational auditing, the reviews are not limited to accounting. They can include the evaluation of organization structure, computer operations, production methods, marketing, and any other area in which the auditor is qualified.

The conduct of an operational audit and the reported results are less easily defined than for either of the other two types of audits. Efficiency and effectiveness of operations are far more difficult to evaluate objectively than compliance or the presentation of financial statements in accordance with accounting conventions and principles; and establishing criteria for evaluating the quantifiable information in an operational audit is an extremely subjective matter.
In this sense, operational auditing is more like “management consulting” than what is generally regarded as “auditing”. Operational auditing has increased in importance in the past decade.

Compliance Audits:

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The purpose of a compliance audit is to determine whether the entity is following specific procedures, rules, or regulations set down by some higher authority. A compliance audit for a private business could include determining whether accounting personnel are following the procedures prescribed by the company controller, reviewing wage rates for compliance with minimum wage laws, or examining contractual agreements with bankers and other lenders to be sure the company is complying with legal requirements. In the audit of governmental units such as districts school, there is extensive compliance auditing due to extensive regulation by higher government authorities. In virtually every private and non profit organization,

there are prescribed policies, contractual agreements, and legal requirements that may call for compliance auditing. Results of compliance audits are typically reported to someone within the entity being audited rather than to a broad spectrum of users. Management, as opposed to outside users, is the primary group concerned with the extent of compliance with certain prescribed procedures and regulations. Hence, a significant portion of work of this type is done by auditors employed by the entity itself. There are exceptions; when an organization wants to determine whether individuals or entities that are obligated to follow its requirements are actually complying, the auditor is employed by the entity issuing the requirements. An example is the auditing of taxpayers for compliance with the federal tax laws, where the auditor is employed by the government to audit the taxpayers’ tax returns. 

Source Documents ( Invoices, Checks, etc.)
Journals -Transactions first recorded using Debits and Credits
General Ledger -Summarized transactions posted to the General Ledger Accounts using Debits and Credits
Abbreviated Accounting Equation	Property =		Property Rights
Expanded Accounting Equation	Assets =		Liabilities +		Owner's Equity
	Balance Sheet Accounts Permanent Accounts
Types Of Accounts	Asset Accounts =		Liability Accounts +		Capital Accounts (Mom)
Increase/Decrease Columns	Increase	Decrease	Decrease	Increase	Decrease	Increase
Account -Left / Right Side Columns	Left Side	Right Side	Left Side	Right Side	Left Side	Right Side
Debit / Credit Columns	Debit	Credit	Debit	Credit	Debit	Credit
Owner's Equity Equation that illustrates the effect of closing the temporary accounts -revenue-expenses-draws to the permanent Equity Accounts.					Owner's Equity = Beginning Capital + Profit or - Loss - Owners Draws + Owner's Investments
					Income Statement Accounts
Accounts Closed To Capital Account at End Of Period					Temporary (Nominal) Accounts
"Mom" Equity's "Kids" - Revenue - Expense - Draws					Expenses Draws	Revenue
Effect On "Mom" Equity (Capital)					Decreases	Increases
Revenue , Expense, and Draw Account "Rules" These accounts are often referred to as temporary or nominal accounts because at the end of a year (period) they are closed and their balances are transferred to a permanent Equity (Capital) Account (Balance Sheet Account). Debit / Credit Columns					Increase Decrease Decrease Increase Left Side Right Side Left Side Right Side Debit Credit Debit Credit
Profit / Loss Equation					Profit / Loss = Revenue - Costs and Expenses

Note: Yellow highlighted items in my cheat sheet represent the Normal Type Of Balance For an Account - Debit or Credit

The purpose of the table above is to serve as an aid for those needing help in determining how to record the debits and credits for a transaction.

The table begins by illustrating that source documents such as sales invoices and checks are analyzed and then recorded in Journals using debits and credits. These Journals are then summarized and the debit and credit balances are posted (transferred) to the General Ledger Accounts and the amounts are posted to the left side of the general ledger accounts for debit balances and to the right side of the general ledger accounts for credit balances. The General Ledger Accounts are made up of Balance Sheet and Income Statement Accounts.

Account Definition:

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An Account is a separate record for each type of asset, liability, equity, revenue, and expense used to show the beginning balance and to record the increases and decreases for a period and the resulting ending balance at the end of a period.

You should be aware that all Accounts:

• Can Be Debited and Credited
• Have an Increase Side and a Decrease Side
• Have a Debit Side and a Credit Side
      Debit Side is the Left Side (Left Column)
      Credit Side is the Right Side (Right Column)
• Have a Normal Balance Amount that is normally a Debit Balance or a Credit Balance
• Have a Type and are classified as an Asset, Liability, Equity, Revenue, Expense, or Draw
• Are Either a Balance Sheet or Income Statement Account