Using A Top Down Approach To Auditing
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The top-down approach is a highly accurate tool used
to detect material misstatements in a company’s financial records. Auditors
should use this approach to determining a company’s overall risks in internal
control. The process begins with a review of the financial statements then
spotlights entity-level controls to further focus on major accounts and
disclosures. Once the auditor has an understanding of possible risks that may
slip through the internal control process, they set up tests to ensure the
accuracy of company controls. The controls that attract attention from the
auditor relate directly with their conclusion on whether the company’s internal
controls are accurate in financial statements. Entity-level controls are
different from company to company but are generally set up to monitor areas
that commonly lead to inaccurate figures. Some examples of these entity-level
controls include limiting management override, monitoring results of
operations, and developing new company policies that address business control
and risk management practices.
A key entity-level control screens the environment of
a company to insure the precision of their internal controls over financial
reporting. In testing this control, the auditor must ensure that the motives of
management promote an effective and responsible approach to financial reporting
and also whether the audit committee shows responsibility in their supervision
of management. The auditor must also develop an understanding of the company’s
period-end financial reporting process by reviewing company procedures. These
procedures include entering in data into general ledger accounts, selecting
accounting policies, processing journal entries, recording recurring and
nonrecurring adjustments, and prepare financial statements and related
disclosures. The auditor must review input systems and information technology
the company uses in reporting financial statements to insure there accuracy.
The auditor must also be knowledgeable on management’s responsibility in the
process of reporting figures on the financial statements.
Auditors using the top down approach must be able to
identify important accounts and disclosures that may have a higher probability
of containing inaccuracies; leading to material misstatement in the company’s
financial statements. Common assertions include existence, completeness,
valuation, rights and obligation, presentation and disclosures. Auditors
continually evaluate qualitative and quantitative factors related to the
figures listed on the financial statements these assertions would include but
not limited to the size and volume of accounts, complexity of disclosures, and
significant changes from year to year or quarter to quarter. A judgment call
must be made by the auditor in figuring what is most likely to slip through
company controls and result in materially misstated financial records. The
risks in internal control are similar to those risks in an audit of companies’
financial statements, so an auditor may evaluate comparable accounts and
disclosures to help identify the major threats. Companies functioning with
different locations or multiple entities should have consolidated financial statement
in which the auditor examines, finding possible weaknesses and then indicates
scoping decisions for the company.
To understand key sources of misstatements the auditor
must realize and understand how the transactions flow within the company
(procedures, authorization, and documentation), controls that management has
put in place and how they stay free of misstatements due to managements
eagerness to please stockholders. Due to the fact that a large majority of the
auditors work is based on judgment the work should be delegated to different
individuals within a firm so the auditor is not always auditing his or her own
work. One of the most beneficial resources to the auditor is the use of
walkthroughs. Walkthroughs are the process of following a transaction from
basic journal entries all the way to the financial statement. During critical
points of the walkthrough the auditor will question personnel and discuss
issues dealing with internal control procedures issued by the company. The
auditor will select transactions that will test those controls that are
important to the auditor’s decision on the company controls. Multiple controls
may be tested with one transaction if so it is not necessary to retest that
control. The controls selected to be tested extensively deal with the auditors
relevant assertion not on how the control is labeled.
It often becomes cloudy when determining the
differences between a significant deficiency and a material weakness. Both in
essence are the same, although a significant deficiency is less severe than a
material weakness. If a company has a material weakness in their internal
control over financial reporting they have a flawed system. This creates the
possibility that a material misstatement will be translated onto the company’s
financial statements and will not be discovered until it is too late. A
significant deficiency is similar in the fact that there is also a flaw in the
company’s internal control system; however this flaw is less significant than a
material misstatement. If a company is found to have a significant deficiency
the auditor will relay this information to those individuals in charge of
overseeing the company’s financial reporting.
Accordingly, auditors use techniques of detection to
help them discover material weaknesses. Typical indicators include the
recognition of fraud (even if the fraud is immaterial), reviewing previous
material misstatement corrections, an indication of material misstatement that
would not have been discovered by company controls, and the effectiveness of
the company’s audit committee. When a deficiency or a combination of
deficiencies arises the auditor must decide on the type assurance that would
please company leaders and would satisfy the regulations of GAAP. If it is
determined that a deficiency will hinder company officials in the conduct of
their own dealings in concluding that they have “reasonable assurance that
transactions are recorded as necessary to permit the
preparation of financial statements in conformity with
generally accepted accounting
principles, then the auditor should treat the
deficiency, or combination of deficiencies, as
an indicator of a material weakness”.
In addition, all material weaknesses must be
communicated to the company’s management and the audit committee. This is done
with a written statement identifying these deficiencies that the audit team has
discovered. The written statement on the company’s internal control procedures
must be given to these groups prior to the auditor’s final report. If it is discovered
that audit committee is unproductive in supervising internal control over
financial reporting a written statement must be given to the company’s broad of
directors. Significant deficiencies should also be communicated to the audit
committee and management in writing. These deficiencies if previously stated do
not have to be repeated. The auditor is not responsible to perform procedures
that clearly explain the deficiencies but they must communicate deficiencies
they are aware of. The audit of internal control over financial reporting does
not offer the auditor assurance that all deficiencies under material weaknesses
have been identified so the auditor should not issue a report. Finally, the
auditor must be aware of their responsibilities under AU section 316 and
section 317 in case they discover fraud or illegal acts.
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