Audit Planning, Understanding the Client, Assessing Risks and Responding Chapter 6

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 6-2 Obtaining Clients  Submit a proposal Contact the audit committee Make fee arrangements  Communicate with the predecessor auditors Topics Disagreements over accounting principles Predecessor’s understanding of reason for change of auditors Other Overall procedure is important for evaluation of management integrity

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 6-3 The Audit Process--Steps After obtaining a client, the audit process includes : 1. Plan the audit 2. Obtain an understanding of the client and its environment, including internal control 3. Assess the risks of material misstatement and design further audit procedures 4. Perform further audit procedures 5. Complete the audit 6. Form an opinion and issue the audit report This chapter emphasizes obtaining a client and steps 1-3.

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 6-4 Stages of an Audit-- Diagram

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Plan the Audit  Establish an understanding with the client This is ordinarily accomplished through use of an engagement letter Related, determine that The firm meets professional independence requirements There are no issues relating to management integrity The client understands the terms of the engagement

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 6-6 Items Included in Engagement Letters  Name of the entity  Management responsibilities Financial statements Establishing effective internal control over financial reporting Compliance with laws and regulations Making records available to the auditors Providing written representations at end of the audit, including that adjustments discovered by the auditors and not recorded to the financials are not material  Auditor responsibilities Conducting an audit in accordance with GAAS Obtaining an understanding of internal control to plan audit and to determine the nature, timing and extent of procedures Making communications required by GAAS

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 6-7 Engagement Letters--Optional Items  Arrangements regarding Conduct of the audit (e.g., timing, client assistance) Use of specialists or internal auditors Obtaining information from predecessor auditors Fees and billing  Other services to be provided, such as examination of internal control over financial reporting  Limitation of or other arrangements regarding liability of auditors or client  Conditions under which access to the auditors’ working papers may be granted to others

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 6-8 Audit Planning—Overall  Develop an overall audit strategy and an audit plan  Plan use of client’s staff  Plan involvement of other CPAs  Arrange for specialists  On first year audits: Communicate with predecessor auditors Establish opening balances on the financial statements

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Obtain an Understanding of the Client and its Environment  Perform risk assessment procedures, including Inquiries of management and others within the entity Analytical procedures Observation and inspection relating to client activities, operations, documents, reports and premises. Other procedures, such as inquiries of others outside the company (e.g., legal counsel, valuation experts) and reviewing information from external sources such as analysts, banks, rating organizations, journals.

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Understanding the Client’s Business—Nature of the Client  Competitive position  Organizational structure  Accounting policies and procedures  Ownership  Capital structure  Product and service lines  Critical business processes  Internal control

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Understanding the Client’s Business, Industry, Regulatory, and Other Factors  Competitive environment  Supplier and customer relationships  Technology developments  Major laws and regulations  Economic conditions

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Understanding the Client’s Business— Attractiveness of the Industry  Barriers to entry  Strength of competitors  Bargaining power of suppliers of raw materials and labor  Bargaining power of customers

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Understanding the Client’s Business— Objectives, Strategies & Business Risks  Objectives—Overall plans  Operating and financial strategies— Operational actions to achieve objectives  Business risks—Threats to achieving objectives

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Understanding the Client’s Business- -Basic Strategy  Product differentiation  Cost leadership

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Understanding the Client’s Business— Measuring and Reviewing Performance  Budgets  Key performance indicators  Segment performance reports  Balanced scorecard  External parties

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Understanding the Client’s Business—Sources of Information  Inquiries of management  Industry Accounting and Auditing Guides  Industry Risk Alerts  Trade journals and news stories  Government publications  Prior company annual reports and SEC filings  Prior tax returns  Electronic sources  Tour of plant and offices  Analytical procedures

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Assess the Risks of Material Misstatement and Design Further Audit Procedures  Overall approach What could go wrong? How likely is it that it will go wrong? What are the likely amounts involved?  Particularly consider Inherent risks Risks of material misstatement due to fraud (fraud risks)  Design further audit procedures

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Assessing Fraud Risks  Two types Fraudulent financial reporting (management fraud) Misappropriation of assets (defalcations)  Procedures to assess fraud risks Discussion among engagement team Inquiries of management and other personnel Planning analytical procedures Considering fraud risk factors Incentives Opportunity Attitude

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Assessing Fraud Risks—Identifying Fraud Risks  Considerations in identifying fraud risks Type Significance Likelihood that it will result in a material misstatement Pervasiveness

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Responding to Fraud Risks  Overall response Professional skepticism and audit evidence Assigning personnel and supervision Accounting principles Predictability of auditing procedures  Alterations in audit procedures More reliable evidence Shifting timing to year end Increasing sample sizes  Response to the possibility of management override Examining journal entries Review accounting estimates for biases Evaluating the business rationale for significant unusual transactions

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Consideration of Fraud Throughout the Audit  Evaluating the results of audit tests  Discovery of fraud Communication to appropriate level of management If fraud involves senior management or material misstatement communicate to audit committee

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Design further audit procedures—1 of 2  Types Tests of controls Analytical procedures Tests of details of transactions and balances  Audit procedures Inspection Observation Inquiry Confirmation Recalculation Reperformance

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Design further audit procedures—2 of 2  Further audit procedures should include Substantive procedures for all relevant assertions Tests of controls when the auditors’ risk assessment includes an expectation that controls are operating effectively, or when substantive procedures alone are not sufficient  Procedures should be linked with the assessed risks of material misstatement at the relevant assertion level  Overall responses when assessed risks of material misstatement are high Heightened professional skepticism Assigning more experienced staff Assigning staff with specialized skills Providing more supervision

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Objectives of Substantive Programs for Asset Accounts  Establish the existence of assets  Establish that the company has rights to the assets  Establish the completeness of recorded assets  Verify the cutoff of transactions  Determine the appropriate valuation of the assets and accuracy of related transactions  Determine the appropriate financial statement presentation and disclosure of the assets

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Transactions Affecting Accounts Receivable

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Indirect Verification of Income Statement Accounts

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Financial Statement Assertions to the Audit

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Direction of Audit Testing

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Relationships among Audit Objectives, Risks of Material Misstatement, and Audit Procedures