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Lesson 6: The Audit Process - YouTube
Channel: Executive Finance
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in this lesson we're going to do a
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high-level run-through of the audit
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process so that you get a feel for what
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an odd it is and how its conducted the
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rest of the course will take a deeper
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look into each of these audit procedures
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let's pretend that our client is
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Lakeview hotels it's a small
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capitalization public company that
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operates a small portfolio of hotels
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across the country and we work for early
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in young public accountants here's a bit
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of background
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Lakeview has been a client for the past
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four years the company has been
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negatively impacted by the slow recovery
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in the economy and it's older properties
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two years ago lakyn Lakeview outsource
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the management of its hotels to an
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external manager Lake view's corporate
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staff are responsible for the oversight
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of the managers the strategic decisions
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the financing decisions and of course
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preparing the public reporting Lakeview
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CEO is a seasoned veteran of the hotel
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industry the CFO has been with the
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company for the past three years and
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does not have a background in hotels the
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company is faced with a significant
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maturity of a debenture so with that
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background in mind let's walk through
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the high-level audit process let's start
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with the end in mind an audit is the
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expression of an independent opinion on
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the fairness of presentation of the
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financial statements as prepared by
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management two important points to make
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here first of all the responsibility for
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the preparation of the financial
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statements lies with management and not
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the auditors and secondly the auditors
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are responsible for their opinion which
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is based on the evaluation of audit
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evidence they gather so put in the
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simplest terms possible an audit is
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attended to ensure that every number and
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every disclosure within the financial
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statements is valid and supported so for
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instance let's just flip to the
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statement of financial position also
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known as the balance sheet management
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represents that there is one million
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four hundred
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thirty six thousand seven hundred and
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eighty nine dollars as of December 31st
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has auditors we need to gather evidence
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to support that this is in fact true
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think about this for a moment and
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consider the types of evidence you would
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expect the order to request to support
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this cash assertion here are some of the
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examples of the sorts of evidence you
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would have in mind a bank reconciliation
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a bank statement talking to the bank
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about how much money is in the account
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as of December 31st count the cash on
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hand
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the idea is to gather what is called
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sufficient appropriate audit evidence to
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support management's representation that
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there is only one million four hundred
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thirty six thousand seven hundred and
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eighty nine dollars of cash on the
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balance sheet the audit process and
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evidence gathering activity goes on and
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on for everything you see in the balance
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sheet and tell everything has been
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validated
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that's auditing in a nutshell however as
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you can imagine there's a bit more to it
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than that
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why well first of all and most
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importantly you need to realize that we
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practically can't look at every single
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piece of evidence that exists that would
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be cost prohibitive and in most cases is
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unnecessary for the users so what the
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auditors do instead is they use a
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risk-based approach to auditing that is
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to say they identify where the greatest
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risk for a material misstatement exists
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and then focus their audit procedures to
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ensure one or more of these so-called
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material misstatements does not exist
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notice I use the word material
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misstatement not just misstatement
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material implies a misstatement in the
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order of magnitude that it would change
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a user's decision when relying upon the
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financial statements now we're going to
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discuss this in much greater depth in a
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later lesson so let's go back to the
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beginning once again and then go through
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the audit process step by step the first
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thing we need to do has auditors of a
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youth is to evaluate whether we want to
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continue as the artists of Lakeview if
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this was a new client we would have to
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determine whether we want to accept the
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engagement the things to consider
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include the risk to the firm of taking
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on the engagement generally we don't
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want to get ourselves involved with any
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client that would expose us to a lawsuit
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we should also be wary of the businesses
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that are under pressure or companies
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with a bad reputation as these would be
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the sorts of indicators of a high
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business risk if it's a new engagement
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we will communicate with the predecessor
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auditor to determine if there's anything
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we should be concerned about of course
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we need to do our independence
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assessments by looking at the five
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threats to independence and the possible
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safeguards as we discussed in the
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previous lesson we will document the
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parameters of the engagement in what is
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called an engagement letter a fancy term
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that really means a contract between the
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audit firm and the client that covers
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the scope of services our fees and the
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deliverables assuming we are able to
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address all these items satisfactorily
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we can accept the engagement and move on
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to the actual planning audit planning
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encompasses a number of activities that
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are performed well ahead of the year-end
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audits are very much tailored to the
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client circumstances and no tool audits
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are exactly alike we begin with a risk
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assessment our risk assessment requires
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an in-depth study of the client's
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business the industry and the important
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factors that potentially impact the
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financial reporting the outcome of this
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analysis is that the higher the risk the
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more work we will likely have to perform
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before we get to that warm fuzzy feeling
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about the financial statements
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management has prepared risk assessments
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require professional judgment and
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general business acumen clients that
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have weak businesses post higher risks
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collides with weak people processes or
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systems post higher risk clients with
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strong incentives for manipulation of
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results through such things as bonus
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plans coveted calculations IPO
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aspirations or other set
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situations pose a higher risk you begin
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to get the idea about the sorts of
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things you are looking for when you're
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evaluating the client profile the formal
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planning incorporates the client risk
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profile analysis into an assessment of
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what is called audit risk now audit risk
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is the risk that we issue an unqualified
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opinion or a clean opinion when in fact
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there are material misstatements
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contained within the financial
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statements so in other words we get it
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wrong we obviously want to minimize this
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rest of the extent possible under the
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cost-benefit constraints note that you
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cannot eliminate Auto risk only minimize
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it pay careful attention to the language
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I'm using eliminating audit risk is not
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possible we will look at this in much
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greater detail in a separate module
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during planning we also want to assess
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materiality materiality is a concept
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tied to users though there is a
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correlation to audit risk a misstatement
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that is material is one that would
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change a user's decision for an investor
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it would be a decision to say sell the
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investment rather than hold it for a
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bank it might be whether to lend funds
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to a company or take a pass determining
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on what is material also requires a high
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degree of professional judgment what is
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material to an investor may be different
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than what is material to the bank but
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once you know what materiality is you
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can now focus your audit work on only
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those items which potentially have a
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material impact next we need to consider
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our audit approach and there are two
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general audit approaches that can be
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used in auditing and let me just spend a
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moment giving you the quick version of
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this and we'll look at it in detail
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later our combined approach is one that
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relies in part on the strength of a
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client's existing internal controls to
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reduce the amount of audit evidence we
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have to collect now some clients spend a
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considerable amount of time and
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resources in establishing and
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maintaining internal controls and where
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exist the auditors can rely on these
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controls the second approach is called a
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substantive approach and this approach
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does not rely on a client's system of
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internal controls and generally speaking
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requires the auditor to gather more
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evidence substantive evidence is
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collected to validate the amounts
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reported in the financial statements for
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example if our client reported that they
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had bought a new stove at one of the
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hotels we would seek a purchase invoice
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to validate that the amount recorded
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reflected the amount spent and the
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nature of the item purchased one of
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these two approaches we use for all
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material balances or transaction cycles
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in a financial statement a transaction
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cycle is simply a way of grouping like
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accounts in the financial statements for
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efficiency purposes for instance the
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sales cycle would include our room
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revenue our accounts receivable our cash
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receipts accounts because all these
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accounts are related to how we collect
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record and aggregate sales transactions
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there are other common cycles as well
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including the purchase cycle the payroll
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cycle the capital asset cycle so during
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the planning phase we will need to
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document the internal controls and
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design our audit approach for each of
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these material cycles based on our risk
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assessments and materiality hopefully
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you get the idea that there's a lot of
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upfront work to do before we ever start
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actually auditing the client now in the
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execution phases we look at the actual
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procedures the audit procedures are
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designed and documented in checklists
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called audit programs an audit program
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is a list of evidence gathering
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activities that are given to jr. on its
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staff to perform during fieldwork now
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field work most often happens on the
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clients premises as it requires access
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to the clients documents records and
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systems as procedures are performed
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evidence is gathered and filed and the
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audit program is signed off to signify
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the procedure has been completed by the
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audit staff member a combined audit
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approach requires that we test controls
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and gather substantive evidence these
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two procedures are similar but have
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different objectives now we already
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talked about what a substantive
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procedure is a test of control is
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performed by looking at a documented
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control that we think is pretty
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important to the integrity of the
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clients financial reporting system and
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if we can prove that that control has
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functioned as it's designed and
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effectively throughout the period then
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we can reduce the amount of substantive
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evidence that we need to collect
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generally speaking this is a more
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efficient proach for the auditors to
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take and one that is absolutely
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necessary for large complex multi
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billion-dollar companies next we have
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substantive procedures and they include
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analytical procedures tested details and
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account analysis analytical procedures
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are procedures that compare the bowa's
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reported against an expectation that the
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auditors establish for example we might
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project hotel revenue by looking at
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industry statistics and compared to our
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own hotel revenue and if the expected
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revenue in the actual revenue are close
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then we have proven that that number is
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plausible attested details another
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substantive procedure that compares the
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bowels reported to some supporting
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backup documentation for example if we
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want to audit the inventory balance we
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would expect the client to give us a
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listing of all the items that are
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included in inventory we would then
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prove that that inventory exists and is
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valued properly account analysis is a
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procedure that the order to use is to
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scan all the accounts that make up a
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given amount on the financial statements
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to identify and investigate anything
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that looks odd for example we may scan
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the professional fees looking for fees
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that were paid to lawyers which may
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indicate a potential lawsuit or
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contingent liability in the last step in
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the execution phase we evaluate the
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audit evidence gathered by the field
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staff the audit seniors will review the
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work of the audit juniors and they
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oughta managers will
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review the work of the audit team and
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the partners will review the entire file
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to the extent that the evidence supports
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the risk assessments and the clients
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version of what happened we can move on
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to the reporting phase however
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oftentimes evidence is gathered that
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doesn't support what we expected during
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the planning phase and this will result
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in review notes that need to be cleared
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by the audit field staff it could be
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that the internal controls aren't quite
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as effective as we thought or that there
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are certain balances that are misstated
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or a can athon correctly these sorts of
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findings require us to go back to our
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audit plan reassess the audit risk which
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in turn forces us to modify our
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procedures and gather more evidence in
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order for us to reach our warm fuzzy
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happy place some errors are found for
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which the client will have to make an
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adjustment to the financial statements
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smaller immaterial errors may be tracked
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by the auditor but no adjustment made
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the final replace of the audit is the
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reporting phase and during this phase
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all final reviews and quality control
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procedures are completed to make sure
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that the file supports the overall
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opinion of the accounting firm the
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auditors will communicate their findings
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to the Audit Committee and the senior
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management team the audit report will be
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released and attached to the financial
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statements an unqualified on opinion
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means that the financial information
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management has prepared as fairly
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presented if the auditors and management
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disagree on certain matters or there are
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errors that management refuses to
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correct or perhaps there are numbers
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which the auditors cannot find
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sufficient evidence to support then the
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auditors will amend their audit report
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accordingly to alert the readers to the
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financial statements of such findings
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I'm kind of tired just walking you
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through this whole eight step process so
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hopefully you'll walk away understanding
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there's a lot of work that goes into an
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audit opinion and even though the
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opinion itself is less than a page long
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if you find that's a lot to remember
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don't worry because we're really
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to a lot more depth in each of these
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steps in the lessons that follow now
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odds are cheap small microwaves will
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cost upwards of five thousand dollars a
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small capitalization public company will
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often have an auto cost of $100,000 or
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more large capitalization companies will
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pay millions of dollars to have their
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annual audit done auditing is a very
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profitable business for public
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accounting firms and it provides
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wonderful training ground for new
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professionals so until next time don't
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stop to get to the top when you get to
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the top don't stop
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