Audit Planning, Types of Audit Tests, and Materiality Chapter 3 Audit Planning, Types of Audit Tests, and Materiality McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

The Phases of an Audit That Relate to Audit Planning LO# 1 3-2

Prospective Client Acceptance LO# 1 Prospective Client Acceptance Obtain and review financial information. Inquire of third parties regarding client integrity. 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. 3-3

Continuing Client Retention LO# 1 Continuing Client Retention Evaluate client retention periodically Near audit completion or after a significant event Conflicts over accounting and auditing issues Dispute over fees 3-4

Preliminary Engagement Activities LO# 2 Preliminary Engagement Activities Determine the Audit Engagement Team Requirements Assess Compliance with Ethical Requirements, Including Independence 3-5

Establish Terms of the Engagement LO# 3 Establish Terms of the Engagement In establishing the terms of the engagement, three topics must be discussed: The engagement letter; Using the work of the internal auditors; and The role of the audit committee. 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. Who signs the engagement letter? 3-6

LO# 4 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 3-1 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. 3-7

LO# 5 Internal Auditors 3-8

The Audit Committee Subcommittee of the board of directors LO# 6 Section 301 of Sarbanes-Oxley Act requires the following for audit committee members of publicly held companies: Member of board of directors and 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 3-9

LO# 7 Planning the Audit The auditor will develop an overall audit strategy for conducting the audit. This will help the auditor to determine what resources are needed to perform the engagement. An audit plan is more detailed than the audit strategy. Basically, the audit plan should consider how to conduct the engagement in an effective and efficient manner. 3-10

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 client acceptance/continuance process, procedures performed to gain an understanding of the entity, and preliminary engagement activities. Additional steps: Assess business risks. Establish materiality. Consider multilocations. Assess the need for specialists. Assess the possibility of illegal acts. Identify related parties. Consider additional value-added services. Let’s look at each of these steps. 3-11

LO# 7 Assess Business Risks 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. 3-12

Establish Materiality LO# 7 Establish planning (overall) materiality (more on this later!) Establish tolerable misstatement for specific accounts Establish tolerable misstatement for classes of transactions 3-13

Consider Multilocations or Business Units Consolidated Financial Statements High Risk Moderate Risk Low Risk The auditor correlates the amount of audit attention devoted to the location or business unit with the level of risk present. 3-14

What other types of specialists might be needed? LO# 7 Use of Specialists A major consideration in planning the audit is the need for a specialist. The use of an IT specialist is a significant aspect of most audit engagements. The presence of complex information technology may require the use of an IT specialist. What other types of specialists might be needed? 3-15

Illegal Acts Illegal Acts Direct and Material Material and Indirect LO# 7 Illegal Acts Illegal Acts Direct and Material Consider laws and regulations as part of audit Material and Indirect Be aware may have occurred; investigate if brought to attention 3-16

Supervision of the Audit LO# 8 Supervision of the Audit Engagement partner and other supervisory members of the team: Inform engagement team members of their responsibilities Direct engagement team members to identify and communicate audit issues Review the work of the engagement team members 3-17

Risk Assessment Procedures Substantive Procedures LO# 9 Types of Audit Tests Risk Assessment Procedures Used to obtain an understanding of the entity and its environment, including its internal control. Tests of Controls Directed toward the evaluation of the effectiveness of the design and operation of internal controls. Substantive Procedures Detect material misstatements in a transaction class, account balance, and disclosure component of the financial statements. 3-18

Tests of Controls Inquiry Inspection Observation Walkthrough LO# 9 Tests of Controls Inquiry Inspection Observation Walkthrough Reperformance 3-19

LO# 9 Tests of Controls 3-20

Substantive Procedures LO# 9 Substantive Procedures Tests of Details Tests for errors or fraud in individual transactions, account balances, and disclosures Analytical Procedures Obtains evidential matter about particular assertions related to account balances or classes of transactions 3-21

Substantive Tests of Transactions LO# 9 Dual-Purpose Tests Tests of Controls Substantive Tests of Transactions Dual-Purpose Tests 3-22

LO# 10 Materiality The magnitude of an omission or misstatement of accounting information that makes it probable that the judgment of a reasonable person relying on the information would be changed or influenced by the omission or misstatement. Materiality is not an absolute and it is not a black or white issue! The determination of materiality requires professional judgment. 3-23

Steps in Applying Materiality on an Audit LO# 11 Steps in Applying Materiality on an Audit Step 1: Determine a materiality level for the overall financial statements (planning materiality) Step 2: Determine tolerable misstatement (allocation of materiality at individual account/class of transactions level) Step 3: Evaluate auditing findings (near the end of the audit) 3-24