Lessons1 3

ACCT 460
Principles of Auditing
Lesson 1: Introduction to Auditing
Introduction
Objectives and Reading

Lesson 1 provides information about the nature of auditing and the influences on auditing
activities. Auditing provides services to society. Many companies that are incorporated
under federal or provincial law must have an annual financial statement audit. Auditors
include public accountants, government auditors, and internal auditors. In this lesson, we
describe
z auditing and why it is needed

z various types of audits and auditors
z professional accounting organizations
z the economics of financial statement auditing
z how quality control in audits is maintained.
This lesson also introduces generally accepted auditing standards (GAAS).
Objectives
When you have completed Lesson 1, you should be able to accomplish the following
objectives.
1. Define auditing and distinguish between auditing and accounting.
2. Describe the different types of audits and auditors.
3. State the reason for audits.
4. Identify the generally accepted auditing standards (GAAS) set by the Canadian Institute
of Chartered Accountants.
5. Explain how quality control is exercised over public accounting firms.
6. Describe the parts of the auditor’s reports.
7. Explain the concept of materiality.
8. Identify the different categories of audit reports and describe the circumstances under
which each type of audit report should be rendered.
9. Identify the auditor’s reporting responsibilities.
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10. Identify the factors that give rise to litigation.
11. Identify the major sources of litigation against public accountants.
Reading
z Chapters 1, 3, and 4 in the textbook

z Lesson 1 Notes
z Lesson 1 Audio Notes (9.8 MB) (zipped .mp3 files)
Note: Audio Notes are an alternative to supplement the .html Notes on the
following Web pages. Some elements of the .html Notes (e.g., tables, figures,
sample reports) are not reproduced in audio format, and a few others may be
mispronounced or misinterpreted by the text-reading program. If you have any
difficulties understanding the Audio Notes, refer to the .html format, or contact
the Call Centre for assistance.
Working Through This Lesson

After you complete the readings, review the objectives to ensure you have mastered them
all. If you are unsure about one or more of the objectives, reread the relevant passages
from the textbook or the Lesson Notes. If you still do not understand the objectives or the
readings, contact the Call Centre, and your query will be forwarded to an Academic Expert.
Textbook Lesson
Topic Objective
Reference Note
Definition 1 pp. 3–7 1
Types of Audits 2 pp. 7-13 2, 3, 4
Reason for Auditing 3 pp. 14-17 5
GAAS 4 pp. 18-21 6
Quality Control of Audit Firms 5 pp. 22-26 7
Auditor’s Report 6 pp. 64-66 8
Materiality 7 pp. 56-63 9
Reservations 8 pp. 66-70 10
Reporting Obligations 9 pp. 70-72 11
Causes of Liability 10 pp. 80-87 12
Sources of Liability 11 pp. 87-102 12
As you proceed through your readings, follow the numbered objectives in the table above.
These numbers correspond to the list of objectives in Lesson 1. You may also find this table
useful when preparing for the Final Examination.
Lesson Notes
Note 1: Definition of Auditing
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Auditing is a process by which a competent, independent person gathers, assesses, and
reports on financial and operational data about an organization as evidence in determining
whether certain criteria about that data have been met.
Note 2: Types of Audits

Financial Statement Audit
A financial statement audit involves the examination of financial statements to determine if

they are in accordance with generally accepted accounting principles (GAAP), cash basis, or
with some other appropriately disclosed basis of accounting for certain types of
organizations. It is the most common type of audit for businesses. The underlying reason
for performing such an audit is to add credibility to the financial statements. Business
owners, creditors, government agencies, labour unions, and other external users of the
financial statements rely on this information, and their reliance will be more easily obtained
if the information is audited.
Any company that publicly trades its securities is required to have an audit. The company’s
banker or owners may also request that the financial statements be audited. The financial
statements include the balance sheet, income statement, statement of retained earnings,
cash flow statement, and the footnotes.
Operational Audit
An operational audit focuses on the organization’s operating procedures to evaluate their

economy, effectiveness, and efficiency. Performance criteria are usually set by management
and do not necessarily have to be defined in dollar amounts. Operational audits are not
limited to accounting and are therefore more difficult to evaluate objectively than
compliance or financial statement audits. For example, an operational audit may be done to
determine if a company has too many, or too few, tankers in its shipping fleet. The end
result of this audit is a list of recommendations to management for improving operations.
Compliance Audit
A compliance audit is conducted to determine whether an organization is following certain

procedures and policies as designed by management, or whether the organization is
complying with the terms of certain contracts, agreements, and legal requirements that it
must follow. The auditor reports the results to the specific entity that issued the
requirements (whether it is management or a government agency) rather than to many
outside users, as in the case of a financial statement audit.
Comprehensive Audit
A comprehensive audit is a combination of all of the types of audits previously described.

Most of the literature about comprehensive audits concerns the work done by the Auditor
General for various government departments and agencies. This audit not only involves an
examination of financial statements, but also may reveal an inefficient use of resources by
these government agencies.
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Note 3: Types of Auditors
External Independent Auditors (Public Accountants)
Most financial statement audits are conducted by external auditors who are not employees
of the company being audited. If external auditors were company employees, the credibility
of their work would be questioned by the users of the financial statements. These auditors
are hired by the shareholders and represent their interests. As the size of corporations has
grown, so too has the size of many major external audit firms such as KPMG,
PricewaterhouseCoopers, Ernst & Young, and Deloitte & Touche. These large international
firms, as well as smaller national and regional firms, not only conduct financial statement
audits, but also perform compliance and operational audits and provide bookkeeping, tax,
and management consulting services.
Government Auditors
Auditors General are appointed by government. Government auditors are legislated by

various jurisdictions to conduct all types of audits for the ministries, departments, and
agencies that report to the government. Note, however, that even though these auditors
are employees of the government, they are considered to be independent enough to audit
other government departments.
Canada Revenue Agency Auditors
Canada Revenue Agency auditors perform compliance audits of taxpayers to determine

whether or not they have complied with government regulations such as personal tax laws,
corporate tax laws, goods and services tax laws, and trusts laws.
Internal Auditors
Internal auditors are not independent of the company that employs them, unlike external
auditors, who must be independent. Internal auditors conduct audits of a financial,
compliance, or operational nature in various departments or areas of the business. Their in–
depth knowledge of the business allows them to examine more detailed transactions and
practices than an external auditor would examine. Internal auditors often assist the
external auditor with their work.
Internal auditors are commonly employed by larger businesses, where it is economical to

have such a group performing audits. To enhance their effectiveness, most internal audit
groups report directly to senior personnel, to a high executive officer, or to the audit
committee of the board of directors. Internal auditors strive to remain independent from
the accounting or other personnel whose work they will be examining. Their reports provide
organizations with information that helps them conduct their operations in an efficient and
effective manner.
Note 4: Professional Accounting and Auditing Organizations

Depending on provincial law, the role of auditing may be restricted to members of
professional organizations. Members of the following organizations conduct audits in most
Canadian provinces.
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Canadian Institute of Chartered Accountants (CICA)
Certified General Accountants of Canada (CGA-Canada)
Society of Management Accountants of Canada (CMA Canada)
The Institute of Internal Auditors (IIA) This international organization has headquarters in
the United States
Note 5: Reasons for Auditing

Users of financial information may need to have audits performed for one or more of the
following reasons.
Remoteness of the Information
The owners and creditors of a business do not have access to the daily financial records of
the company, and therefore they rely heavily on the company’s financial statements about
the enterprise, which are the primary source of financial information about the organization.
Bias and Motives of Management
The management and employees of a company may have goals and objectives that differ
from those of the owners. For example, management and employees may wish to maximize
earnings because their year-end bonuses are based on a percentage of net income. The
owners, on the other hand, may wish to minimize net income so that income taxes will be
reduced. The best way the owners have of ensuring their goals are met is to hire
independent auditors to conduct an examination of the financial statements and accounting
policies of the business.
Voluminous Data
As a company grows, so does the volume of its transactions. It is almost impossible for
users of the financial statements—even with access to all of the accounting records—to
examine the large number of transactions recorded in the company’s accounts. It is more
economical to have an auditor examine these records and present an audit report to all
users of the data.
Complexity of Transactions
Because of the complexity of many financial transactions, users of financial information

generally prefer to have a financial expert examine complex transactions from an
independent point of view.
Note 6: Generally Accepted Auditing Standards (GAAS)

The Canadian Institute of Chartered Accountants (CICA), through the Canada Business
Corporations Act and each provincial corporation Act, has the authority to set the
accounting and auditing standards that public accountants must follow when they perform
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audits. This authority has also been given to the CICA by Canadian securities administrators
in their National Policy Statement 27 .
The auditing standards for the CICA are found in the CICA Handbook , which contains two
assurance volumes that consist of two sections: “Assurance Recommendations” and
“Assurance and Related Services Guidelines.” The latter contains interpretations of the
Assurance Recommendations, or views of the Auditing and Assurance Standards Board.
General Standard
The examination should be performed and the report prepared by a person or persons
having adequate technical training and proficiency in auditing, with due care and with an
objective state of mind. (CICA Handbook , Section 5100)
The key words in this standard are proficiency , due care , and an objective state of mind .
Most auditors adhere to these standards by having rigorous training programs and by
ensuring that they have no ownership interests in their clients’ companies.
Examination Standards
1. The work should be adequately planned and properly executed. If assistants are
employed they should be properly supervised.
2. A sufficient understanding of internal control should be obtained to plan the audit. When
control risk is assessed below maximum, sufficient appropriate audit evidence should be
obtained through tests of controls to support the assessment. (CICA Handbook,
Section 5100)
In larger businesses, it would not be economical for an auditor to examine every

transaction into which the business had entered. The only way the auditor could
conclude, for example, that sales are stated fairly would be to test the internal control
system that recorded sales transactions and to establish that the system was operating
effectively. If it was, then control risk would be considered less than maximum, and the
system could be relied on to generate data that was fairly stated. Control risk is the risk
that the system of internal controls will fail to prevent or to detect errors. (Control risk
is covered in more detail in Lessons 3 and 4.) If the system of internal controls was not
very good, control risk would be assessed at maximum, and the auditor would then
have to examine many more sales transactions before being able to render an opinion
that the sales were fairly stated. This additional work would be performed because the
controls could not be relied on to generate information that was fairly stated.
3. Sufficient appropriate audit evidence should be obtained, by such means as inspection,

observation, inquiry, confirmation, computation, and analysis, to afford a reasonable
basis to support the content of the report. (CICA Handbook , Section 5100)
This standard requires the auditor to obtain evidence to substantiate the account
balances shown in the financial statements at year-end.
Reporting Standards
Auditors’ reports generally precede the financial statements in any annual report of a
business. These standards give guidance to auditors on how their report should be worded.
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1. The report should identify the financial statements and distinguish between the
responsibilities of management and of the auditor.
2. The report should describe the scope of the auditor’s examination.
3. The report should contain either an expression of opinion on the financial statements or
an assertion that an opinion cannot be expressed. In the latter case, the reasons
therefore should be stated.
4. Where an opinion is expressed, it should indicate whether the financial statements

present fairly, in all material respects, the financial position, results of operations, and
cash flows in accordance with an appropriate disclosed basis of accounting, which
except in special circumstances should be generally accepted accounting principles
(GAAP). For a basis of accounting other than GAAP see paragraph 5600.09 and section
PS 5200 of the CICA Handbook . The report should provide adequate explanation with
respect to any reservation contained in such opinion. (CICA Handbook , Section 5100)
These standards are reviewed in more detail in the next section of Lesson 1 on audit
reports (Notes 8, 9, and 10).
When a standard for a specific issue does not exist in the CICA Handbook , the auditor must
turn to other authoritative sources. These sources may be standards issued by AICPA, ASB,
or PCAOB (all in the US), by the International Federation of Accountants, or textbooks and
journals published by these associations.
Many countries have developed their own auditing standards, and in an effort to ensure
some uniformity across the world, international guidelines have been established; these
guidelines do not, however, take precedence over the CICA Handbook .
Note 7: Quality Control of Audit Firms

In July of 2002, the Sarbanes-Oxley Act (SOX) was legislated in The Unites States, as a
result of bankruptcies and alleged audit failures involving Enron and WorldCom. In the
United States, one impact of SOX was the establishment of the Public Company Accounting
Oversight Board (PCAOB), appointed and overseen by the Securities and Exchange
Commission (SEC). The PCAOB is responsible for establishing auditing and quality control
standards for public company audits, and for inspecting the quality controls at audit firms
responsible for performing public company audits.
These events have caused the accounting profession in Canada to take a long look at, and
to reassess, the processes and standards used in audits. In Canada effective December 1,
2005, the CICA adopted quality control standards for audits. As a result, massive revisions
of the CICA Handbook in 2005 reflect a more risk-based approach to auditing. Another
outcome was the formation of the Canadian Public Accountability Board (CPAB). The CICA
Assurance Handbook Section GSF-QC lists the “Elements of Quality Controls at the Firm
Level.” These general standards of quality controls apply to public accounting firms that
perform assurance engagements. These standards list the policies and procedures that the
audit firms should have in place. A summary of these standards is presented in Table 1-2
on page 23 of your textbook. The impact of these standards will be discussed in more detail
in subsequent lessons. The CPAB performs regular inspections of the public accounting
firms that audit Canadian public companies.
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A major difference between the PCAOB (US) and the CPAB (Cdn) is that the PCAOB is also
responsible for developing auditing standards for public companies (formally done by
AICPA), while in Canada that responsibility still lies with the CICA.
Note 8: The Auditor’s Report

Section 5400 of the CICA Handbook is a major source of information for this Lesson Note.
Standard Unqualified
A standard unqualified auditor’s report is issued when
z audit engagement has been undertaken for the purpose of expressing an opinion on the
financial statements
z generally accepted auditing standards (GAAS) have been followed; see Note 6
z no significant misstatements have been discovered or left uncorrected
z the financial statements are fairly stated and in accordance with GAAP
z no circumstances exist that would require modifying the wording of the report or adding
an additional explanatory paragraph.
Standard Report (CICA Handbook , Section 5400)
Auditor’s Report
To the Shareholders of (name of company) :
I have audited the (consolidated) balance sheet of (name of company) as at

(date) , (year) and the (consolidated) statements of income, retained earnings and
cash flows for the year then ended. These financial statements are the responsibility of the
company’s management. My responsibility is to express an opinion on these financial
statements based on my audit.
I conducted my audit in accordance with Canadian generally accepted auditing standards.

Those standards require that I plan and perform an audit to obtain reasonable assurance
whether the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial
statement presentation.
In my opinion, these (consolidated) financial statements present fairly, in all material

respects, the financial position of the company as at (date) , (year) and the results of
its operations and the cash flows for the year then ended in accordance with Canadian
generally accepted accounting principles.
City (signed) (name of accounting firm)
Date Chartered Accountant
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Key features of the auditor’s report include the following:
1. Report title.
2. Addressee (usually the shareholders).
3. Introductory paragraph that states

a. an audit was performed
b. the name of the financial statements audited
c. management and auditor responsibilities.
4. Scope paragraph that states what the auditor did.
Auditor followed GAAS as described in Note 6.
Auditors attempt to obtain reasonable, not absolute, assurance that the financial
statements are free of material errors, not of all errors. Absolute assurance cannot be
achieved, because only a sample of the transactions entered into by the company is
examined. Even if auditors were to examine every transaction recorded by a company,
they could still not achieve absolute assurance, because there is always a risk that some
transactions were never recorded in the first place. In addition to this testing, auditors
assess the application of appropriate accounting principles, significant management
estimates, and financial statement presentation.
5. Opinion paragraph that states the auditor’s conclusion on the work performed.
This relates to the reporting standards of GAAS, see Note 6.
Note that this paragraph states that the financial statements are presented fairly in all
material respects. This term is difficult to define; it is discussed in Note 9.
The opinion paragraph also states that the financial statements are in accordance with
Canadian generally accepted accounting principles (GAAP) or with an appropriately
disclosed basis of accounting.
6. Name of the auditing firm—could be the name of the public accounting firm or of a sole
practitioner.
7. Place of issue—where the audit firm issuing the report is located.
8. Date of the report, that is, the last day the auditor did significant fieldwork. This date
indicates the last day that the auditor is responsible for the review of significant events
that occurred after the year-end of the company.
The auditor may issue unqualified reports with an explanatory paragraph or with slightly
modified wording, when the auditor believes it is necessary to provide additional
information. This may be the case when
z the appropriate basis of accounting is not GAAP

z additional information is required due to a statute
z reporting on Comparative Financial Statements
z there are reporting differences, such as exist between Canada and the United States for
companies listed on multiple stock exchanges
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z changes in GAAP or the application of the change need to be explained.
Although the standard unqualified auditor’s report has an unqualified, or “clean” opinion,
such an opinion cannot be issued if
z the scope of the examination has been restricted (scope limitation)

z GAAP has not been followed (GAAP departure).
When a scope limitation or GAAP departure could result in a material misstatement in the
financial statements, the audit opinion must contain a reservation. Reservations in the
Auditor’s Report are discussed in Note 10.
Note 9: Materiality and Misstatements in the Financial

Statements
A misstatement in the financial statements can be considered material if knowledge of the
misstatement would affect a decision of a reasonable user of the company’s financial
statements. What is material for one company may be immaterial for another, mainly due
to differences in the size of the company’s accounts. For each engagement, the auditor
must determine what is material. This determination requires a professional judgment and
cannot be determined through purely objective methods. Nevertheless, materiality is
usually calculated as a percentage (arrived at through professional judgment) of one or
more of the following:
z net income before taxes

z revenue
z gross profit
z total assets
z shareholders’ equity.
A dollar value is not the only way to determine if an item is material. For example, the
existence of a lawsuit may be significant to the users of the financial statements, even if
the potential damages of that suit are not yet quantifiable. The occurrence of illegal
activities, although immaterial in dollar amount, may be material to the users of the
financial statements. The pervasive nature of the item, that is, the impact of the item on
other accounts of the financial statements, must also be considered.
During an audit, auditors may encounter a number of immaterial GAAP departures. Auditors
must total the dollar effect of each departure together to determine whether, on an
aggregate basis, a material GAAP departure exists.
During an audit, the auditor cannot examine all transactions. Any errors discovered in the
sample of transactions selected should be extrapolated over the total population. This total
error, which includes the extrapolated portion, can then be assessed as being material or
immaterial.
Note 10: Reservations in the Audit Report

Reservations in the auditor’s report are due to scope limitations or non-conformity with GAAP.
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For scope limitations the auditor can render a Qualified Opinion or a Denial of Opinion,
depending on materiality and pervasiveness of the item.
For non-conformity with GAAP the auditor can render a Qualified Opinion or an Adverse
Opinion, depending on materiality and pervasiveness of the item.
Reports for Scope Limitation
Restriction of the auditor’s scope can lead to the reservation of an opinion, and depending on
materiality and pervasiveness, this can take one of two forms—Qualified Opinion or Denial of
Opinion.
Qualified Opinion
In such an opinion, the scope and opinion paragraphs are amended and an extra reservation
paragraph is added, before the opinion paragraph, to explain the limitation. An example of a
scope limitation would be the auditor’s inability to attend an inventory count at the end of the
preceding year. Consequently, the auditor cannot verify the impact that the opening inventory
has on the cost of goods sold calculation for the current year. A qualified audit opinion for this
circumstance is shown as follows. (Changes from the standard unqualified report are shown in
italics.)
Auditor’s Report
I have audited the (consolidated) balance sheet of (name of company) as at (date)

, (year) and the (consolidated) statements of income, retained earnings and cash flows for
the year then ended. These financial statements are the responsibility of the company’s
management. My responsibility is to express an opinion on these financial statements based on
my audit.
Except as explained in the following paragraph , I conducted my audit in accordance with

Canadian generally accepted auditing standards. Those standards require that I plan and
perform an audit to obtain reasonable assurance whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence supporting the
amounts and disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation.
Because I was appointed auditor of the company during the current year, I was not able to
observe the counting of physical inventories at the beginning of the year nor satisfy myself
concerning those inventory quantities by alternative means. Since opening inventory enters
into the determination of the results of operations and cash flows, I was unable to determine
whether adjustments to cost of sales, income taxes, net income for the year, opening retained
earnings , and cash provided from operations might be necessary.
In my opinion, except for the effect of adjustments, if any, which I might have determined to
be necessary had I been able to examine opening inventory quantities, as described in the
preceding paragraph , the statements of income, retained earnings and cash flows present
fairly, in all material respects, the results of operations and cash flows of the company for the
year ended (date) , (year) in accordance with Canadian generally accepted accounting
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principles. Further, in my opinion, the balance sheet presents fairly, in all material respects,
the financial position of the company as at (date) , (year) in accordance with Canadian
generally accepted accounting principles.
Denial of Opinion (extremely material; severe scope limitation)
If the scope limitation is so severe as to lead the auditor to believe that the overall fairness of
the financial statements is in question, then the auditor will issue a report that denies an
opinion. One circumstance under which this opinion could be rendered occurs when the
accounting records of the company are so unreliable that the auditor simply cannot obtain the
necessary information to perform an audit. In this case, the scope of the work is not just
limited—it is almost nonexistent. An example of such a report follows.
Auditor’s Report

my audit.
Except as explained in the following paragraph , I conducted my audit in accordance with

Canadian generally accepted auditing standards. Those standards require that I plan and
perform an audit to obtain reasonable assurance whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence supporting the
amounts and disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation.
My examination indicated serious deficiencies in the accounting records and in the system of
internal control. As a consequence, I was unable to satisfy myself that all revenues and
expenses of the company had been recorded. I was also not able to satisfy myself that the
recorded transactions were proper. As a result, I was unable to determine whether
adjustments were required in respect of recorded or unrecorded assets ; recorded or
unrecorded liabilities ; and the components making up the statements of income, retained
earnings , and cash flows.
In view of the possible material effects on the financial statements of the matters described in
the preceding paragraph, I am unable to express an opinion whether these financial
statements are presented fairly in accordance with Canadian generally accepted accounting
principles.
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Reports for Non-Conformity of GAAP
If the auditor has determined that the client’s financial statements are not in accordance with
GAAP, depending on materiality and pervasiveness, two possible outcomes can occur—Qualified
Opinion or Adverse Opinion.
Qualified Opinion (when the effects can be quantified or isolated)
In this type of opinion, the financial statements as a whole are not considered to be false or
misleading; only some of the items included in them are considered to be. The opinion
paragraph will be amended, and an extra paragraph inserted before it to explain the departure.
The following is an example of an auditor’s report where a company has failed to comply with
GAAP by not properly disclosing a note about the going concern problems of the business. In
this case, only one or a few parts of the financial statements are misleading, not the
statements as a whole.
Auditor’s Report

my audit.

examining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial statement
presentation.
The accompanying financial statements, in my opinion, do not draw attention explicitly to

doubts concerning the company's ability to realize its assets and discharge its liabilities in the
normal course of business. These doubts arise because it is uncertain whether the company
will be able to refinance its long-term debt in the amount of $ due on (date) ,
(year) in view of (e.g,. recurring operating losses, working capital deficiency) . If such
refinancing cannot be arranged, it is not known whether the company will be able to generate
adequate funds to repay this debt and continue as a going concern.
In my opinion, except for the omission of the disclosure described in the preceding paragraph ,
these (consolidated) financial statements present fairly, in all material respects, the financial
position of the company as at (date) , (year) and the results of its operations and the
cash flows for the year then ended in accordance with Canadian generally accepted accounting
principles.
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Adverse Opinion (extremely material and pervasive)
If the GAAP departure is so pervasive as to render the financial statements as a whole

misleading or useless, the auditor should give an adverse opinion, which states that the
financial statements have somehow not been prepared in accordance with GAAP. For example,
the failure of a company to consolidate the accounts of a major subsidiary would make almost
every number on the financial statements incorrect. The auditor’s report appears as follows.
Auditor’s Report

my audit.

examining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial statement
presentation.
As explained in note xx to the financial statements, commencing this year the company
ceased to consolidate the financial statements of its subsidiary company because it believes
that consolidation would not provide meaningful information to the readers of the financial
statements. Under generally accepted accounting principles, consolidation is required and
virtually every account on the financial statements is materially misstated as a result of the
failure to consolidate the subsidiary accounts.
In my opinion, because the investment in the subsidiary company is not accounted for on a
consolidated basis as explained in the preceding paragraph , these (consolidated) financial
statements do not present fairly, the financial position of the company as at (date) ,
(year) and the results of its operations and the cash flows for the year then ended in
accordance with Canadian generally accepted accounting principles.
If both a GAAP departure and a scope limitation exist, the auditor should qualify (or deny) the
opinion for each condition.
In summary, the types of reports are summarized in the following table.
GAAP Departure Scope Limitation

Qualified Qualified
Adverse Denial
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For many businesses, several auditors are hired to conduct audit work in different areas of the
company. The primary auditor must rely on the work of these other (secondary) auditors, and
he or she will not refer to them in the unqualified auditor’s report.
The primary auditor must assess the secondary auditors’ competence, and review their work. If
their work is not satisfactory, it could result in a qualified report. In this case, the secondary
auditors’ names could be mentioned in explaining the reason for the qualification, in the
reservation paragraph (scope limitation). In the case, where a secondary auditor is a specialist
(and a qualification has risen because of the inability to rely on the work of the specialist) then
the name of the specialist would be mentioned in the reservation paragraph.
Note 11: Other Reporting Responsibilities

Reports on Internal Control
The auditor of large listed companies or of Canadian subsidiaries of American companies is

required to attest to management’s report on the effectiveness of internal control over
financial reporting. Separate reports may be issued, one on the financial statements and
the other for the internal controls over financial reporting. The auditor may also issue a
combined report. See Figure 3-9 (textbook p. 71) for an example of a combined report.
Impact of e-Commerce on Audit Reporting
Under GAAS, as it stands now, the auditors have no responsibility to read information
contained in electronic sites, such as the company’s Web site.
Note 12: Legal Liability

The Changing Legal Environment
An increase in the number of cases brought against auditors have changed users’
expectations and affected the rulings which guide the auditors in their work. The massive
revision of the CICA Handbook in 2005 will continue to have an impact on auditors in the
years to come, as the accounting profession takes action to meet the expectations of the
public.
Under common law the audit profession has the obligation to fulfill implied or expressed
contracts with their client. If they fail to provide the services that were agreed upon, they
can be sued for negligence and/or breach of contract.
Under the provincial securities Acts, auditors are also legally responsible to third parties, in
certain circumstances. The Supreme Court of Canada’s position is that the auditor is held
accountable for duty of care to third parties—that limited group of persons whom the
auditor knows will use and rely on the audit and financial statements.
The major cause of lawsuits against public accountants is the lack of understanding, on the
part of those who use the financial statements, of the following.
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z Business Failure—when a business is unable to pay its liabilities.
z Audit Failure—when the auditors have failed to discover material misstatements,

because of not having followed GAAS.
z Audit Risk—the risk that the audit will not uncover a material financial statement
misstatement, even when GAAS have been followed.
The areas of liability in auditing can be classified as liability to clients, liability to third
parties, and criminal liability.
Liability to Clients
The term client refers to the entity being audited. An auditor’s liability may be due to failure
to fulfill the terms of a contract (letter of engagement), or to failure to comply with GAAS.
The auditor cannot withhold from the courts information or working papers on grounds of
privileged information.
In a partnership, every partner can be held liable in a civil action for the actions of each of
the other partners and the employees of the partnership. In Ontario, since 1998,
accounting firms have been allowed to form limited liability partnerships whereby partners
who had nothing to do with the engagement would not be liable on their personal assets.
Liability to Third Parties
To begin, read the cases on pages 88 to 94 of the textbook (Figures 4-1 to 4-9) as well as
the summary in Figure 4-10.
The term third parties refers to anyone who did not enter into a contract with the auditor.
Remember that the letter of engagement is between the auditor and the company—not the
shareholders, bankers, and so forth. The courts have still not agreed as to who is included
under the third party umbrella, and each case has to be decided individually.
Liability due to claim of negligence results from failure to exercise reasonable care.
Liability due to claim of fraud results from deliberately producing an assertion that is know
to be false.
The public accounting firm may use the following defences on its behalf.
z Lack of duty—expectation was not part of a letter of engagement: read the case in
Figure 4-3 (p. 89).
z Absence of misstatement—before defending negligence, the auditor would provide

evidence that there is nothing wrong with the financial statements, that is, they are in
accordance with GAAP and no material errors exist.
z Absence of negligence—the audit was performed according to GAAS, and the auditor is
not expected to be infallible: read the case in Figure 4-4 (p. 90).
z Contributory negligence—here the auditor must prove that the client was negligent, by
not acting on some of the auditor’s recommendation or by providing false information to
the auditor: read the case in Figure 4-2 (p. 89).
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z No damages—when a party makes a claim for which they have suffered no damages:
read the case in Figure 4-9 (p. 94).
z Absence of causal connection—the auditor claims that the losses had nothing to do with
anything that the auditor did: read the case in Figure 4-3 (p. 89).
Criminal Liability
The auditor knowingly commits a wrongful act and is found guilty under the statute of
criminal law appropriate in the jurisdiction where the crime occurs—in Canada, this is the
Criminal Code of Canada. Read the case in Figure 4-11 on page 96 of the textbook.
References
CICA Handbook , Sections 5020, 5021, 5025, 5030, 5049, 5100, 5142, 5400, 5510, 5600,
5701, 6930, 7110, 9200, PS 5200, and GSF-QC.
Review Activities
ACCT 460
Lesson 2: Professional Ethics, Audit Objectives, Phases of

the Audit, and Audit Evidence
Introduction

Lesson 2 expands your knowledge of the underlying concepts of auditing and explains the
need for ethical behaviour by professionals who conduct audits.
Objectives
objectives.
1. Describe the ethical behaviour required of auditors and apply the components of the
professional rules of conduct.
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2. State the overall objective of the audit.
3. Compare management’s responsibilities with the auditor’s responsibilities.
4. Explain the difference between fraud and error.
5. Describe the major accounting cycles.
6. Describe the nature of substantive testing and the audit objectives that this type of
testing attempts to prove.
7. Identify the four major phases of an audit and describe the relationship they have with
the examination standards for generally accepted auditing standards.
8. Explain the meaning of sufficient and appropriate audit evidence.
9. Describe the techniques the auditor uses to accumulate evidence and meet the audit
objectives.
10. Describe the purpose and types of analytical procedures used in auditing.
Reading
z Chapters 2, 5, and 6 in the textbook

z Lesson 2 Notes

Textbook Lesson
Topic Objective
Reference Note
Ethics 1 pp. 32–50 1
2 pp. 109–110 2
3, 4 pp. 110–114 2
Objectives of the Audit
5 pp. 114–120 3
6 pp. 120–126 4
Phases of the Audit 7 pp. 127-129 5
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8 pp. 152-158 6
Audit Evidence 9 pp. 158-165 7
10 pp. 166-176 8
Lesson Notes
Note 1: Ethics and Rules of Conduct

Ethics are the backbone of the practice of public accounting and auditing. They are a set of
moral principles that include honesty, integrity, and fairness. Ethics are needed for society
to function in an orderly manner.
Society has attached a special meaning to the term “professional,” and thus expects
professionals to act with a high level of ethical behaviour.
For an accountant, being a professional means
z maintaining independence
z acting in a manner that serves to enhance the image of the profession and the public’s
confidence in the profession
z monitoring the level of performance of the profession’s members.
Unlike other professionals, accountants are providing a service to unknown parties (users of
the financial statements) and they must ensure that these parties have confidence in an
accountant’s integrity and conduct.
To read an extensive and detailed code of professional conduct, go to the Web site for one
of the professional accounting organizations. The textbook refers to the rules of conduct for
CGA Association of Canada and the Ontario CAs.
On the CGA site, search for code of ethics and select the document titled Code of Ethical
Principles and Rules of Conduct Version 2.6 .
On the Ontario CA site, search for member’s handbook and select the document titled
Rules of Professional Conduct .
There are differences in the codes between provinces, but all professional accounting
organizations have developed codes of professional conduct that are based on certain
principles. The most important of these principles are summarized in the following
paragraphs.
Independence
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Professional independence ensures that the auditor has an unbiased viewpoint, which is
critical to the credibility of the audit opinion. Independence is the most important
characteristic of the auditor. Auditors take steps to ensure that they are not just
independent “in fact,” but are also independent “in appearance.”
When evaluating the acceptance of an audit, the public accountant must examine the
following five facets of independence and document the safeguards used to eliminate or
reduce them to acceptable levels.
Self-interest threat—when there is a financial interest.
Advocacy threat—when the firm or public accountant seems to be promoting the client or
acting as its representative.
Self-review threat—when any of the audit staff is auditing their own work.
Familiarity threat—when audit staff conduct a company’s audit for many years, they may
take some aspects of the company for granted.
Intimidation threat—when the client is trying to impose some conditions on the audit.
Independence is maintained by
z threat of legal liability, and the consequences thereof
z rules of professional conduct
z GAAS
z quality controls established by individual accounting firms
z an audit committee (see below)
z application of accounting principles (e.g., CICA Handbook section 7600 sets out the
requirements that must be met when an auditor is requested to give an opinion on the
application of accounting principles)
z shareholders’ approval of auditors.
Confidentiality
Accounting professionals are not allowed to disclose confidential information about their
clients or employer. However, this rule does not apply to information demanded by a court.
As well, this rule does not apply when the member’s professional association will be
conducting a practice review or when there is a disciplinary process. Consequently, an
auditor must be very careful when placing information in a file and should not release that
information to anyone (except a court) without the client’s permission.
Maintaining the Reputation of the Profession
This principle prohibits public criticism of professional colleagues. Accountants should never
do anything that diminishes the reputation of their profession.
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Integrity and Due Care
Integrity refers to the accountant’s honesty and fairness, which must be above question.
Failure to exercise due care results in negligence, which may lead to legal liability.
Competence
Professional competence is usually maintained by participating in continuing education

programs and practice inspections.
Adherence to GAAP and GAAS
Professional accountants cannot associate themselves with false or misleading information

or fail to reveal material omissions. GAAP and GAAS are the means by which accountants
determine their professional actions.
Advertising and Solicitation
Solicitation of another public accountant’s client is strictly prohibited. However, responses

to proposals to provide accounting services are allowed. Advertising must not be
comparative or include dollar amounts for fees, and must not promise favourable outcomes.
Other Rules
A member of a professional organization who becomes aware of a breach of the rules of

conduct by another member has a duty to report this breach to the discipline committee of
that profession. The professions are self-policing, and public pressure has forced many
professional organizations to include nonmembers on their discipline committees. The
formation of the CPAB is another self-policing measure. Punishment can result in fines, loss
of designation for an extended period, and public disclosure of the punishment rendered.
Communication with predecessor auditors is required before the new audit engagement is
accepted. This consultation ensures that the new auditor does not risk accepting unethical
clients without obtaining a reference from the predecessor auditor.
Professional liability insurance is required of all practising public accountants.
Audit Committees
Under the Canada Business Corporations Act , public companies are required to have an
audit committee, although provision is made for a waiver in some circumstances. The audit
committee is required to review the company’s financial statements before they are issued.
The committee must comprise at least three members of the company’s board of directors,
the majority of whom must be outside directors. The directors have an obligation to inform
the auditor and audit committee of any wrongdoing or misstatements that come to their
attention.
Duties of the audit committee include
z advising shareholders about which firm to appoint as auditors

z meeting with the auditors on a periodic basis
z resolving any disputes that auditors may have with management
z monitoring the findings and audit work performed by both the external and internal
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auditors.
The auditor should communicate with the audit committee (or those responsible for
overseeing the financial reporting process). Matters to be included and the extent of
communication may vary, depending on the needs and accountability of the entity. For
public companies, the communication should be more extensive and should include
z details of the audit process, including planning and approach

z matters that arise during the audit
z matters that could bear on the independence of the auditor.
Note 2: Overall Audit Objective

“The objective of an audit … is to express an opinion on whether the financial statements
present fairly, in all material respects, the financial position, results of operations and cash
flows in accordance with generally accepted accounting principles” (CICA Handbook , para.
5090.01).
In performing an audit, the auditor has the responsibility to
z hold an attitude of professional skepticism (though one should still assume

management’s good faith until proven otherwise)
z seek reasonable assurance as to whether the financial statements are free of material
misstatement.
While conducting an audit, the auditor may discover misstatements (errors and fraud). An
error is an unintentional misstatement. Fraud is the intentional misappropriation of assets,
and it results in a misstatement. Fraud can be divided into four categories: management
fraud, employee fraud, computer fraud, and illegal acts. Lesson 10 addresses this issue in
more detail. When fraud is discovered, the audit committee or the board of directors should
be informed.
The auditor’s prime objective is not to discover fraud, especially if it is not material.
Because an auditor cannot provide absolute assurance that financial statements are free of
misstatements, even material fraud may go undetected.
An auditor who discovers an illegal act should, if possible, obtain more audit evidence
regarding the situation and discuss it with management and the audit committee.
Management should be asked to provide written representations, in the form of statements
given to the auditor, explaining the nature of the activity and their opinions regarding it.
Also, legal counsel should be consulted to determine the effect of the item on the financial
statements.
Management’s Responsibilities
Management is responsible for the decisions involving the selection of accounting principles,
maintaining adequate internal control, and making fair representations in the financial
statements.
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As noted in your textbook (p. 111) the Canadian Securities Administrators (CSA) require
the following of companies listed on Canadian stock exchanges.
z The CEO and the CFO must certify annual and interim financial statements, as well as
management discussion and analysis and other forms that are filed with the stock
exchanges.
z Management must certify that they have reviewed the documents, that the documents
are free of misrepresentation, and that internal control over financial reporting has been
designed, evaluated, and disclosed.
Note 3: Financial Statement Cycles

An auditor conducts an audit efficiently by designing tests of similar transactions. The
auditor may test the various systems or transaction cycles used by an entity. This
procedure satisfies the second examination standard, and testing of controls is necessary if
the auditor is to rely upon the controls. There are four major financial statement cycles.
1. Sales and receivables . Transactions in this cycle record sales, receivables, and cash
receipts; these transactions are usually the responsibility of the entity’s accounts
receivable department.
2. Purchases and payables . This cycle includes transactions that record purchases of assets
and expenses, current liabilities, and cash disbursements. The capital acquisition and
repayment cycle is a subset of this cycle.
3. Payroll . Transactions in this cycle pertain to the payment of employee compensation.
4. Inventory . Transactions in this cycle include those that affect the cost of goods sold and
inventory balances.
Many of these cycles are interrelated. When auditors test transactions to determine
whether the system of internal controls for that cycle is functioning as designed, they are
performing “tests of controls.” The results of these tests help auditors determine if internal
controls can be relied on, and the extent of other audit procedures.
Refer to Table 5-1 (textbook, p. 119) for transactions and accounts that are included in
each cycle.
Note 4: Auditor’s Objectives

Just as a lawyer accumulates evidence to prove that a client is innocent, an auditor
accumulates evidence to determine that the financial statements are fairly stated. If the
internal controls that accumulate the financial data are operating effectively, then the
amount of evidence to be gathered is reduced. Nonetheless, as described in Section 5300 of
the CICA Handbook , the auditor must accumulate evidence to prove the following
assertions about the components of the financial statements.
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z Existence. Assets and liabilities included in the financial statements exist.
z Occurrence. The transactions actually took place.
z Completeness. There are no unrecorded amounts.
z Valuation. Assets and liabilities are properly valued.
z Measurement , accuracy, classification, timing, and posting and summarization.

Revenues and expenses are recorded in the proper amount and in the proper period.
The general ledger agrees to supporting records (such as subsidiary ledgers).
z Ownership (rights and obligations). The assets on the balance sheet are owned by the
entity.
z Statement presentation and disclosure. The item and related disclosure requirements
are properly presented.
These objectives can be used as a framework from which all other objectives—
management’s or transaction-related—can be derived. Table 5-2 on page 125 of the
textbook depicts the relationships between various assertions and objectives.
Let us illustrate these assertions with an example. Suppose you are auditing the inventory
of a particular company. To ensure that the inventory existed, you would observe your
client counting the inventory. To ensure that the inventory is complete, you would examine
accounting records for evidence of any shipments in transit. This examination would also
reveal if the cost of the inventory was lower than market (a test of valuation); if the
company actually owned the inventory; if the inventory transactions were recorded in the
proper period (measurement); and if the financial statements had appropriate note
disclosure on the types of inventory and their costing methods.
These types of audit procedures focus primarily on tests to substantiate a balance in an

account on a particular date. These tests are called substantive tests, and they are
performed to satisfy the third examination standard of GAAS.
If the auditor cannot prove each of these assertions for every material item in the financial
statements, then a reservation to the audit report is warranted.
Note 5: The Phases of an Audit

To meet the audit objectives described previously in Lesson 2, an auditor must conduct an
audit properly. An audit is done in four phases.
1. Plan the audit.

2. Test internal controls.
3. Perform analytical and substantive procedures.
4. Complete the audit and issue the report.
1. Plan the Audit
In planning the audit, the auditor must ensure that sufficient and appropriate audit
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evidence is gathered, but at a minimal cost.
A plan cannot be established until the auditor has learned something about the client’s
business. The auditor must also gain an understanding of the company’s system of internal
control. This information is required under GAAS and is necessary in assessing control risk.
If the system of internal control is effective, control risk (the risk that the system of internal
controls will fail to prevent or detect errors in the financial statements) will be assessed as
low. As a result, the auditor can rely on the system of internal control to a large extent, and
the amount of substantive audit testing can be reduced. (Control risk is discussed in more
detail in Lessons 3 and 4.)
2. Test Internal Controls
The assessment of control risk at a level below maximum must be confirmed by performing
tests on the system of internal controls. Tests of control involve inquiry, observation,
reperformance, and inspection of controls and transactions. If control risk is assessed at
maximum during the planning stage of the audit, this phase will not be conducted. When
control risk is assessed at maximum, internal controls cannot be relied on so there is no
point in testing them, or it is considered more efficient to obtain the audit evidence through
substantive tests (tests of details of balances).
3. Perform Analytical or Substantive Procedures
At this stage, tests are done to substantiate the balance in an account at a certain date.
These tests satisfy the third examination standard of GAAS. They consist of analytical
procedures, confirmation, inspection, observation, and computation.
4. Complete the Audit and Issue the Report
The auditor must consider not only events that have occurred before the audit report date,
but also those that have occurred subsequent to the year-end, and the auditor must
determine whether these events affect the financial statements. The audit report represents
a conclusion about the financial statements taken as a whole.
Note 6: Audit Evidence

Audit evidence is any information the auditor uses to determine whether the information
being audited is stated in accordance with certain specified criteria such as GAAP. For audit
evidence to be valid, it must be persuasive. Three characteristics determine if evidence is
persuasive.
Sufficiency
This condition is met if there is enough sample evidence. The auditor must ensure that the
sample size being tested is large enough to draw a conclusion about an audit objective.
Sample size is increased if the expectation of error is high or if the internal control system
is considered to be less than effective.
Appropriateness
This condition is met if evidence of sufficient quality (that is, relevant to the objective
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being tested) has been gathered. This issue relates to competence of the auditor. The
evidence must also be reliable. Evidence obtained from the auditor’s direct personal
knowledge, such as from the observation of inventory counts, is the most reliable. Evidence
received directly from reputable third parties is also very reliable. An example of such
evidence would be confirmations received by the auditor directly from the bank with respect
to the balance in the bank account. Evidence that originated with a third party is the next
most reliable type of evidence. Examples of this type of evidence include copies of
suppliers’ invoices or statements kept in the company’s files. Lastly, the evidence that
originates from within the company is the least reliable, because of the possible bias with
which it was prepared. The reliability of this evidence is directly related to the quality of
internal controls and the integrity of management.
Audit evidence should be as objective as possible, although not all evidence can be
completely objective. When it is not, the qualification of the person who provides the
evidence should be considered.
Timeliness
Audit evidence is more reliable when it is closer to the balance sheet date. For example,
evidence to substantiate year-end inventory amounts about an inventory count on
December 31 (the year-end date) is more reliable than evidence gathered from an
inventory count on November 30.
In most cases, it is possible to obtain various types of evidence to meet an audit objective.
The benefit of obtaining the most persuasive evidence may not always outweigh the cost of
obtaining it. Auditors must always exercise judgment in measuring the benefit against the
cost of obtaining evidence.
Note 7: Methods of Obtaining Audit Evidence

There are seven major methods of obtaining audit evidence. Each is discussed in the CICA
Handbook , Section 5300.
1. Inspection and documentation. This method involves inspecting assets and examining,
reading, reviewing, scanning, scrutinizing, and vouching (tracing the details from an
accounting record to source documents) documents and records.
2. Observation . This method involves observing the application of policies and procedures
by client staff (e.g., observing the client perform a well-organized inventory count).
3. Inquiry. This method consists of seeking appropriate information from knowledgeable

client staff (e.g., notes taken from an interview with the controller of the organization).
A response from such a person in the organization does not always constitute sufficient
and appropriate evidence; consequently, evidence obtained through inquiry is usually
used to corroborate other evidence that has been gathered.
4. Confirmation . This method involves inquiry in written form, usually from persons
independent of the organization (e.g., confirmation of a bank account balance obtained
from the bank). The value of a confirmation is directly related to the objectivity and
competence of the person responding to the request for the confirmation.
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5. Recalculation . This method consists of checking the arithmetic accuracy of certain
records (e.g., footing, which means adding, the balance in subledger accounts, and
agreeing the total to the balance in the general ledger control account).
6. Reperformance. This method is the auditor’s independent reperformance of the

company’s procedures or internal controls, which means redoing a procedure that has
already been done by company personnel (e.g., agreeing the amounts from an invoice
to the purchase journal).
7. Analytical procedures . This method is one of the most important techniques for
obtaining evidence. It consists of
z identifying components in the financial statements that require further investigation
z studying and evaluating the interrelationships among the financial elements and
other information.
These evidence-gathering procedures are used in the planning stages of the audit, during
the performance of substantive tests, and in the completion stage of the audit when
assessing whether an opinion can be expressed on the financial statements taken as a
whole.
These methods can also be used to compare actual results to those anticipated by the
auditor, to the results in prior periods, to the results of nonfinancial events, and to the
results in other accounts. For example, the auditor may know that a hotel is expanding and
is adding 100 rooms to its facility. Because of this expansion, the auditor will expect capital
assets to rise. This rise, in turn, would increase amortization for the current year when
compared to the prior year. The auditor could also use nonfinancial information, such as
local hotel occupancy rates, to assess the reasonableness of the revenue increase resulting
from the addition of the new rooms. If revenues were expected to increase, the auditor
would also expect other related accounts, such as housekeeping expenses, to increase. If
the actual amounts on the financial statements do not appear to reflect these anticipated
changes, the auditor would assess this situation during the planning stage of the audit and
probably perform more substantive tests, the results of which would be reviewed at the
completion stage of the audit.
However, the effectiveness of analytical procedures depends on how thoroughly the auditor
considers the factors that affect the amount being audited, the level of detail and reliability
of data used to develop the expectation, and the method used to convert data into an
expectation.
To meet the auditor’s objectives, an auditor must use his or her professional judgment to
determine which evidence to gather and when to gather it.
Note 8: Analysis
The CICA issued Section 5301, Analysis, to expand on guidance regarding the use of
analysis as an audit procedure. The section emphasizes that analysis can be used at all
phases of audit planning, as a substantive procedure, and in the overall evaluation phase.
Along with knowledge of the client’s business, the auditor can use analytical procedures to
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z help make the assessment of a company’s ability to continue as a going concern
z possibly indicate misstatements that require further investigation (through unusual

fluctuations in accounts)
z reduce the extent of other tests of detail.
Analysis involves comparison of data and ratio analysis. It can be internal client or industry
data, prior periods, expected results from the client (budget) or auditor, or other
nonfinancial data. Technology provides many tools to help the auditor perform analytical
procedures.
References
7600, and GSF-QC.
Review Activities
Lesson Review
Learning Objectives
Read the objectives at the beginning of Chapters 2, 5, and 6 in the textbook, and compare
your answers to those provided in the Summary at the end of each chapter.
Review the Lesson 2 learning objectives and be sure you have mastered them all.
Terms
Review the Essential Terms at the end of Chapters 2, 5, and 6.
The following interactive exercises may help you review. Choose the chapter you wish to
review, and select the format you prefer (e.g., plain text, define terms).
Practice Questions
Go to the textbook companion Web site and work through as many practice questions and
exercises as you need to in order to reinforce your learning. Submit your answers on that
Web site for immediate feedback.
Lesson 2 Discussion
Read the Professional Judgment Problems listed below. Go to the ACCT 460 Discussion
Board to enter your comments, and read what other students have to say.
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z For Chapter 2: Problem 2-22 on page 54
ACCT 460
Lesson 3: Audit Planning, Materiality, and Risk
Introduction

Lesson 3 introduces you to the first steps in the audit process. You will come to realize that
professional judgment is critical in planning the audit, assessing risk, and determining the
amount of audit evidence to be gathered.
Objectives
objectives.
1. List items to be considered when entering into an audit engagement.
2. Describe how auditors obtain knowledge about their client’s business.
3. Explain how analytical procedures are used in planning an audit.
4. Describe some features of audit working papers.
5. Explain the meaning of materiality and describe how it is applied.
6. Explain the risk model and describe each of its components.
7. Describe how inherent risk is assessed.
8. Explain the relationships among audit risk, materiality, and evidence.
Reading
z Chapters 7 and 8 in the textbook

z Lesson 3 Notes
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Textbook Lesson
Topic Objective
Reference Note
1 pp. 183–190 1, 2
Preliminary Procedures
2 pp. 190–194 3
Analytical Procedures 3 pp. 194–195 4
Working Papers 4 pp. 195–202 5, 6
Materiality 5 pp. 210–216 7
6 pp. 217-224 8
Risk 7 pp. 224-231 9, 10
8 pp. 231-232 11
Lesson Notes
Note 1: Importance of Planning

Planning is essential if the auditor expects to meet the requirements of the first
examination standard of GAAS. Proper audit planning must be done to ensure that
sufficient, appropriate audit evidence is obtained in a cost-effective manner. Proper
planning will help identify information for the auditor to use in assessing audit risk and
inherent risk of the client. Assessing these risks will help the auditor make decisions
concerning: accepting a client, continuing with a client, gathering evidence, staffing, and
formulating the engagement letter. The planning phase of the audit includes the following
steps.
1. Client acceptance procedures

2. Obtaining an understanding of the business
3. Performing analytical procedures
4. Assessing materiality and risk
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Note 2: Client Acceptance Procedures
Auditors must conduct an appropriate investigation of new clients to ensure they are not
conducting business with unethical persons. This investigation involves assessing the client’
s reasons for needing an audit and determining if the client has hired other auditors in
previous years. Auditors must also consider who the intended users of the financial
statements will be, and gauge the independent threat issue.
Auditors must also assess their relationship with current clients to ensure that they have
not undertaken any unethical practices. Before accepting an engagement, auditors must
ensure that they have the expertise and staff available to complete the work requested.
They must also communicate with the auditors who were engaged in the preceding year,
and ask them if they are aware of any reasons why this assignment should not be
accepted. Previous auditors rarely suggest that the engagement should not be accepted,
but this can occur if they feel the client is unethical. If no such problem is encountered, an
engagement letter is then prepared that specifies the work to be performed. This procedure
is used for the continuing client as well. The engagement letter is signed by both the
auditor and the client. An example is included in Figure 7-2 on pages 188 and 189 of the
textbook.
Note 3: Obtaining an Understanding of the Business

This step is an essential prerequisite to any audit plan. Developing an understanding of the
client’s business, industry, and operations will allow the auditor to assess the client’s
business risk. This will, in turn, affect the auditor’s assessment of the audit risk, the
inherent risk, and the risk of fraud or error. Knowledge of the client’s business can be
obtained in a number of ways, including
z reviewing trade magazines and economic publications to learn about the economy and
industry in which the client operates
z reviewing the prior year’s audit files and discussing anything of significance with the
predecessor auditor
z consulting with co-workers or colleagues who have similar engagements
z touring the client’s facilities and meeting with key personnel to discuss business
conditions and outlook
z conferencing with the client’s personnel, including internal auditors
z identifying related parties, major suppliers, and customers
z consulting with specialists
z evaluating current financial and accounting policies
z reviewing organization charts and the most recent financial statements
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z meeting with the audit committee, and senior management
z reviewing with the client the nature of any contractual obligations and loan conditions
z reading articles of incorporation, corporate bylaws, and major legal agreements
z reading the minutes from the meetings of the audit committee, directors, shareholders,
and key management committees.
Note 4: Performing Analytical Procedures

As mentioned in Lesson 2, analytical procedures can play a role in many phases of the
audit, beginning with the planning phase. These procedures can be performed using
computer spreadsheet applications or other software.
Analytical procedures involve
z comparing recent financial results with those in the industry
z comparing recent financial results with the results of the previous period
z comparing recent financial results with those shown in the client’s budget
z comparing client data with auditor-determined expected results. The auditor can
estimate the results by using both financial and nonfinancial information.
Generally, analytical procedures are used to assess the reasonableness of amounts shown
in the financial statements. The quality of the procedure is largely determined by the
appropriateness and reliability of the data used. For example, it would be difficult to assess
the reasonableness of interest expense if the client or the bank gave you an incorrect
interest rate on the bank loan balance.
Auditors often find differences between the amounts that they estimated and the amounts
shown in the financial statements. Before performing the analytical procedure, an
acceptable level of difference should be determined on the basis of materiality.
When analyzing the results of analytical procedures, the auditor may have to perform
additional work. For example, if the reasonableness of interest expense was analyzed by
taking the average interest rate on a bank loan and multiplying it by the average balance of
the loan during the period, and this calculation yielded a result considerably different from
that shown in the financial statements, additional work (such as the examination of
monthly bank debit memos for loan interest) would be performed.
Note 5: Working Papers

The CICA requires that the auditor maintain written or electronic records, that is, working
papers of the procedures performed that support the conclusions reached in performing the
audit. The working papers may be contained in computerized files. The purpose of working
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papers is to
z serve as a basis for planning the audit
z maintain a record of evidence accumulated and the results of tests
z assist the auditor in preparing the audit report and the financial statements (as well as
tax returns and reports for regulatory agencies)
z serve as a basis for review by senior members of the auditing firm (managers and
partners).
Note 6: Working Paper Organization

There are two major types of working papers.
Permanent Files
Permanent files contain any ongoing legal and planning information about the client, such
as copies of important legal documents, details on the accounting policies used,
descriptions of the systems of internal controls, and financial statement analyses from
previous years. All information about the client that is of continuing interest from year to
year is filed in the permanent file.
Current Files
Current files document the work performed in the current year, and may include any or all
the following items:
z documents supporting reasons and conclusions for materiality, audit risk, inherent risk,
control risks, and the resulting overall audit approach
z financial statements cross-referenced to work performed on the account balances in the

file
z documentation on related party transactions and subsequent events
z memos to the audit committee and to the client about recommendations for
improvement in the system of internal controls
z management representation letters (usually signed by the president and controller of

the company) stating that the financial statements are presented fairly and that all
information about them has been given to the auditors
z letters from the company’s lawyers informing the auditor about the status of any
lawsuits, so as to assess the need for the accrual or disclosure of contingent liabilities
z audit programs (questionnaires completed by audit staff members documenting that the
compliance and substantive audit procedures had been performed)
z general information about current company or audit activities
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z working trial balance
z adjusting journal entries
z unadjusted journal entries for immaterial errors discovered by the auditor. Individually,
these entries do not warrant adjustment to the financial statements. They are listed and
it is later determined whether, in total, they are material. If they are material, an
adjustment would be required.
z reclassification entries that are made to the financial statements but not to the records
of the company
z supporting schedules, usually organized by balance sheet component, showing analysis

of the account, procedures performed, confirmations obtained, and other relevant
evidence gathered to prove the audit objectives. (Refer to Figure 7-5 on p. 201 of the
textbook for an example.)
These working papers are owned by the auditor, and are generally not shown to anyone
without the permission of the client; exceptions include regulatory authorities and members
of the profession conducting a peer review of the auditor’s practice. Working papers contain
sensitive information about the client’s business and must be protected at all times. As
more of this information is held in electronic forms, it becomes important that working
papers be stored on secure systems.
Working papers should be properly identified with the name of the company, initials of the
auditor, and date of preparation on all pages. They should also include conclusions for each
component on the financial statements. The conclusion would state that the balance of the
component was fairly stated in accordance with GAAP.
Note 7: Assessing Materiality

The audit opinion states that the financial statements are presented fairly in all material
respects. This means that no assurance can be made about amounts that are not material.
But what does materiality mean? According to paragraph 5142.04 of the CICA Handbook :
A misstatement or the aggregate of all misstatements in financial statements is

considered to be material if, in light of the surrounding circumstances, it is probable that
the decision of a person who is relying on the financial statements, and who has a
reasonable knowledge of business and economic activities (the user), will be changed or
influenced by such misstatement or the aggregate of all misstatements.
In applying materiality in an audit context, you must have an understanding of

misstatements. The CICA auditing guideline “Applying the Concept of Materiality” (CICA
Handbook , AuG–41 ) identifies four levels of misstatements.
1. Identified misstatement . An actual misstatement identified in a sample.
2. Likely misstatement . An identified misstatement, plus the projection of actual

misstatements from the sample to the whole population.
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3. Likely aggregate misstatement . Sum of all identified misstatements, plus the projection
of likely misstatements in the financial statements.
4. Maximum possible misstatements. The possible misstatements that arise over and
above the likely aggregate misstatements that result from the imprecise sampling
process.
Applications of Materiality
Early in the audit, a preliminary estimate of materiality should be made on the basis of the
auditor’s professional judgment. This estimate helps the auditor determine how much audit
evidence should be gathered.
Materiality is relative, not absolute. What is material for one company or purpose may not
be material for another. To determine a measure of materiality, most auditors use factors
such as percentage of net income, gross profit, total assets, shareholders’ equity, revenue,
or a combination thereof. Qualitative factors must also be considered when determining
materiality. For example, if fraud is suspected in a certain area, materiality will be lowered
for the work conducted in that area.
Note 8: Audit Risk

Risk is the uncertainty an auditor accepts when performing an engagement. Audit risk (AR)
is the risk that the auditor will fail to express a reservation in the opinion on financial
statements that are materially misstated. A lower audit risk means the auditor is less willing
to live with the uncertainty of misstatements in the financial statements and therefore will
lead the auditor to increase the amount of evidence testing in the audit, and/or assign more
experienced staff, and/or have an additional independent review of their working papers.
The CICA (Section 5095) has developed a risk model that defines the component types of
risk.
Audit risk (AR) = Inherent risk (IR) x Control risk (CR) x Detection risk (DR)
Note that audit risk is described in percentage terms, or, more frequently, through the use
of such adjectives as low, moderate, or high. Audit risk can also be described as a measure
of the willingness of the auditor to accept a material misstatement in the financial
statements. The lower this measure is, the lower the auditor’s tolerance to error (zero is
absolute certainty that no errors exist). Absolute certainty is not economically feasible.
Inherent risk (IR) is the measure of the auditor’s assessment of the likelihood that a
material misstatement might occur in the first place, without considering the effect of
internal controls. A thorough understanding of the business is needed to assess inherent
risk.
Control risk (CR) is the measure of an auditor’s assessment of the likelihood that a material
misstatement will not be prevented or detected by the system of internal control. However,
for the auditor to assess a control risk, an understanding of the control system must first be
obtained. For control risk to be assessed at less than maximum, two tasks must be done:
z an evaluation of the system must be performed
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z tests of the internal controls must be performed.
Detection risk (DR) is the measure that the audit evidence gathered will fail to detect
material errors or fraud and other irregularities, should such errors or fraud exist. The
auditor can control the level of this risk by increasing the amounts of audit evidence
gathered.
Audit risk and the level of audit evidence required are inversely related. As audit risk
increases, the amount of acceptable tolerable misstatements also increases, and therefore,
the amount of audit evidence accumulated can be reduced.
Note 9: Assessing Inherent Risk

In planning an audit, the auditor must attempt to predict where misstatements are most,
and least, likely to occur. The auditor can do little to reduce inherent risk. However, the
effect of inherent risk on audit risk can be reduced by decreasing other risk factors, such as
detection risk.
In assessing inherent risk, the following factors should be considered.
z the nature of the business, including the nature of the products and services
z the nature and use of data-processing systems and data communications (see Appendix
D, pp. 234–235 of the textbook)
z the integrity of management
z client motivation
z results of previous audits
z initial versus repeat engagement
z related parties
z nonroutine transactions
z extent of estimates used to determine balances and transactions
z assets that are susceptible to misappropriation
z make-up of the population (e.g., age of inventory, age of accounts receivable, foreign
currency items).
Remember that inherent risk and other forms of risk are assessed not just on an overall
basis, but for each cycle and account to be audited. Risk can also be assessed for each
assertion or audit objective.
Note 10: The Order of Risk Assessments
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When a client engages an auditor, the auditor must obtain an understanding of the client’s
business to assess inherent risk. At the same time, overall audit risk is assessed. Next,
control risk is assessed on the basis of the procedures performed by the auditor to
understand the system of internal controls. If inherent risk and control risk are high enough
to make audit risk greater than the auditor can accept, then steps are taken to reduce
detection risk and, indirectly, audit risk. These steps include the accumulation of more audit
evidence.
Audit risk is generally held to be the same for each cycle and account because the audit
opinion is expressed on the financial statements as a whole. Inherent and control risk,
however, usually vary from cycle to cycle, or from account to account. For a constant audit
risk to be maintained, the levels of audit evidence and detection risk also vary from cycle to
cycle, or from account to account.
Risk assessment is an ongoing process. For example, in the initial stages of an audit,
control risk over inventories may be assessed as low. On conducting limited tests on these
inventories, it may later be determined that controls are very poor. If all other risk
components are to remain unchanged, the amount of audit evidence required must be
increased.
Note 11: Relationships Among Audit Risk, Materiality, and

Evidence
There is a relationship among evidence, materiality, and the risk of an error occurring.
If audit evidence remains unchanged and materiality is increased, then audit risk is
decreased. Audit risk is decreased because, given the change in the materiality level, the
level of audit evidence has not been reduced.
If materiality remains unchanged and audit evidence is increased, then audit risk is also
decreased. Audit risk is decreased because additional evidence has been obtained, which
reduces detection risk and, therefore, audit risk.
If audit risk remains unchanged and materiality is decreased, the amount of audit evidence
needed is increased. Given the lower level of materiality, additional audit evidence is
needed to ensure that no material errors occur in the financial statements.
Example
For the company described in the following paragraph, assess audit risk, inherent risk,
control risk, detection risk, and the amount of audit evidence that will have to be obtained.
Describe your assessment using terms such as low, moderate, or high.
ABC Company is a new public company that develops computer parts for export to
developing countries. All accounting functions are performed by one accountant. The
company’s bank loans have a working capital covenant that is close to being violated.
Answer
Audit risk is assessed as low. You would not be very tolerant of errors in the financial
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statements, given the public ownership of the company and the bank’s concern with the
loan covenant. Inherent risk is high because of the complexity of the transactions (foreign
currency effects) and the potential inventory valuation problems prevalent in this industry.
Control risk is also assessed as high because no segregation of duties exists. Consequently,
to lower detection risk as much as possible, a large amount of audit evidence must be
gathered.
References
and Guideline AuG-41.
Review Activities
Lesson Review
Learning Objectives
Read the learning objectives at the beginning of Chapters 7 and 8 in the textbook, and
compare your answers to those provided in the Summary at the end of each chapter.
Review the Lesson 3 learning objectives and be sure you have mastered them all.
Terms
Review the Essential Terms at the end of Chapters 7 and 8.
The following interactive exercises may help you review. Choose the chapter you wish to
review, and select the format you prefer (e.g., plain text, define terms).
Practice Questions
Go to the textbook companion Web site and work through as many practice questions and
exercises as you need to in order to reinforce your learning. Submit your answers on that
Web site for immediate feedback.
Lesson 3 Discussion
Read the Professional Judgment Problems listed below. Go to the ACCT 460 Discussion
Board to enter your comments, and read what other students have to say.

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ACCT 460

Lesson 1: Introduction to Auditing

Objectives and Reading

z auditing and why it is needed

This lesson also introduces generally accepted auditing standards (GAAS).

1. Define auditing and distinguish between auditing and accounting.

2. Describe the different types of audits and auditors.

3. State the reason for audits.

5. Explain how quality control is exercised over public accounting firms.

6. Describe the parts of the auditor’s reports.

7. Explain the concept of materiality.

9. Identify the auditor’s reporting responsibilities.

11. Identify the major sources of litigation against public accountants.

z Chapters 1, 3, and 4 in the textbook

Working Through This Lesson

Note 1: Definition of Auditing

Note 2: Types of Audits

A financial statement audit involves the examination of financial statements to determine if

An operational audit focuses on the organization’s operating procedures to evaluate their

A compliance audit is conducted to determine whether an organization is following certain

A comprehensive audit is a combination of all of the types of audits previously described.

Auditors General are appointed by government. Government auditors are legislated by

Canada Revenue Agency Auditors

Canada Revenue Agency auditors perform compliance audits of taxpayers to determine

Internal auditors are commonly employed by larger businesses, where it is economical to

Note 4: Professional Accounting and Auditing Organizations

Certified General Accountants of Canada (CGA-Canada)

Society of Management Accountants of Canada (CMA Canada)

Note 5: Reasons for Auditing

Remoteness of the Information

Bias and Motives of Management

Because of the complexity of many financial transactions, users of financial information

Note 6: Generally Accepted Auditing Standards (GAAS)

In larger businesses, it would not be economical for an auditor to examine every

3. Sufficient appropriate audit evidence should be obtained, by such means as inspection,

2. The report should describe the scope of the auditor’s examination.

4. Where an opinion is expressed, it should indicate whether the financial statements

Note 7: Quality Control of Audit Firms

Note 8: The Auditor’s Report

A standard unqualified auditor’s report is issued when

Standard Report (CICA Handbook , Section 5400)

To the Shareholders of (name of company) :

I have audited the (consolidated) balance sheet of (name of company) as at

I conducted my audit in accordance with Canadian generally accepted auditing standards.

In my opinion, these (consolidated) financial statements present fairly, in all material

City (signed) (name of accounting firm)

Date Chartered Accountant

2. Addressee (usually the shareholders).

3. Introductory paragraph that states

4. Scope paragraph that states what the auditor did.

Auditor followed GAAS as described in Note 6.

This relates to the reporting standards of GAAS, see Note 6.

7. Place of issue—where the audit firm issuing the report is located.

z the appropriate basis of accounting is not GAAP

z the scope of the examination has been restricted (scope limitation)

Note 9: Materiality and Misstatements in the Financial

z net income before taxes

Note 10: Reservations in the Audit Report

Reports for Scope Limitation

To the Shareholders of (name of company) :

I have audited the (consolidated) balance sheet of (name of company) as at (date)

Except as explained in the following paragraph , I conducted my audit in accordance with