Knowledge of Clients Needed for the AUD Test - dummies

Knowledge of Clients Needed for the AUD Test

By Kenneth W. Boyd

For the auditing and attestation (AUD) test on the CPA exam, you need to know the difference between the auditor’s responsibilities and those of the client. A CPA needs to be clear about what the client is asking him to do. That may require an audit or some other attestation service.

An auditor also considers the assertions a company makes about its financials and how those assertions can be tested using audit procedures.

Going over the nature and scope of the audit

Both management’s responsibilities and those of the auditor need to be clarified during the planning process. For example, the financial statements are the responsibility of management. The CPA’s responsibility is to obtain audit evidence to provide an opinion on the financial statements.

The “nature and scope of the audit” also refers to the audit’s objectives — and to audit limitations. An audit, for example, isn’t designed to detect fraud, which is willful intent to deceive. Common audit procedures can’t detect fraud. Also, the audit is limited to providing an opinion on whether the financial statements are materially correct.

The audit doesn’t verify that the dollar amount of every account balance is exactly correct. These guidelines generally apply to audits of both public and nonpublic companies.

During planning, the CPA needs to decide on a dollar amount large enough to represent a material misstatement of the financial statements. For example, the CPA may conclude that a $10,000 misstatement in the $250,000 accounts receivable balance is a material misstatement.

The dollar amount of material misstatement can be the sum of many individual misstatements in accounts receivable, so the CPA firm keeps a running total of the misstatements noted during the audit. The CPA communicates to the audit staff that misstatements of $10,000 or greater for accounts receivable are to be considered material. Different financial statements may have different dollar amounts for considering misstatement.

Walking through assertions

Assertions are representations of management that are components of the financial statements. An assertion may be the dollar amount of accounts receivable, or it may state whether a liability balance is a current balance or a long-term one. When an auditor plans an audit, the procedures are designed to address each of the assertions in the following list.

These assertions address issues that may cause the financials to be misstated. Internal controls should be designed with these assertions in mind.

The AUD test nearly always covers these assertions:

  • Occurrence: The transactions recorded in the financial statements reflect events that actually occurred.

    If a company records sales and accounts receivable, the auditor may test the balances by sending a confirmation letter to the customer. The CPA firm can send a copy of the unpaid invoice and ask the client to confirm that she bought the product or service.

  • Completeness: All the transactions that should be recorded are actually recorded.

    CPAs perform an audit procedure called the search for unrecorded liabilities to ensure that all material accounts payable are posted as of the balance sheet date. The CPA looks at checks that are paid shortly after year-end. The auditor then determines whether a payable needs to be set up for a check written after year-end.

    If, for example, the client pays a large balance for raw materials on January 5, the CPA wants to see whether the raw-materials balance was a payable as of December 31 (the balance sheet date). If the raw materials were received on December 29, the company should set up accounts payable on December 29.

  • Accuracy: The amounts and other data in the financial statements have been reported accurately.

    Suppose the company has a $100,000, 7 percent corporate bond outstanding. To ensure that the interest expense calculation is accurate, the CPA recomputes the annual interest expense as $100,000 x 0.07 = $7,000. The auditor makes sure the interest expense calculated agrees with the amount recorded in the financial statements.

  • Cutoff: Accounting transactions are recorded in the proper period.

    Revenue recognition is a company’s policy for deciding when revenue should be posted to the financial statements. Suppose an online seller of electronics has a policy to recognize revenue when goods are shipped to the client. A CPA may select large sales posted in the last week of the year and review the related shipping documents. If the items sold were shipped after year-end, the sales should not be recorded before year-end.

  • Classification: Transactions are posted to the proper accounts.

    Say a company has a 5-year corporate bond outstanding. An auditor reviews the loan document and calculates how much of the principal will be paid back in the next 12 months. That amount should be posted to current liabilities, not long-term liabilities. The issue of current versus long-term is a classification issue.

  • Existence: Balance sheet items (assets, liabilities, and equity) posted to the financial statements actually exist.

    Note that the occurrence assertion deals with transactions in any type of account, whereas the existence assertion primarily addresses assets posted to the balance sheet. For example, if a company lists 1,000 shares of Acme Manufacturing common stock as an investment, the CPA can inspect an account statement from the company’s investment firm to confirm existence.

  • Rights and obligations: This assertion refers to ownership of assets and obligations to pay liabilities.

    To verify that a company owns a piece of machinery, for example, an auditor can review the title for the machine. Having title to an asset indicates ownership.

  • Valuation: The valuation assertion refers to the dollar amount of an item posted to the financials.

    The principle of conservatism states that companies should avoid overstating the value of assets and equity and avoid understating the dollar amount of liabilities. These steps help prevent a firm from presenting a balance sheet that’s overly optimistic. Assets, for example, are most often recorded at historical cost. An auditor could review purchase records to verify cost of an asset.

One challenge on the CPA exam is that some of the assertions are very similar. The valuation assertion, for example, is similar to the accuracy assertion. You may find that you can only narrow down your answer choices to two assertions. If you reach that point, pick one of the two and move on.

Don’t spend too much time debating over two very similar choices. Your time is better spent on another question that may be clearer to you.