Chapter 6 Audit Planning, Understanding the Client, Assessing Risks and Responding 1

Three standards of field work Acronym PIE Planning (Ch. 6) Internal Control (Ch. 7) Evidence (Ch. 5) 6-2

Obtaining Clients Submit a proposal Contact the audit committee Make fee arrangements Communicate with the predecessor auditors Must attempt to get client’s permission to talk to auditors Evaluate the integrity of client Discuss any disagreements over accounting principles Predecessor’s understanding of reason for change of auditors Change in auditors reported on SEC Form 8-K Overall procedure is important for evaluation of management integrity New companies are more risky (e.g. ZZZ Best!)

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. 9

1. Planning the Audit Establish an understanding with the client This is ordinarily accomplished through use of an engagement letter Determine that The firm meets professional independence requirements There are no issues relating to management integrity The client understands the terms of the engagement Deal with audit committee (consisting of at least 3, non-employee or non-officer directors) – Also see SOX requirements.

Items in Engagement Letters AGREEMENT SHOULD BE CLEARLY MADE IN WRITING (1136 Tenants) 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 2 2

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 See example shown in class. 3

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 Tour of office and plant (memorize personnel names, copyroom, thermostat, restroom, dusty inventory, etc.)

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. 9

2. 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, ratings, trade journals.

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 Auditor has to be super human A

Competitive environment Supplier and customer relationships Understanding the Client’s Business, Industry, Regulatory, and Other Factors Competitive environment Supplier and customer relationships Technology developments Major laws and regulations Economic conditions

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 5

Objectives—Overall plans 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

Understanding the Client’s Business--Basic Strategy Product differentiation Cost leadership Auditor has to be super human A 6

A Budgets Key performance indicators Segment performance reports Understanding the Client’s Business—Measuring and Reviewing Performance Budgets Key performance indicators Segment performance reports Balanced scorecard External parties A

Understanding the Client’s Business – Internal Control Need knowledge and understanding of how a client’s internal control works: What controls exists Who performs them How various types of transactions are processed and recorded What accounting records and supporting documentation exist 6-18

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 (Google!!) Tour of plant and offices Analytical procedures

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. 9

Particularly consider 3. 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 Control risks Risks of material misstatement due to fraud Design further audit procedures

Assessing Fraud Risks Two types Procedures to assess fraud risks Fraudulent financial reporting (management fraud) Misappropriation of assets (defalcations, theft) Procedures to assess fraud risks Discussion among engagement team Inquiries of management and other personnel Planning analytical procedures Considering fraud risk factors (fraud triangle) Incentives/Pressure Opportunity Rationalization

Assessing Fraud Risks—Identifying Fraud Risks Considerations in identifying fraud risks Type Significance Likelihood that it will result in a material misstatement Pervasiveness

Responding to Fraud Risks Overall response Professional skepticism and audit evidence Assigning personnel and supervision 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

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 the audit committee of the board

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, including substantive and control tests 5. Complete the audit 6. Form an opinion and issue the audit report 9

Audit procedures Two Main Types of Audit Tests 1. Tests of controls (often called systems tests or cycles tests or tests of transactions) Examples: pick 25 checks at random and test for proper authorization and proper documentation pick 25 receipts and check for timely deposit at the bank pick 25 expense reports and test for adherence to company policy

Audit procedures (cont.) Two Main Types of Audit Tests 2. Substantive tests (often called test of balances) Examples: confirm cash balance with the bank physically inspect inventories or fixed assets perform analytical review to test reasonableness of balances Dual Tests - some tests have characteristics of both test of controls and substantive tests Example: test Dec’s payroll for compliance with rules and in the process verify calculations of payroll expenses and taxes payable at year-end.

Audit procedures (cont.) Audit procedures include Inspection Observation Inquiry Confirmation Recalculation Reperformance

Objectives of Substantive Programs for Asset Accounts Remember the six financial statement assertions and the acronym PERCCV? What are they? 4 7

Cash & Cash Equivalents Blue Mountain Storage Audit Program Cash & Cash Equivalents March 31, 2009 PB: RB: Ref Audit Procedures Completed by:   1. Confirm bank accounts using the standard bank confirmation forms, which will be supplied. 2. Review bank reconciliations done by client. Complete any bank recs not done by client. For at least one month of your choice, a four-column proof of cash must be completed. 3. Reclassify any cash that cannot be used for current purposes. 4. Count petty cash and complete the worksheet. Prepare an adjusting entry to record any cash used, if material. 5. Age the outstanding checks, listing all checks older than 90 days. Checks older than 90 days should be reclassified as a current liability, if material. 6. Review bank transfers, if any, around March 31 for kiting. Which assertion(s) do each of these steps test?

The Audit Trail Direction of Audit Testing Tracing Vouching

TRUE OR FALSE: Tests for unrecorded assets (completeness) typically involve tracing from source documents to the books (journals/ledgers) The direction of testing for unsupported entries in books starts with the supporting documents that are then traced to the books Moving from the supporting documentation to the journals/ledgers is called tracing; and moving from the books to the supporting documentation is called vouching.

Transaction Cycles Revenue (sales & collections) Acquisition (purchases & disbursements) Conversion (production & inventory) Payroll Investing Financing NOTE: Although understanding cycles is important, audits are done primarily via the balance sheet. In other words, the income stmt and other activities accounts are audited in conjunction with their related balance sheet accounts. Your textbook was selected because it follows the balance sheet approach.

Relationships Between Bal. Sheet & Income Statement Accounts Balance Sheet Item Revenue Expenses Accounts receivable Notes receivable Securities and investments Sales Interest, Interest, dividends, gains, investee’s income Uncollectible accounts Uncollectible notes Losses Inventories Purchases, cost of goods sold, payroll Property, plant and equip. Intangible assets Prepaid expenses Accrued liabilities Rent, gains Royalties Depreciation; repairs Amortization Various expenses Various expenses Interest-bearing debt Interest 2 2

Transactions Affecting Accounts Receivable

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 in all material respects and issue the audit report 9

Materiality in Perspective The audit report says the financial statements are fairly stated in all material respects. What does this mean? Materiality is very hard for new auditors to accept. If it’s wrong, it needs to be corrected, right? Not if it’s not considered material (NCM). The public doesn’t understand materiality either (would you stand before a judge and say “Your Honor, you’re worried about a little thing like that?” Materiality is indirectly related to the time left to finish the audit.

Determining Materiality Use professional judgment and based on reasonable person Considers both Quantitative and qualitative factors Materiality used in Planning the audit At the overall financial statement level Allocate to individual accounts Evaluating audit findings

Planning Materiality Rules of thumb help but ultimately it is a judgment call 5-10% of net income 0.5%-1.0% of total assets or total revenues 1.0% of total equity Planning materiality is really the amount that the big picture accounting equation can be off before you think the fin. stmts. are not fairly stated in all material respects.