BA 427 – Assurance and Attestation Services Lecture 20 The Audit: Phase I

Lecture 20 – Phase I Client acceptance and continuation Initial planning Assess client business risk Preliminary analytical procedures Set materiality and overall audit risk Assess inherent risk Assess control risk Assess fraud risk Audit evidence and the audit program

Client acceptance and continuation New clients Evaluate management’s integrity, reputation, and financial stability. Evaluate client business risk. Evaluate industry risk. Communicate with predecessor auditor. Understand the services desired by the client, and evaluate the accounting firm’s desire and ability to deliver those services.

Client acceptance and continuation Communications with predecessor auditor Initiated by the successor auditor. Required, under GAAS (SAS 84), prior to accepting the engagement. Requires permission of the client. Old working papers are normally made available.

Client acceptance and continuation Existing clients Ongoing evaluation of management integrity and the working relationship between the auditors and client management. Evaluation of trends with regard to client business risk and industry risk. Ongoing evaluation of the services desired by the client, and the accounting firm’s desire and ability to deliver those services.

Lecture 20 – Phase I Client acceptance and continuation Initial planning Assess client business risk Preliminary analytical procedures Set materiality and overall audit risk Assess inherent risk Assess control risk Assess fraud risk Audit evidence and the audit program

Initial Planning Prepare an engagement letter. Select the audit team. Evaluate the client’s internal audit function, if any. Evaluate the need for outside specialists.

Initial Planning Prepare an engagement letter and obtain a signed copy from the client. The engagement letter should specify: Nature of services to be rendered Deadlines for completing the audit Assistance to be provided by client personnel Fees Limitations on the auditor’s responsibilities

Initial Planning Select the audit team According to the first General Standard of GAAS: “The audit is to be performed by a person or persons having adequate technical training and proficiency as an auditor.” According to the first Standard of Field Work of GAAS: “The work is to be adequately planned and assistants, if any, are to be properly supervised.”

Initial Planning Evaluate the internal audit function This evaluation affects the nature, timing and extent of external audit procedures. The external auditor assesses the competence and objectivity of the internal audit function.

Initial Planning Using the work of a specialist Examples include actuaries and appraisers. Auditor must be satisfied with the qualifications and reputation of the specialist. (The specialist need not be independent of the client.) The auditor should understand the specialist’s methods and assumptions, consider whether the specialist’s findings support the assertions, and test the data provided by the client.

Initial Planning Using the work of a specialist The client, auditor and specialist should document their understanding of the nature of the work to be performed. The audit report normally does not refer to the work of the specialist.

Lecture 20 – Phase I Client acceptance and continuation Initial planning Assess client business risk Preliminary analytical procedures Set materiality and overall audit risk Assess inherent risk Assess control risk Assess fraud risk Audit evidence and the audit program

Assess client business risk Client business risk is the risk that the client will fail to achieve its objectives. Sources of client business risk: Industry and external environment Business operations and processes Management and governance, objectives and strategies, measurement and performance

Assess client business risk Industry and external environment Industry-wide risks (regulation, deregulation, economic trends, competition). Inherent risks typical for companies in the industry (e.g., inventory obsolescence, regulatory approval). Accounting issues relevant to the industry.

Assess client business risk Business operations and processes Key products and associated risks. Key customers and associated risks. Key suppliers and associated risks. Tour the plant and offices. Identify related parties and related party transactions.

Assess client business risk Management and governance, objectives and strategies, measurement and performance Review corporate charter and bylaws. Review the company’s code of ethics. Review minutes of meetings. Identify terms of key contracts and legal obligations. Identify the client’s key performance measures.

Lecture 20 – Phase I Client acceptance and continuation Initial planning Assess client business risk Preliminary analytical procedures Set materiality and overall audit risk Assess inherent risk Assess control risk Assess fraud risk Audit evidence and the audit program

Preliminary analytical procedures Analytical procedures conducted in the planning phase of the audit serve the following objectives: Understand the client’s industry and business Assess going concern Indicate possible misstatements Reduce detailed tests

Preliminary analytical procedures Analytical procedures are defined by SAS no. 56: “Evaluations of financial information made by a study of plausible relationships among financial and nonfinancial data … involving comparisons of recorded amounts to expectations developed by the auditor.”

Preliminary analytical procedures Types of analytical procedures: Compare client data to industry data. Compare current period to prior periods. Compare current period to budget. Compare financial data for internal consistency between accounts. Compare financial data to expected results based on operational data.

Preliminary analytical procedures Ratios used in analytical procedures: Cash ratio, quick ratio and current ratio. A/R turnover and A/R days to collect. Inventory turnover and inventory days to sell. Debt to equity EPS Gross profit percentage ROA and ROE

Lecture 20 – Phase I Client acceptance and continuation Initial planning Assess client business risk Preliminary analytical procedures Set materiality and overall audit risk Assess inherent risk Assess control risk Assess fraud risk Audit evidence and the audit program

Set materiality and overall audit risk Materiality as defined by the FASB: 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.

Set materiality and overall audit risk Five steps in applying materiality Step 1: Set preliminary judgment about materiality. Step 2: Allocate preliminary judgment about materiality to segments. Step 3: Estimate misstatement in segment. Step 4: Estimate combined misstatement. Step 5: Compare combined estimate with preliminary or revised judgment about materiality.

Set materiality and overall audit risk The first two steps are the only steps that occur in the planning phase of the audit. Step 1: Set preliminary judgment about materiality. Step 2: Allocate preliminary judgment about materiality to segments.

Set materiality and overall audit risk Step 1: Set preliminary judgment about materiality. The maximum amount by which the statements could be misstated and still not affect the decisions of reasonable users. One of the most important decisions the auditor makes. Requires considerable professional judgment. Professional standards do not say 5% or 10!

Set materiality and overall audit risk Step 1: Quantitative factors in setting materiality. Materiality is a relative concept. Hence, the auditor must identify one or more bases by which to set materiality. Net income before taxes is a common base. Other bases include: net sales, gross profit, total assets, current assets, owners’ equity.

Set materiality and overall audit risk Step 1: Qualitative factors in setting materiality. Misstatements that affect contractual obligations. Misstatements that affect a trend in earnings. Misstatements that turn a loss into a profit (or vice versa). Misstatements arising from irregularities.

Set materiality and overall audit risk Step 2: Allocate preliminary judgment about materiality to individual accounts. This allocation facilitates planning the audit of individual balance sheet line-items. This allocation identifies the tolerable misstatement in each account. The sum of tolerable misstatements can exceed overall materiality. The allocation must consider the possibility that a significant misstatement in an individual account might affect F/S users.

Set materiality and overall audit risk The Audit Risk Model: AR = IR x CR x DR Where AR = Audit Risk IR = Inherent Risk CR = Control Risk DR = Detection Risk Each of these items ranges from 0 to 1.

Set materiality and overall audit risk The Audit Risk Model (A.R.M.): AR = IR x CR x DR Audit Risk: This is the likelihood that the F/S are materially misstated. It is a probability, and a choice variable by the auditor. 5%, 1%, or 1/10 of 1% are common objectives. The A.R.M. can be applied separately for each balance sheet account. (Even so, the auditor might choose the same level of Audit Risk for each account).

Set materiality and overall audit risk Engagement risk is the risk the audit firm will suffer a loss arising from the client relationship. Engagement risk is closely related to, but not synonymous with, client business risk. Auditors disagree about whether engagement risk should be considered in planning the audit. In other words, should some audits provide more assurance than others?

Set materiality and overall audit risk If Engagement Risk Affects Acceptable Audit Risk, then consider: The degree to which external users will rely on the financial statements. Related factors are client size, distribution of ownership, and nature and amount of liabilities. The likelihood that the client will experience financial difficulties. Management integrity.

Lecture 20 – Phase I Client acceptance and continuation Initial planning Assess client business risk Preliminary analytical procedures Set materiality and overall audit risk Assess inherent risk Assess control risk Assess fraud risk Audit evidence and the audit program

Assess Inherent Risk Inherent risk (IR): The auditor’s assessment of the likelihood that there are material misstatements before considering the effectiveness of controls. In assessing inherent risk, the auditor considers such factors as: Nature of the client’s business Initial versus repeat engagement Nature of accounting judgments and estimates Non-routine transactions

Lecture 20 – Phase I Client acceptance and continuation Initial planning Assess client business risk Preliminary analytical procedures Set materiality and overall audit risk Assess inherent risk Assess control risk Assess fraud risk Audit evidence and the audit program

Assess control risk Control Risk (CR): The auditor’s assessment of the likelihood that material misstatements are not prevented or detected by the client’s internal controls. Hence: CR x IR is the likelihood that the account is materially misstated as presented to the auditors. To set CR below 1, the auditor will have to understand controls and test controls.

Assess control risk Control Risk (CR): Therefore, if the auditor does not want to test internal controls, CR must be set at 1, regardless of the actual effectiveness of internal controls.

Lecture 20 – Phase I Client acceptance and continuation Initial planning Assess client business risk Preliminary analytical procedures Set materiality and overall audit risk Assess inherent risk Assess control risk Assess fraud risk Audit evidence and the audit program

Assess fraud risk We discussed this topic in connection with SAS No. 99.

Lecture 20 – Phase I Client acceptance and continuation Initial planning Assess client business risk Preliminary analytical procedures Set materiality and overall audit risk Assess inherent risk Assess control risk Assess fraud risk Audit evidence and the audit program

Audit evidence and the audit program Third standard of field work: Sufficient competent evidential matter is to be obtained through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit.

Audit evidence and the audit program Competence of evidential matter Sufficiency of evidential matter

Audit evidence and the audit program Competence of evidential matter: Evidence should be Valid (objective and reliable) Independent sources are better than sources internal to the organization. Direct evidence (from physical examination, observation, computation and inspection) is more persuasive than indirect evidence. Relevant (including timely)

Audit evidence and the audit program Sufficiency of evidential matter Five ways to accumulate evidential matter: Procedures to obtain an understanding of controls Tests of controls Substantive tests of transactions Analytical procedures Tests of details of balances

Audit evidence and the audit program Financial statement assertions: Completeness Rights and Obligations Valuation or Allocation Existence or Occurrence Presentation and Disclosure

Audit evidence and the audit program Financial statement assertions: Completeness Whether all transactions and accounts that should be presented in the financial statements are included. Rights and Obligations Valuation or Allocation Existence or Occurrence Presentation and Disclosure

Audit evidence and the audit program Financial statement assertions: Completeness Rights and Obligations Whether, at a given date, all assets are the rights of the entity and all liabilities are the obligations of the entity. Valuation or Allocation Existence or Occurrence Presentation and Disclosure

Audit evidence and the audit program Financial statement assertions: Completeness Rights and Obligations Valuation or Allocation Whether the assets, liabilities, revenues and expenses of an entity have been included in the financial statements at the appropriate amounts, in conformity with GAAP. Existence or Occurrence Presentation and Disclosure

Audit evidence and the audit program Financial statement assertions: Completeness Rights and Obligations Valuation or Allocation Existence or Occurrence Whether assets and liabilities exist at a given date and whether recorded transactions have occurred during a given period. Presentation and Disclosure

Audit evidence and the audit program Financial statement assertions: Completeness Rights and Obligations Valuation or Allocation Existence or Occurrence Presentation and Disclosure Whether financial statement components have been properly classified, described, and disclosed.

Audit evidence and the audit program Existence F/S Completeness Underlying Accounting Data Corroborating Information Economic Transactions

Audit evidence and the audit program Types of Evidence Physical evidence of tangible assets Confirmation by a third party Documentation, internal and external Observation to assess certain activities Client inquiry, can be written or oral Reperformance Analytical procedures

Audit evidence and the audit program Audit workpapers Permanent files (used every year) Articles of incorporation and bylaws Contracts and debt agreements Organization chart Internal control analyses

Audit evidence and the audit program Audit workpapers Current files (annual) The Audit Program Working Trial Balance Lead Schedules Tests of controls Substantive tests

Audit evidence and the audit program Assets Liabilities & Equity Cash Accounts receivable Inventory Prepaid assets Property, plant and equipment Other assets Total Accounts payable Other current liabilities Long-term debt Shareholders’ equity Common stock Retained earnings Total liabilities and equity

Audit evidence and the audit program Assets Liabilities & Equity Cash Accounts receivable Inventory Prepaid assets Property, plant and equipment Other assets Total Accounts payable Other current liabilities Long-term debt Shareholders’ equity Common stock Retained earnings Total liabilities and equity

Audit evidence and the audit program Working Trial Balance Prior year Trial balance Adjusting entries Reclassifications Final balance Account Cash Accounts receivable Inventory Prepaid assets Property, plant and equipment Other assets Total

Audit evidence and the audit program Lead Schedule: Cash Prior year Trial balance Adjusting entries Reclassifications Final balance Account Sunwest Bank – general account Sunwest Bank – Payroll account First Federal Savings and Loan Petty cash Total cash