Lesson 6: The Audit Process

Summary

This lesson offers an introductory overview of the audit process, using Lakeview Hotels as a case study. It emphasizes that while management prepares financial statements, auditors independently assess their fairness, gathering sufficient evidence to support every figure and disclosure. The process is streamlined through a risk-based approach, focusing on areas most prone to material misstatements that could sway user decisions, rather than examining every piece of evidence.

Takeaways

• 🏢 The client, Lakeview Hotels, is a small-cap public company with a portfolio of hotels, facing economic challenges and property age issues.
• 👔 Lakeview's management structure includes a seasoned CEO and a CFO with three years of tenure but no hotel industry background.
• 💼 Early and Youth Public Accountants are responsible for auditing Lakeview, focusing on the fairness of financial statement presentation.
• 📊 The audit's primary goal is to validate the accuracy of every number and disclosure in the financial statements, ensuring their validity and support.
• 💼 Management is responsible for preparing the financial statements, while auditors provide an independent opinion based on the evidence they gather.
• 📑 Evidence for financial statement assertions includes bank reconciliations, statements, confirmations, and physical cash counts.
• 🔍 Auditors use a risk-based approach, focusing on areas with the highest risk of material misstatement to ensure financial integrity.
• 📈 The term 'material misstatement' refers to errors significant enough to potentially alter a user's decisions based on the financial statements.
• 🔑 The audit process is iterative, with a continuous validation of financial statement items until all are supported by sufficient and appropriate evidence.
• 📚 The script hints at a deeper dive into these concepts in subsequent lessons, promising a more detailed exploration of audit procedures and risk assessment.

Q & A

What is the primary objective of an audit?

The primary objective of an audit is to express an independent opinion on the fairness of the presentation of financial statements prepared by management.

Who is responsible for the preparation of financial statements?

Management is responsible for the preparation of the financial statements, not the auditors.

What is the auditor's role in the audit process?

The auditor's role is to form an opinion based on the evaluation of the audit evidence they gather to ensure the validity and support of every number and disclosure within the financial statements.

What is the Statement of Financial Position also known as?

The Statement of Financial Position is also known as the Balance Sheet.

How much cash does Lakeview Hotels claim to have as of December 31st?

Lakeview Hotels claims to have $1.4 million of cash as of December 31st.

What types of evidence might an auditor request to support the cash amount stated by Lakeview Hotels?

An auditor might request a bank reconciliation, a bank statement, confirmation with the bank, or a physical cash count as evidence to support the stated cash amount.

What does the term 'sufficient appropriate audit evidence' refer to?

Sufficient appropriate audit evidence refers to the quantity and quality of evidence needed to support management's representations in the financial statements.

What is a 'risk-based approach' to auditing?

A risk-based approach to auditing involves identifying the areas with the greatest risks for material misstatements and focusing audit procedures to ensure these misstatements do not exist.

Why can't auditors practically examine every piece of evidence?

Examining every piece of evidence would be cost prohibitive and unnecessary for the users, so auditors use a risk-based approach to prioritize their efforts.

What is the significance of the term 'material' in the context of misstatements?

A 'material' misstatement refers to an error significant enough to change a user's decision when using the financial statements, indicating its importance in the context of the audit.

What is the background of Lakeview Hotels' CFO?

The CFO of Lakeview Hotels has been with the company for the past three years and does not have a background in the hotel industry.

Outlines

00:00

📊 Introduction to the Audit Process

This paragraph introduces the concept of an audit, explaining it as a high-level review process to understand what an audit entails and how it is conducted. The example of Lakeview Hotels, a small public company, is used to illustrate the context. The paragraph establishes that the auditor's role is to provide an independent opinion on the fairness of the financial statements prepared by the company's management. It emphasizes that while management is responsible for the preparation of these statements, auditors must evaluate the evidence to support the numbers presented, such as verifying the claimed cash balance of $1.4 million through bank reconciliations, statements, and direct communication with the bank.

🔍 The Role of Evidence in Auditing

This section delves deeper into the importance of gathering sufficient and appropriate audit evidence to support the representations made by management in the financial statements. It uses the example of confirming the cash balance on the Statement of Financial Position, explaining the types of evidence auditors might seek, such as bank reconciliations and statements, and the process of counting cash on hand. The paragraph highlights the continuous nature of this evidence-gathering process, which is aimed at validating every aspect of the financial statements.

📉 Risk-Based Approach in Auditing

The paragraph discusses the practical limitations of auditing, pointing out that it is not feasible to examine every piece of evidence due to cost and necessity. Instead, auditors employ a 'risk-based approach' to identify areas where the risk of material misstatements is highest and focus their efforts there. The concept of 'material' is introduced, indicating that only misstatements significant enough to potentially alter a user's decision are of concern. The paragraph sets the stage for a more in-depth discussion of this approach in later lessons.

Keywords

💡Audit

An audit refers to the systematic examination and verification of financial accounts, statements, and records conducted by an auditor. In the context of the video, it is the process of ensuring the fairness and accuracy of the financial statements prepared by Lakeview Hotels' management. The audit is crucial for providing an independent opinion on the company's financial health, which is vital for stakeholders to make informed decisions.

💡Financial Statements

Financial statements are formal records of a company's financial activities, including the balance sheet, income statement, and cash flow statement. They are the primary tool used by management to represent the financial position and performance of a company. In the video, the auditor's role is to validate the accuracy of these statements, ensuring that every number and disclosure is supported by sufficient evidence.

💡Management

In the context of auditing, management refers to the individuals or team responsible for the day-to-day operations and strategic decisions of a company. In the script, Lakeview Hotels' management is responsible for preparing the financial statements, which the auditors then evaluate for accuracy and fairness of presentation.

💡Auditors

Auditors are professionals who perform audits to provide an independent opinion on the financial statements. They are responsible for gathering audit evidence and evaluating it to form their opinion. In the video, the auditors work for Early and Youth Public Accountants and are tasked with auditing Lakeview Hotels' financial statements.

💡Audit Evidence

Audit evidence is the information obtained by the auditor during the audit process to support their opinion on the financial statements. It must be sufficient and appropriate to provide a reasonable basis for the auditor's conclusion. The video script mentions examples such as a bank reconciliation, bank statement, and cash count as potential audit evidence to validate the reported cash balance.

💡Risk-Based Approach

A risk-based approach in auditing involves identifying and focusing on areas where there is a higher risk of material misstatement in the financial statements. This approach allows auditors to allocate their resources efficiently and effectively, targeting areas that pose the greatest threat to the integrity of the financial statements. The script emphasizes that auditors cannot look at every piece of evidence due to cost and practicality, hence the adoption of this approach.

💡Material Misstatement

A material misstatement refers to an error or omission in the financial statements that is large enough to influence the decisions of users relying on that information. The term 'material' implies significance in the context of the financial statements. In the video, the focus is on identifying and preventing material misstatements to ensure the reliability of the financial reporting.

💡Lakeview Hotels

Lakeview Hotels is the client company in the video script, a small capitalization public company operating a portfolio of hotels. The company serves as the context for the audit process being described, with its financial statements being the subject of the auditors' examination. The script provides background information on Lakeview Hotels to set the stage for the audit process.

💡Public Accountants

Public accountants are professionals who provide accounting services to the public, including auditing, tax preparation, and financial advisory services. In the script, Early and Youth Public Accountants are the firm that the auditors work for, and they are responsible for conducting the audit of Lakeview Hotels.

💡Balance Sheet

The balance sheet, also known as the Statement of Financial Position, is one of the primary financial statements that provides a snapshot of a company's assets, liabilities, and equity at a specific point in time. In the video, the balance sheet is used as an example to illustrate the process of validating the reported cash balance of Lakeview Hotels.

💡CFO

The CFO, or Chief Financial Officer, is a senior executive responsible for managing the financial actions and affairs of a company. In the script, Lakeview Hotels' CFO has been with the company for three years and does not have a background in the hotel industry, which may impact their approach to financial management and reporting.

Highlights

Introduction to the high-level audit process for understanding what an audit is and how it is conducted.

Client background: Lakeview Hotels, a small-cap public company with a portfolio of hotels, facing economic challenges.

Auditor's firm background: Early and Youth Public Accountants with a 4-year client relationship.

Lakeview's management structure with external managers and corporate staff oversight.

Key personnel background: CEO with industry experience and CFO with 3 years at the company but no hotel background.

Financial challenges: significant maturity of a debenture impacting Lakeview.

Definition of an audit: expression of independent opinion on the fairness of financial statement presentation.

Management's responsibility for financial statement preparation versus auditor's responsibility for opinion.

Audit's purpose: to ensure validity and support for every financial statement number and disclosure.

Example of evidence gathering for cash balance assertion in the Statement of Financial Position.

Types of evidence auditors may request: bank reconciliation, statement, confirmation, and cash count.

Concept of sufficient appropriate audit evidence to support management's representations.

The iterative nature of the audit process and evidence gathering for financial statement validation.

Limitations of a full evidence review: cost prohibitive and unnecessary for most users.

Introduction to the risk-based approach in auditing to identify and focus on material misstatement risks.

Differentiation between 'material' and 'non-material' misstatements in the context of user decision impact.

Preview of deeper discussions on material misstatement and its significance in future lessons.

Transcripts

In this lesson we are going to do a high level run through of the audit process so that you get a feel for what an audit is and how it is conducted.

The rest of the course will take a deeper look at each of these audit procedures.

Let’s pretend our client is Lakeview Hotels.

It’s a small capitalization public company that operates a small portfolio of hotels across the country.

We work for Early and Youth Public Accountants. Here is a bit of background.

Lakeview has been a client for the past four years.

The company has been negatively impacted by the slow recovery in the economy and older properties.

Two years ago, Lakeview outsourced the management of the hotels to external managers.

Lakeview’s corporate staff are responsible for oversight of the managers, strategic decisions, financing decisions, and public reporting.

Lakeview’s CEO is a seasoned veteran of the hotel industry.

The CFO has been with the company for the past three years, and does not have a background in hotels.

The company is faced with significant maturity of a debenture.

So with that background in mind, let’s walk through the high level audit process.

Let’s start with the end in mind, an audit is the expression of independent opinion on the fairness of presentation of the...

financial statements as prepared by management.

Two important points to make here.

First, management is responsible for the preparation of the financial statements, not the auditors.

Second, the auditors are responsible for their opinion, which is based on the evaluation of the audit evidence they gather.

So let’s put this into the simplest terms possible...

An audit is intended to ensure that every number and every disclosure contained within the financial statements is valid and supported.

So for instance, let’s just flip to the Statement of Financial Position (also known as the Balance Sheet).

Management represent that there is $1.4 million of cash in the company as at December 31st.

As auditors, we need to gather evidence to support that this is in fact true.

Think about this for a moment and consider the types of evidence you would expect the auditor to request to support this assertion.

[PAUSE: YOU ARE SUPPOSED TO BE THINKING!]

Here are some examples of the sorts of evidence should have in mind.

A bank reconciliation.

A bank statement.

Talking to the bank about how much cash is in the account as of that date.

Count the cash on hand.

The idea is to gather what is called, sufficient appropriate audit evidence to support management’s representation that...

there is $1,436,789 of cash on the balance sheet.

This audit process and evidence gathering activity goes on and on

for everything you see in the financial statements until everything has been validated.

That’s auditing in a nutshell; however, as you can imagine, there is a bit more to it than that.

Why?

Well first and perhaps most importantly, you need to realize we can’t practically look at every piece of evidence that exists,

that would be cost prohibitive and in most cases unnecessary for the users.

So what auditors do instead, is they use a “risk based approach” to auditing.

That is to say, they identify where the greatest risks exist for a material misstatement,

and then focus their audit procedures to ensure one or more of these so called "material misstatements" does not exist.

Notice I use the word “material” misstatement and not just misstatement.

Material implies a misstatement in the order of magnitude that it would change a user’s decision when using the financial statements.

We will discuss this in much greater depth in a later lesson.

So, let’s go back to the beginning once again, and this time go through the audit process step