Assurance

Understanding Financial Statement Assertions (Part 2)

Hi readers!  My name is Gus Patel, and I have offered to help with updates to content on the UFE Blog.  I have recently been in your situation, having written the 2013 UFE.  Currently, I work as an Audit Senior at BDO Canada LLP.  In my spare time, I enjoy being active, as well as teaching students about accounting concepts.

Today we continue the discussion of financial statement assertions from yesterday.

Before getting into the specifics of each assertion, it might be helpful to understand why aspiring CA’s should care.

Audit Assertions

Why are audit assertions important to auditors?

From the above chart, we can see that at the end of the day, the real essence of addressing assertions are to evaluate management’s overall position on the financial statements, either about transactions and events for the period under audit (See CAS 315 – A.124), or otherwise known as the income statement assertions or assertions about account balances that are at period end – or balance sheet assertions and finally presentation and disclosure assertions.  Presentation assertions will not be covered in this post to focus on the most popular assertions on the UFE:

So what are the assertions and how can you pair them with a correct procedure?

Existence (or Occurence if you are referencing the Income Statement side)

This is essentially understood as management’s claim that the amounts recorded are actually genuine, or “exist”, and are not ficticious transactions.  An existence error essentially is an account overstatement (i.e. something isn’t there when it is recorded that it is).  An easy procedure to address whether anything exists is to actually physically verify.  Auditors can physically count cash, inventory, or obtain confirmations on receivable balances.

Completeness

Completeness is management’s claim that all transactions to be included are included, or “complete”.  A completeness error would be an understatement (i.e. something is there which isn’t recorded).  Therefore, an easy procedure to verify completeness is to do a floor-to-sheet count.  Another example could be having auditors verify accruals are accurate through subsequent testing of related expenses.

Accuracy

All data (amounts) relating to the transactions are properly recorded.  A good way to remember accuracy is to think of cases where there is something that management needs to calculate in order to arrive at an account balance.  For example, foreign exchange needs to be accurately recorded, and a procedure to address the accuracy of foreign exchange would be to recalculate and compare to what management has recorded.

Cutoff

Ensuring appropriate cutoff means accounting for every transaction that occurred during the (financial statement) period without either aggressively recording entries which are within the next-periods transactions, or postponing the recording of transactions until the next period.  An easy way to remember cut off is to think of revenue or balance sheet liabilities, things that management might be interested in delaying or accelerating due to bias for either obtaining a management bonus, or for covenant compliance.  A procedure to address cut off is to determine the date of the transaction, either the sale or liability in this case.

Classification

Transactions occurring are within the correct accounts.  For example,  your revenue recorded really isn’t an expense, or an asset really isn’t a liability.

Rights and Obligations (balance sheet assertion only)

The entity holds the “right” or actually controls the asset or liability.  For instance, an entity has the legal “right” to record property plant and equipment on the balance sheet if they have entered into a purchase agreement, and funny enough, the easy way to verify that is to look at the purchase agreement!

Valuation and Allocation (balance sheet assertion only)

Assets, liabilities and equity are included in the financial statement presentation at appropriate amounts, and all valuation adjustments are properly recorded in accordance with the financial reporting framework being used.  Measurement of valuation can either be: fair value, historical cost, present value or a method of allocation of joint costs.  Procedures to verify this could be comparing market data to ensure inventory does not require a write down, or evaluating the collectibility of receivables greater than 90 days – asking the question: is it really collectible?

Once you understand what the assertions are, the next challenging part is identifying which assertion addresses the real risk, because remember, all balance sheet assertions have: existence, rights and obligations, completeness and valuation and allocation assertions, and all income statement items have occurrence, completeness, accuracy, cutoff and classification assertions!

Again, remember these assertions are all in your CICA Handbook and can be referenced during your practice exams and in a pinch, even during the UFE! However, if you’re getting started now, procedures will be second nature to you.

 

Understanding Audit Assertions (Part 1)

Hi readers!  My name is Gus Patel, and I have offered to help update some content on the UFE Blog.  I have recently been in your situation, having written the 2013 UFE.  Currently, I work as an Audit Senior at BDO Canada LLP.  In my spare time, I enjoy being active, as well as teaching students about accounting concepts.

Today I’m going to introduce you to how audit assertions will be an important aspect of writing good procedures on the UFE. Tomorrow I will dive into the technical aspects of audit assertions which CKE candidates may find helpful.

Please have a look at Creating good procedures on the UFE  before diving into this audit assertions topic, as this post will focus on the key assertions that candidates will integrate as part of their procedure response.

Given the increased attention on the UFE to relevant procedures, it’s worth examining one aspect of procedures which is key to understanding how to write good procedures from the start. Scoring on procedure indicators includes the requirement to identify the relevant “audit assertion”.  Candidates will probably not score competent on a discussion of procedures which address an irrelevant assertion.  Where candidates have difficulty is in pairing a relevant assertion to the procedure that they create.

For example:  If case facts indicate an accounting issue is related to a writedown of inventory, which you correctly identify and respond as apart of your accounting discussions, an easy procedure candidates may choose to write could be an inventory count.  Inventory counts address two assertions through testing, either completeness of the listing obtained by vouching from items on the records (known as floor-to-sheet), or existence of inventory by vouching from items on the books to items held in inventory (known as sheet-to-floor).  While you may correctly identify an assertion related to this particular procedure, the real risk you identified is around inventory valuation.  Thus, discussion of an inventory count would not address the real risk you identified.  In this case, a valid response could be as follows:

  • To address the risk of proper inventory valuation at year-end, we should obtain an aged inventory listing as well as the most recent sales invoice, to ensure the product is selling higher than the cost recorded.  If it is determined that the product has been sold for less than costs recorded, or has not been sold recently, this may be indicative of a write-down being required.

While this may be easier for candidates in audit, assertions can be somewhat tricky for writers with little to no audit experience. Luckily, audit assertions can be found in the CICA Handbook.  With this in mind, if you are having difficulty with developing procedures, it may be wise to keep the Handbook open, at least in the beginning while writing and quickly reference what the relevant assertion would be.

If you are struggling with this at the beginning, you are not alone!  Pairing audit assertions to the procedures you create tends to be one of the more difficult areas for candidates to master at first, but with time and practice it is something that will become second nature by the time you are ready to write the UFE.  Also remember, topics such as the inventory count discussion above do not change, therefore, frequently tested topics which you will debrief over your study period will cover virtually all assertions for the popularly tested risk areas.

What difficulties with audit assertions do you have?

 

Discussing Control Weakness on the UFE

You’ll more than likely encounter control weaknesses at some point during the UFE and you’ll have to probably discuss at least 4-5 of them to get the C in this assurance indicator. Here’s the WIR (weakness, implication and recommendation) strategy most students will probably use to tackle control weaknesses. As always, I caution that this is just a strategy and not always applicable so use your judgment in determining when this is appropriate and inappropriate to apply.

Weakness

Here you are answering, using case facts, what the specific control weakness is. You can include this as part of a longer paragraph covering off everything or I prefer to keep everything separate and just use “Weakness: … ” so it’s even more clear and keeps you on track.

Examples of a weaknesses:

  • Presently the finance department is overworked and there are insufficient segregation of duties since the same individuals are creating POs, entering information into the accounting system and preparing the cheque runs.
  • The transposition error for the receivable contract of $1.5M was not caught despite managements insistence that this would normally be caught by a manager’s review.

Implication

The implication answers the “so what?” This is equally as important as identifying the weakness, you must state what will continue to go wrong if this weakness is not resolved. Think about the Financial Statements or the business itself. Will amounts be misstated? Will the business lose cash? Will fraud occur? And so forth.

Examples of an implication:

  • The lack of segregation of duties is inappropriate since it does not separate accounting entry from payment and can result in finance staff making inappropriate accounting entries (for example payments to themselves) and then issuing the cheques to themselves with no oversight. Fraud could occur without being detected in time to prevent it.
  • It is possible that there are other (possibily material) errors due to similar oversights by management review. Managers are presently being overworked and unable to keep up with their duties resulting in a lack of functioning controls such as this review. This can result in misstatements due to errors not being caught by management review.

Recommendation

The recommendation is your suggested solution to this problem. This must be a control that is specific and practical given the circumstances and of course must be related to the simulation risk and implication discussed.

Examples of a recommendation:

  • Hiring a new controlled ASAP should be given priority in order to set up proper segregation of duties and have proper oversight. Presently, management review is too late and merely a detective control and not preventative.
  • For the time being, managers should be spoken to regarding the importance of reviewing these forms and held accountable for their oversights. Longer-term, CompanyX should assess whether they should hire additional staff in order to allow the manager to focus on reviewing such forms appropriately since the cost of errors may outweigh the savings in management reductions.

 

Now altogether, what an actual response might look like:

Segregation of Duties

Weakness: Presently the finance department is overworked and there are insufficient segregation of duties since the same individuals are creating POs, entering information into the accounting system and preparing the cheque runs.
Implication:  The lack of segregation of duties is inappropriate since it does not separate accounting entry from payment and can result in finance staff making inappropriate accounting entries (for example payments to themselves) and then issuing the cheques to themselves with no oversight. Fraud could occur without being detected in time to prevent it.
Recommendation:  Hiring a new controlled ASAP should be given priority in order to set up proper segregation of duties and have proper oversight. Presently, management review is too late and merely a detective control and not preventative.

Oversight Problems

Weakness: The transposition error for the receivable contract of $1.5M was not caught despite managements insistence that this would normally be caught by a manager’s review.
Implication: It is possible that there are other (possibily material) errors due to similar oversights by management review. Managers are presently being overworked and unable to keep up with their duties resulting in a lack of functioning controls such as this review. This can result in misstatements due to errors not being caught by management review.
Recommendation: For the time being, managers should be spoken to regarding the importance of reviewing these forms and held accountable for their oversights. Longer-term, CompanyX should assess whether they should hire additional staff in order to allow the manager to focus on reviewing such forms appropriately since the cost of errors may outweigh the savings in management reductions.

As you can see, each is 4-5 sentences in total and covers off everything neatly. I’m sure the wordsmiths out there can even get them shorter and more direct.

Do you have any trouble discussing Control Weaknesses? What’s the worst part about these?

 

Audit Engagement Considerations

Timing in the audit process can be an issue and may change the way you discuss the issue.

  • If the audit has not yet been accepted, consider acceptance issues. Do not jump into a discussion in a way that assumes you’ve accepted the engagement (unless case facts indicate that you will). You may need to state whether your firm should do this audit in the first place.
  • If the audit is accepted but has not yet been started, consider audit planning issues. This is where you’d use the audit planning memo to plan out your audit.
  • If the audit is in progress, consider procedures. Sometimes you’ll already have materiality set and risks identified and you’ll need to discuss audit procedures.
  • If the audit is already complete, consider the work performed and any errors. If the audit is complete you should not be suggesting new procedures or discussing materiality but discuss surrounding whether the work performed is sufficient to provide assurance and the materiality of errors or issues for the management letter.

Another issue which frequently pops up, and it’s easy to mention, is that your audit may have a scope limitation regarding opening balances. Don’t forget to mention this easy point if you cannot provide assurance over opening balances.

Due Diligence Procedures on the UFE

As I discussed before, the 2010 UFE Report mentioned that due diligence was a weakness and I suggested this year’s UFE writers may want to brush up on the topic. One of our readers sent in a few questions around this topic so I did a little digging and I’ll discuss how I understand it today.

Reporting on the results of due diligence procedures is not itself a report and therefore in a UFE simulation, it is important to provide valid procedures which are linked to case facts. You should also state why each procedure is important/useful so that the client understands what you are trying to accomplish and why it’s important. Remember what your role is and for whom you are creating the report.

Providing due diligence procedures is not the same as providing a comfort letter which is covered under Section 7200 in the Canadian Auditing Standards. Section 7200 states that when there is an offering document, an auditor may be asked to provide a letter which expresses an opinion as to the compliance of the financial statements with legal requirements. It’s important that the auditor not offer assurance over the entire offering document but only certain financial info/statements referred to in the document. As a side note, I’ll add here that “Auditor involvement with offering documents of public and private entities, including current legislative and regulatory requirements and auditor assistance to underwriters and others (AuG-30)” is a Level C topic on the UFE therefore only a basic understanding is required. (See. p. 68 of the 2010 UFE Candidates’ Competency Map)

A significant difference between a comfort letter and due diligence procedures is that a comfort letter may provide some level of assurance while with due diligence procedures you are only reporting on the results of these procedures without offering positive or negative assurance.

There is a CA Magazine article (caution: from 2000 so a little out of date) about comfort letter which you can read here.

Enjoy your weekend! Remember it’s vital to take time off and refresh in order to stay at your best.

 

If anyone has more to add on this topic please share in the comments below!

Creating good procedures on the UFE

Continuing from yesterday, today we put the P in RAMP and cover one of the most important aspects of assurance which is creating good procedures.

Procedures

Procedures are often the most critical part of your audit planning memo and most often specifically asked for so you’ll have to get good at these. I felt like the 2010 UFE was full of procedures. With procedures you want to focus on the key risk areas in the simulation which is related to audit risk and also often related to accounting issues in the simulation. Here are some things that a good procedure will cover off.

  • Specify how to audit the risk – you’ll need to give a specific procedures to be performed (i.e. inventory count, reconciliation, send out confirmations, etc.) The more specific and non-generic the better. Include specific steps such as observing an inventory count, match x to y, and so forth. These must be very specific to your simulation and shouldn’t be generic. Specificity is the key with procedures so make sure to specify what the overall procedure is (i.e. inventory count) and then some additional detail related to the case (such as for example: by weighing a number of widgets in each crate and multiplying it against an average weight).
  • Specify why you are testing this area, why is it a key risk area? This could be covered off in audit risk as well.
  • Specify what assertion you are testing – Make sure this makes sense, doing an inventory count might be great for existence or completeness but probably poor for accuracy and occurrence. It’s important you understand the assertions and what they mean so that your procedure makes sense.

You’ll want to try and give a good procedure for each risk if possible and, again, the number of procedures to shoot for in many cases is 3-4 valid procedures, but obviously use your judgment and experience in determining how many to write.

One additional insight about what the Evaluation Board expects from procedures can be found on page 8 in the 2010 UFE Report.

Candidates are encouraged to always consider the effectiveness of the procedures they provide. Procedures should address the risk area identified. In addition, when presenting an audit plan to an audit committee or a client, candidates should explain why the procedure is necessary, in other words, how it would successfully address the client’s assurance needs.

 

Last thing: with all of the above, I want to stress that it’s important to use case facts often and clearly when discussing each element. Generic discussion or knowledge “dumps” are seldom rewarded on the UFE so get in the habit early of using lots of case facts in your discussions.

What kind of trouble are you having with procedures?

The Audit Planning Memo on the UFE

Most people will be into their UFE study period now and possibly be seeing their first UFE mock marks. If they are not what you hoped, don’t worry too much yet, most people quickly improve in the first week or two before leveling off.

Today’s topic is something you will almost definitely see on the UFE, and probably more than once so it’s good to master it from the beginning. The Audit Planning Memo.

Although there are some different approaches out there, the most common elements and approach of an Audit Planning Memo is the RAMP approach (Risk, Approach, Materiality and Procedures). For most audit planning memos you don’t need to discuss all three and often two or three is enough with a discussion of risk and procedures being the most important.

Audit Risk Discussion

It’s important, first of all, to state what the audit risk is exactly based on the case facts. Generally the risk is either high or low but it can also be medium at times. If you’ve forgotten, audit risk the risk that the financial statements are materially misstated after a clean audit opinion is given an is usually calculated as Audit Risk = Inherent Risk * Control Risk * Detection Risk.

Next, you must support your conclusion by specific evidence from your simulation. The amount of evidence depends on the simulation but a general rule of thumb is that you should support your conclusion with at least three specific risks from the case. This is only my opinion so use your own judgment and experience to determine how many is enough! If prior year risk is mentioned or the risk is changing from a prior year, it is important to be specific about what has changed to increase or decrease the audit risk this year.

Some examples of risks:

  • New management or ownership may introduce new biases to misstate
  • Complex accounting issues may be prone to error
  • Weak controls discovered or problems reported by employees with the financial information

 

Audit Approach

This is often the least discussed area because most UFE simulations don’t have significant approach issues. You have three options here and must state which you will take and support it with case facts. The three options are substantive approach (you will be reviewing transactions), controls reliance (you are relying on the controls) or a combined approach (for some areas you will rely on controls).

If there are very weak controls all around you will take a substantive approach and support it with information from the case as to why. If all controls are functioning fine you can take a controls reliance approach but this will probably never occur so you are most likely to take a combined approach which will rely on controls in some areas and take a substantive approach in the weak areas.

 

Materiality

Materiality is usually the easier to score a quick few points over audit approach. Materiality is a number which is based on the financial statements so you must calculate it and state why you are calculating it this way. Materiality is mostly linked to users of the financial statements and not risk so when discussing materiality it is important to discuss how it relates to users of the financial statements. Quick reminder: an amount is material if it could influence the decision of a user of the financial statements. Typical materiality amount go-tos are 5% of Net Income from continuing operations or 0.5-1% of total assets but obviously use your judgment at the time.

Some examples of issues around materiality:

  • New users of the financial statements – they may have a lower or higher materiality than previous users
  • Loans or covenants are involved which are based on the financial statements – amounts which breach these covenants are material
  • Whenever there is a sale or purchase of a company occurring, materiality is often a factor since the purchase price is based on the financial statements

 

Last thing: with all of the above, I want to stress that it’s important to use case facts often and clearly when discussing each element. Generic discussion or knowledge “dumps” are seldom rewarded on the UFE so get in the habit early of using lots of case facts in your discussions.

Come back tomorrow where I’ll tackle procedures, the most important part of the RAMP and a critical element of scoring well on the UFE.

Did I miss anything? What else do you include in your Audit Planning Memos and why?

Pin It on Pinterest