and Types of Audit Tests Chapter Five Audit Planning and Types of Audit Tests

The Phases of an Audit That Relate to Audit Planning Client acceptance and continuance Establish the terms of the engagement Preplanning Assess risks and establish materiality Plan the audit

Prospective Client Acceptance Obtain and review financial information. Inquire of third parties. Communicate with the predecessor auditor. Consider unusual business or audit risks. Determine if the firm is independent. Determine if the firm has the necessary skills and knowledge. Determine if acceptance violates any applicable regulatory agency requirements or the Code of Professional Conduct.

Continuing Client Retention Evaluate client retention periodically Near audit completion or after a significant event Conflicts over accounting & auditing issues Dispute over fees

Establish Terms of the Engagement The terms of the engagement, which are documented in the engagement letter, should include the objectives of the engagement, management’s responsibilities, the auditor’s responsibilities, and the limitations of the engagement. In establishing the terms of the engagement, three topics must be discussed: The engagement letter The internal auditors The audit committee.

The Engagement Letter The engagement letter formalizes the arrangement reached between the auditor and the client. In addition to the items mentioned in the sample engagement letter in Exhibit 5-1 in the textbook, the engagement letter may include: Arrangements for use of specialists or internal auditors. Any limitations of liability of the auditor or client. Additional services to be provided. Arrangements regarding other services.

Internal Auditors (continued)

Internal Auditors

The Audit Committee Subcommittee of the board of directors Section 301 of Sarbanes-Oxley Act requires the following for audit committee members of publicly held companies: Member of board of directors & independent. Directly responsible for overseeing work of any registered public accounting firm employed by the company. Must preapprove all audit and nonaudit services provided by its auditors. Must establish procedures to follow for complaints. Must have authority to engage independent counsel. Subcommittee of the board of directors No specific requirements for privately held companies

Determine the Audit Engagement Team Requirements Preplanning Determine the Audit Engagement Team Requirements Assess Independence

Assess Risks and Establish Materiality Use audit risk model Restrict risk at account balance level Achieve acceptable level of audit risk You may want to review the detailed discussion in Chapter 3 of the process used to assess the client’s business risks and to establish materiality.

Let’s look at each of these steps. Planning the Audit When preparing the audit plan, the auditor should be guided by the results of the risk assessment procedures performed to gain an understanding of the entity. Additional steps: Assess a preliminary level of control risk by account and assertion. Assess the possibility of illegal acts. Identify related parties. Conduct preliminary analytical procedures. Develop an overall audit strategy and prepare audit programs. Consider additional value-added services. Let’s look at each of these steps.

Assess a Preliminary Level for Control Risk by Account and Assertion Control risk is the risk that material misstatements will not be prevented or detected by internal controls. The presence of complex information technology may require the use of an IT specialist. A preliminary assessment of control risk is necessary for the auditor to plan the nature, timing, and extent of testing.

Assess the Possibility of Illegal Acts Direct & Material Consider laws & regulations as part of audit Material & Indirect Be aware may have occurred; investigate if brought to attention

Assess the Possibility of Illegal Acts

Identify Related Parties Some examples from FASB No. 57, “Related Party Disclosure” Affiliates of the enterprise. Entities using equity method to account for investments. Trusts for benefit of employees. Principal owners of enterprise. Management. Immediate families of the principal owners & management. Other parties that can have significant influence. How to Identify Related Parties Review board minutes. Review conflict-of-interest statements. Review transactions with major customers, suppliers, borrowers, and lenders. Review large, unusual, or nonrecurring transactions especially at year end. Review loan agreements for guarantees.

Conduct Preliminary Analytical Procedures To understand the client’s business and transactions To identify financial statement accounts likely to contain errors By understanding the client’s business and identifying where errors are likely to occur, the auditor can allocate more resources to investigate necessary accounts.

Develop an Overall Audit Strategy Auditors ensure they have addressed the risks they identified by documenting the linkage from the client’s business, objectives, and strategy to the audit plan. The auditor’s preliminary decision concerning control risk determines the level of control testing, which in turn affects the auditor’s substantive tests of the account balances and transactions. Nature Timing Extent

Consider Additional Value-Added Services Tax Planning System Design and Integration Internal Reporting Risk Assessment Benchmarking Electronic Commerce

Risk Assessment Procedures Substantive Procedures Types of Audit Tests Risk Assessment Procedures Used to obtain an understanding of the entity and its environment, including internal controls. Tests of Controls Directed toward the evaluation of the effectiveness of the design and implementation of internal controls. Substantive Procedures Detect material misstatements in a transaction class, account balance, and disclosure component of the financial statements.

Tests of Controls Inquiry Inspection Observation Walk Through Reperformance

Tests of Controls

Substantive Procedures Tests of Details Tests for errors or fraud in individual transactions Analytical Procedures Obtains evidential matter about particular assertions related to account balances or classes of transactions

Dual Purpose Tests Tests of Controls Substantive Tests

Purposes of Analytical Procedures Preliminary Analytical Procedures Used to assist the auditor to better understand the business and to plan the nature, timing, and extent of audit procedures. Substantive Analytical Procedures Used to obtain evidential matter about particular assertions related to account balances or classes of transactions. Final Analytical Procedures Used as an overall review of the financial information in the final review stage of the audit.

Purposes of Analytical Procedures Trend Analysis Ratio Analysis Reasonableness Analysis

Substantive Analytical Procedures Decision Process

Define a Tolerable Difference The size of the tolerable difference depends on the significance of the account, the desired degree of reliance on the substantive analytical procedures, the level of disaggregation in the amount being tested, and the precision of the expectation.

The Investigation of Differences for Planning and Final Analytical Procedures Preliminary Analytical Procedures Differences Final Analytical Procedures Differences Corroborating evidence not required Corroborating evidence is required

Audit Testing Hierarchy

Filling the Assurance Bucket

Accounts Payable Example of Filling the Assurance Buckets for Each Assertion

Short-Term Liquidity Ratios Current Ratio Quick Ratio Operating Cash Flow Ratio

Days Outstanding in Accounts Receivable Days of Inventory on Hand Activity Ratios Receivables Turnover Days Outstanding in Accounts Receivable Inventory Turnover Days of Inventory on Hand

Gross Profit Percentage Profitability Ratios Gross Profit Percentage Profit Margin Return on Assets Return on Equity

Coverage Ratios Debt to Equity Times Interest Earned

End of Chapter 5