CHAPTER FOUR

AUDIT RESPONSIBILITY, OBJECTIVES,

EVIDENCE AND RECORDING THE AUDIT
 Audit Responsibility
ISA 240, The Auditor's Responsibilities Relating to
Fraud in an Audit of Financial Statements
1. Responsibility for the Prevention and Detection of
Fraud:
 The prevention and detection of fraud rests with both those
charged with governance of the entity and management.

 It is important that management, with the oversight of

those charged with governance, place a strong emphasis on:
 fraud prevention
 fraud deterrence
 Responsibilities of the Auditor
 An auditor conducting an audit in accordance with
ISAs is responsible for obtaining reasonable
assurance that the financial statements taken as a
whole are free from material misstatement, whether
caused by fraud or error.

 Owing to the inherent limitations of an audit, there is

an unavoidable risk that some material misstatements
of the financial statements may not be detected, even
though the audit is properly planned and performed in
accordance with the ISAs.
 Potential effects of inherent limitations are
particularly significant in the case of misstatement
resulting from fraud.

 The risk of not detecting a material misstatement

resulting from fraud is higher than the risk of not
detecting one resulting from error.
 This is because fraud may involve sophisticated and
carefully organized schemes designed to conceal it,
such as forgery, deliberate failure to record
transactions, or intentional misrepresentations
being made to the auditor.

 Such attempts at concealment may be even more

difficult to detect when accompanied by collusion.

 Collusion may cause the auditor to believe that

audit evidence is persuasive when it is, in fact, false.
 The auditor’s ability to detect a fraud depends on factors
such as the skillfulness of the perpetrator, the frequency and
extent of manipulation, the degree of collusion involved, the
relative size of individual amounts manipulated, and the
seniority of those individuals involved.

 The risk of the auditor not detecting a material misstatement

resulting from management fraud is greater than for
employee fraud, because management is frequently in a
position to directly or indirectly manipulate accounting
records, present fraudulent financial information or override
controls designed to prevent similar frauds by other
employees.
 The auditor is responsible for maintaining
professional skepticism throughout the audit,
considering the potential for management
override of controls and recognizing the fact that
audit procedures that are effective for detecting
error may not be effective in detecting fraud.

 The auditor may have additional responsibilities

under law, regulation or relevant ethical
requirements regarding an entity’s non-
compliance
a. Responding to identified or suspected non-
compliance with laws and regulations

b. Communicating identified or suspected non-

compliance with laws and regulations to other
auditors

c. Documentation requirements regarding identified or

suspected non-compliance with laws and regulations.
 Management Assertions
 Management assertions are claims made by
members of management regarding certain aspects
of a business.

 The concept is primarily used in regard to the audit

of a company's financial statements, where the
auditors rely upon a variety of assertions regarding
the business.

 The auditors test the validity of these assertions by

conducting a number of audit tests.
Management assertions fall into the following three
classifications.
1. Transaction-Level Assertions

 The following five items are classified as assertions related to

transactions, mostly in regard to the income statement:

Accuracy: The assertion is that the full amounts of all

transactions were recorded, without error.

Classification: The assertion is that all transactions have been

recorded within the correct accounts in the general ledger.
Completeness: The assertion is that all business
events to which the company was subjected
were recorded.

Cutoff: The assertion is that all transactions

were recorded within the correct reporting
period.

Occurrence: The assertion is that recorded

business transactions actually took place
2. Account Balance Assertions

 The following four items are classified as assertions related to the

ending balances in accounts, and so relate primarily to the balance
sheet:

Completeness: The assertion is that all reported asset, liability, and

equity balances have been fully reported.

Existence: The assertion is that all account balances exist for assets,
liabilities, and equity.

Rights and obligations: The assertion is that the entity has the rights to
the assets it owns and is obligated under its reported liabilities.
Valuation: The assertion is that all asset, liability, and equity balances
have been recorded at their proper valuations

3. Presentation and Disclosure Assertions

 The following five items are classified as assertions related

to the presentation of information within the financial
statements, as well as the accompanying disclosures:

Accuracy: The assertion is that all information disclosed is in

the correct amounts, and which reflect their proper values.
Completeness: The assertion is that all transactions that should
be disclosed have been disclosed.

Occurrence: The assertion is that disclosed transactions have

indeed occurred.

Rights and obligations: The assertion is that disclosed rights and

obligations actually relate to the reporting entity.

Understandability: The assertion is that the information included

in the financial statements has been appropriately presented and
is clearly understandable.
 There is a fair amount of duplication in the types of assertions
across the three categories; however, each assertion type is
intended for a different aspect of the financial statements, with
the first set related to the income statement, the second set to the
balance sheet, and the third set to the accompanying disclosures.

 If the auditor is unable to obtain a letter containing management

assertions from the senior management of a client, the auditor is
unlikely to proceed with audit activities.

 One reason for not proceeding with an audit is that the inability to
obtain a management assertions letter could be an indicator that
management has engaged in fraud in producing the financial
statements.
 Audit Objectives
 In conducting an audit of financial statements, the overall
objectives of the auditor are:

 To obtain reasonable assurance about whether the financial

statements as a whole are free from material misstatement,
whether due to fraud or error, thereby enabling the auditor to
express an opinion on whether the financial statements are
prepared, in all material respects, in accordance with an
applicable financial reporting framework

 To report on the financial statements, and communicate as

required by the ISAs, in accordance with the auditor’s
findings.
 The following table shows management assertions, general audit
objectives and specific audit objectives for inventory.
Management Assertion General Objective Specific Audit Objective
All recorded inventory exist at the balance sheet date
Existence or Occurrence Validity
All existing inventory has been included in the
Completeness Completeness
account
The company has title to all inventory items listed
Rights and Obligations Ownership
Inventory quantity agrees with items physical on
Valuation or Allocation Valuation
hand
Price used to value inventory are correct
Inventory items are properly classified to raw
classification
material, work in process and finished goods

cutoff Purchase and sales cut off at the end is proper

Total of inventory items agree with general ledger
Detail tie in
Inventory quantity on clients perpetual record agree
  Accuracy
with items physically on hand
The pledge and consignment of inventory is
Presentation and Disclosure Disclosure
disclosed
 Audit Evidence
 The foundation of any audit is the evidence gathered and
evaluated by the auditor.

 The auditor must have the knowledge and skill to accumulate

sufficient and competent evidence to every audit to meet the
standards of profession.

Nature of Evidence:

 Audit evidence is any information used by the auditor to

determine whether the information being audited is stated in
accordance with the established criteria.
 Evidence includes information that is highly persuasive, such
as the auditor's count of marketable securities, and less
persuasive information, such as response to questions of
client employees.

The Audit Evidence Decision:

 A major decision facing every auditor is determining the

appropriate types and amounts of evidence to accumulate to
be satisfied that the components of the client's financial
statements and the overall statements are fairly stated.
 The auditor's decision on evidence accumulation can be
broken down into the following four sub decisions.

1) Which audit procedure 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 procedure

Persuasiveness of Evidence:
 Because of the nature of the audit evidence and the cost
consideration of doing an audit it is unlikely that the auditor will be
completely convinced that the opinion is correct.

 However, the auditor must be persuaded that his/her opinion is

correct with a high level of assurance.

 The two determines of the persuasiveness of evidence are

Competence and sufficiency

 Competence of evidence deals only with the audit procedures

selected.

 Competence can not be improved by selecting a larger sample size or

different population items.
 It can be improved only by selecting audit procedures that
contain a higher quality of one or more of the following seven
characteristics of the competent evidence: Relevance,
independence of provider, effectiveness of client's internal
control, auditor's direct knowledge, qualification of individuals
proving the information, degree of objectivity, and timeliness.

 Sufficiency of evidence is measured primarily by the sample size

the auditor selects.

 For a given audit procedure, the evidence obtained from a

sample size of 200 would ordinarily be more sufficient than from
a sample of 100.

 Several factors determine the appropriate sample size in audit.

 The two most important ones are:

1. The auditor's expectation of misstatement

2. Effectiveness of internal control

 Persuasiveness of evidence can be evaluated only after

considering the combination of competence and sufficiency,
including the effects of the factors influencing competence
and sufficiency.
 Types of Audit Evidence
 In making which audit procedures to use, the auditor can
choose from seven broad categories of evidence

1. Physical examination
2. Confirmation
3. Documentation
4. Observation
5. Inquiry of the client
6. Re-performance
7. Analytical Procedure
Information Source
Cash in bank Bank
Accounts receivable Customers
Notes Receivable Maker
Owned inventory on Consignment Consignee
Accounts Payable Creditor
Notes Payable Lender
Advance from Customers Customer
Mortgage Payables Mortgager
Bonds Payable Bondholder
Shares Outstanding Register and transfer agent
Insurance Coverage Insurance company
Contingent Liabilities Bank, Lender and Client's legal counsel
Bond Issuance agreements Bondholder
Collateral held by Creditors Creditor