audit planning and materiality chapter 8 audit planning and materiality a bit of jumping around Ch 6 p. 167 (175) analytical procedures Ch 7 p. 192-199 analytical procedures & common ratios Ch 9 p. 268 (236) nonroutine transactions & judgment Ch 9 p. 269-273 (237- 241) audit risk model and definitions

Enron Related Party Transactions No one could explain how Enron actually made money Incredibly complicated business structure “What we are looking at here is an example of superbly complex financial reports. They didn’t have to lie. All they had to do was to obfuscate it with sheer complexity,” John Dingell, U.S. Congressman Michigan

Obtain engagement Analytical procedures Assess RoMM Understand the client Internal controls AU 315 Tests of controls if CR < 1.00 Substantive tests of transactions AU 500 Substantive Analytical procedures Substantive tests of details of balances Reporting AU 700

environmental client auditor

Ryan What is the definition of control risk?

The risk that a misstatement that could occur in an assertion about a class of transaction, account balance, or disclosure and that could be material, either individually or when aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely basis by the entity’s internal control.

Stages of the Audit Accepting the engagement client acceptance 1) integrity of management

Client Acceptance p. 222 (190) Communicate with predecessor auditor Why the client needs an audit New client investigation Competency, industry knowledge Communicate with predecessor auditor Risks Intended users of the financial statements Independence Engagement Letter

84 AICPA Statement on Auditing Standards February 1997 Statement on Auditing Standards 84 AICPA Communications between Predecessor and Successor Auditors

Katie C what issues need to be discussed with the predecessor auditor ?

Communications with Predecessor Auditor Integrity of senior management Disputes with the client over accounting principles Disputes with the client over audit procedures Disputes with the client over fees p. 223 (191)

Chester who is responsible for initiating the communication between the successor auditor and the predecessor auditor ?

AICPA Code of Professional Conduct 1.300.001 – Confidential Client Information

Roberto Do we care about the nature of the client’s business? Do we care about the reasons they are having their financial statements audited? Do we care who is going to rely on the audited financial statements?

RISK RISK RISK identify the users of the financial statements

Cynthia G How does the AICPA’s Code of Professional Conduct define the Ethical Principle “Objectivity and Independence?”

Objectivity and Independence A member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. A member in public practice should be independent in fact and appearance when providing auditing and other attest services.

Colton Discuss how this affects our decision whether to accept the engagement ?

memo to partners and staff independence memo to partners and staff Partners in the engagement office? Everyone in the engagement office? Everyone in the firm? Consulting and tax employees or just auditors must consider spouses & dependents

Taylor How might the financial investments of non-dependent, close relatives affect the firm’s decision whether to accept a new client ?

Matt D If a non-dependent, close relative is employed by a potential client, what issues does the audit firm need to consider in their decision whether to accept the client?

Close relatives (including immediate family): Covered Members Close relatives (including immediate family): parent, sibling or nondependent child, spouse, dependents Holding a key position with the client Holding a financial interest in the client that is material to the relative (covered member must know) Holding a financial interest that enables the relative to exercise significant influence over the client

Key positions Individual has primary responsibility for significant accounting functions that support material components of the financial statements preparation of the financial statements

Key positions --- always Individual has the ability to influence contents Board of Directors Chief Executive Officer President Chief “xxxxx” Officer General Counsel Controller Director of Internal Audit Director of Financial Reporting Treasurer

When we obtain an understanding of the IC How do we identify other Key Positions When we obtain an understanding of the IC positions subject to significant internal accounting controls positions that are an element of significant internal accounting controls

Phases of the Audit Accepting the engagement Engagement Letter p. 225 (193)

Understand the Client’s Business

Kendall sp what is the objective of AU 315?

AU Section 315 The objective of the auditor is to identify and assess the risk of material misstatement, whether due to fraud or error, at the financial statement and relevant assertion levels through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risk of material misstatement.

Many litigation cases result from the auditor’s failure to fully understand the nature of transactions in the client’s industry. ZZZZ Best ESM

RISK of Material Misstatement Page 276/277 (244/45) Related Party transactions Complex transactions Nonroutine transactions Judgment Chapter 9 Declines in economic conditions Information technology Expansion Accounting complexity of judgments Accounting complexity of estimates Complex financial instruments

Xena how does the Auditor’s Responsibility Paragraph in the independent auditor’s report describe the auditor’s responsibility to detect material misstatements? Does the auditor’s responsibility differ for misstatements that are the result of an error or a fraud?

Auditor’s Responsibility Paragraph standard unmodified opinion Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.

Susie what is the overall objective of the indepent auditor?

Overall Objective AU 200 …obtain reasonable assurance about whether the financial statements as a whole are free of material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are presented fairly, in accordance with an applicable financial reporting framework.

Related Parties --- RISK p. 228 (196) .. an affiliated company, principal owner of the client company, or any other party with which the client deals, where one of the parties can influence the management or operating policies of the other. investors are concerned that the terms of the transaction may not reflect “arms length” bargaining. There is risk that the transaction may not be valued at the same amount as a transaction with a non-related party.

Related Parties --- RISK p 220 (188) Enron - Andy Fastow

Related Parties --- RISK Essentially a related party is any party with which the audit client deals where one party controls or can significantly influence the management or operating policies of the other party. Related parties are frequently involved in fraudulent transactions because they can conceal problems that the auditor would likely detect if the transactions occurred between unrelated parties.

Kendall other what is Client Business Risk?

Analytical Procedures Pages 231-34 (199-202) article on web page If you have the full book Read pages 192-198 Analytical procedures & common financial ratios

Analytical Procedures p. 167 (175) Reasonableness tests evaluations of financial information by a study of plausible relationships among financial and nonfinancial data … ….involving comparisons of recorded amounts … to expectations developed by the auditor.

Shannon at which stages of the audit are Analytical Procedures required ?

Analytical Procedures planning phase testing phase (as substantive tests) completion phase (as an overall review)

Katelyn why do we perform analytical procedures during the planning stage ?

Analytical Procedures During the Planning Phase Understand the client’s business & industry Assess going concern Indicate possible misstatements (attention directing) Reduce detailed tests

Steps in performing Analytical Procedures Develop expectations Define significant difference (what is reasonable) Compare our predictions with recorded amount Investigate Significant differences DOCUMENT the above steps

Jia What is the definition of audit risk?

Audit risk. The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated.

What is the definition of Materiality? Jackie What is the definition of Materiality?

Performance Materiality tolerable error tolerable misstatement The allocation of the preliminary judgment about materiality to segments (account balances or classes of transactions)

Emily Describe a Significant Class of Transactions ? Describe a Transaction Cycle?

Class of Transactions Accounts receivable xxx.xx Sales xxx.xx Revenue & Collection Cycle Cash xxx.xx

Diana In your statistics class, why does a larger sample increase your level of confidence? How does evidence reduce risk?

Sample $ 50,000 Population 450,000 Table 2 p. ??? (210)

Projection allowance for sampling risk p. 242 (210) Sample Results Tolerable Misstatement Known misstatement Projection of sample results to the population Allowance for sampling risk Estimates Difference between auditor’s estimate Book Value (management’s estimate $3,500 $3,500*(450,000/50,000) = $31,500 $15,750 $47,250