Understanding the Client and General Planning

Client Acceptance Quality control policies and procedures Communication with predecessor auditor Engagement letters Conferences with client personnel

Engagement Letter

Engagement Letter (continued)

Knowledge of the Business Organization structure Operations and legal structure Knowledge of operations Tour of plant Legal documents Minutes, contracts, and correspondence Industry and economic conditions

General Planning Decisions Anticipated assessed level of control risk Preliminary estimates of materiality Risk conditions or financial statement items likely to require adjustment Overall timing of audit work Extent of involvement of specialists and internal auditors Staffing Result: Preliminary audit plan and time budget

Knowledge -- Preliminary Audit Plan Business Industry Control environment, risk assessment, and monitoring Accounting system Control activities Management integrity

At the CPA Firm Review of files Discussion with firm personnel Correspondence files prior year’s work papers permanent files prior years’ financial statements and audit reports Discussion with firm personnel nonaudit services provided to client experts in the industry

At the CPA Firm (continued) Review of industry information AICPA industry guides Trade publications Annual reports of other companies in industry Review of authoritative pronouncements Existing or new Accounting or auditing Identify reports to be issued SEC filings Special report on contractual compliance etc.

At the Client Inquiry of management Reading current year’s interim financial statements Agreement on engagement Type Scope Timing Tour facilities

At the Client (continued) Reading legal documents and minutes corporate charter, bylaws major contracts minutes of directors’ and stockholders’ meetings Analytical procedures - calculating general profitability, liquidity, and solvency ratios and trends and comparing to: client experience client plans industry ratios and trends

Audit Decisions in Preliminary Planning Materiality Control risk Audit risk

Materiality The magnitude of an omission or misstatement of accounting information that in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement

Materiality

Audit Risk The risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated

Special Audit Risks Management fraud Related-party transactions Illegal acts Business failure

Fraud - Terminology Errors Irregularities Management fraud Employee fraud Red flags

Red Flags Management Characteristics Management operating and financing decisions are dominated by a single person. Management’s attitude toward financial reporting is unduly aggressive. Management (particularly senior accounting personnel) turnover is high. Management places undue emphasis on meeting earnings projections. Management’s reputation in the business community is poor.

Red Flags (continued) Operating and Industry Characteristics: Profitability of entity relative to its industry is inadequate or inconsistent. Sensitivity of operating results to economic factors (inflation, interest rates, unemployment, etc.) is high. Rate of change in entity’s industry is rapid.

Red Flags (continued) Operating and Industry Characteristics (continued): Direction of change in entity’s industry is declining with many business failures. Organization is decentralized without adequate monitoring. Internal or external matters that raise substantial doubt about the entity’s ability to continue as a going concern are present.

Red Flags (continued) Engagement Characteristics: Many contentious or difficult accounting issues are present. Significant difficult-to-audit transactions or balances are present. Significant and unusual related-party transactions not in the ordinary course of business are present.

Red Flags (continued) Engagement Characteristics (continued): Nature, cause (if known), or the amount of known and likely misstatements detected in the audit or prior period’s financial statements is significant. It is a new client with no prior audit history or sufficient information is not available from the predecessor auditor.

Related-Party Transactions Identify related parties Identify material transactions Examine identified material related-party transactions Evaluate disclosure

Illegal Acts SAS 53 vs. SAS 54 “direct and material effect on the determination of a financial statement line item amount” Violations with indirect effects loss contingencies effect on audit Communication responsibilities

Business Failure

Engagement Timing Basic time segments Efficiency and effectiveness in timing Timing decisions

Involving Specialists Engaged or employed by client CPA firm industry specialists CPA firm functional specialists CPA firm technical specialists

Analytical Procedures In planning the audit* To understand the client and industry To identify transactions and events since the last audit date To identify a risk requiring more than normal audit attention To plan the nature, timing, and extent of other audit procedures. *Required by SAS No. 56

Analytical Procedures (continued) As substantive tests To obtain evidential matter about assertions In overall review at end* Identify any unusual or unexpected balances not previously noted Consider going concern status To assess the conclusions the auditor has reached To evaluate overall financial statement presentation * Required by SAS No. 56