Learn: Auditing Theory Part 2

Overview

Welcome back, future CPAs! Today, we're diving deep into critical concepts from Auditing Theory, focusing on the auditor's responsibilities, the audit engagement process, assurance and related services, audit reports, sampling, substantive testing, and auditing in a computerized environment. By the end of this guide, you'll not only understand the reasoning behind key audit procedures and reporting standards, but also be able to apply professional judgment to real-world audit scenarios and avoid common pitfalls in practice and on your exams.

Concept-by-Concept Deep Dive

Auditor’s Responsibility and Engagement Acceptance

What It Is

An auditor’s responsibilities begin even before accepting an engagement. Their obligations are defined by professional standards, ethical codes, and local regulations. The decision to accept or continue an audit engagement is not automatic and requires careful consideration of risk, independence, and professional competence.

Key Considerations

• Client Integrity: Auditors assess the honesty and reputation of potential clients, including their management.
• Independence and Objectivity: Auditors must avoid situations where their objectivity can be compromised.
• Engagement Terms and Preconditions: Before accepting, auditors must ensure management acknowledges its responsibilities, such as providing all necessary information and unrestricted access.
• Communication with Predecessor Auditor: When a client has been previously audited, the current auditor should communicate with the prior auditor to understand any issues or disagreements.

Reasoning Steps

1. Gather background information and evaluate client integrity.
2. Assess potential conflicts of interest or threats to independence.
3. Confirm management’s responsibilities and willingness to cooperate.
4. For reaudits, obtain permission to communicate with predecessor auditors.

Common Misconceptions

• Assuming independence is only about shareholdings—other relationships matter too.
• Believing engagement acceptance is a mere formality—risk assessment is crucial.

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Audit Sampling and Substantive Testing

What It Is

Audit sampling involves applying audit procedures to less than 100% of items within a population to draw conclusions about the whole. Substantive testing refers to procedures designed to detect material misstatements at the assertion level, including tests of details and analytical procedures.

Types of Sampling

• Statistical Sampling: Uses random selection and probability theory for sample size and evaluation.
• Nonstatistical (Judgmental) Sampling: Relies on auditor’s professional judgment rather than random selection.

Sampling Risks

• Type I (Risk of Incorrect Rejection): The sample supports a conclusion that a balance is materially misstated when it is not.
• Type II (Risk of Incorrect Acceptance): The sample supports a conclusion that a balance is not materially misstated when it actually is.

Steps in Sampling

1. Define the objective and population.
2. Determine sample size (considering detection risk).
3. Select sample items (randomly or judgmentally).
4. Perform audit procedures.
5. Evaluate results and project to the population.

Common Misconceptions

• Believing a larger sample always reduces all types of audit risk.
• Confusing statistical and nonstatistical sampling.

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Audit Reporting and Types of Opinions

What It Is

Auditors express opinions on financial statements through formal reports. The type of opinion depends on the nature and significance of misstatements or limitations encountered during the audit.

Types of Opinions

• Unqualified/Unmodified Opinion: Financial statements are presented fairly, in all material respects.
• Qualified Opinion: Material misstatement or scope limitation, but not pervasive.
• Adverse Opinion: Misstatements are both material and pervasive.
• Disclaimer of Opinion: Unable to obtain sufficient evidence and effects could be both material and pervasive.

Reasoning Steps

1. Evaluate the nature and pervasiveness of misstatements or limitations.
2. Determine the impact on the financial statements as a whole.
3. Decide on the appropriate opinion based on professional standards.

Common Misconceptions

• Thinking a qualified opinion is less serious than it is—clients often find it highly significant.
• Assuming all disagreements with management require a qualified or adverse opinion.

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Computerized Environment and Audit Techniques

What It Is

With the prevalence of computerized accounting systems, auditors must understand IT controls and use specialized techniques to audit effectively in such environments.