Lecture 2 Audit Engagement and Audit Planning BA 202 Auditing Lecture 2 Audit Engagement and Audit Planning

Increased Substantive Test Reduced Substantive Test The Audit Process Planning Risk Assessment Ascertaining & Recording of Accounting System & Internal Control Preliminary Evaluation of Internal Control Bad IC Good IC Increased Substantive Test Compliance Test Final Evaluation of IC Bad IC Good IC Reduced Substantive Test Final review and Concluding the Audit Audit Report

Preliminary Engagement Activities ISA 220 Continuance of the client relationship and specific audit engagement Ethical requirements, including independent ISA 210 Terms of engagement

Engagement Letter ISA 210 Sent to the client by auditors upon appointment To confirm Appointment Scope of the audit Objective of the audit Extent of auditors responsibilities and reports

Engagement Letter AI 210 Circumstances require engagement letter to be revised? Need to remind client of terms of engagement? If change in terms, client and auditor must agree on the new terms. Consider withdrawal & any obligation (AI 250 para. 39 – 40)

Audit Planning ISA 300 para.2 : The auditor should plan the audit work so that the audit will be performed in an effective manner ISA 300 para. 13: The auditor should develop an audit plan for the audit in order to reduce audit risk to an acceptably low level

Audit Planning Conduct planning in accordance with AI 300 Planning AI 310 Knowledge of the Business AI 230 para. 6 - Record in the working paper information on planning the audit work AI 1005 – Audit of small business

Audit Planning AI 210 Term of audit engagement AI 320 Audit materiality AI 400 Risk Assessment AI 530 Audit Sampling AI 520 Analytical procedures AI 620 Using the work of an expert AI 4410 Engagement to compile financial information

Audit Planning – WHY PLAN? Overall Audit Strategy and Direction Identify laws and standards affecting the audit Appropriate attention is devoted to important areas of audit Potential problems are identified Work is completed expeditiously

Audit Planning – WHY PLAN? Assists proper assignment of work to assistance Coordination of work done by other auditors and experts Nature, timing, extend of audit procedures Reduce risk of material misstatements Conduct audit effectively and efficiently

Extent of planning Size of entity Complexity of audit Auditor’s experience with entity Auditor’s knowledge of business

Preliminary Planning Activities Client Acceptance and Continuance Assess Competence and Independence Establishing the Terms of the Engagement

Audit Planning ISA300 para.8 The auditor should plan the audit so that the engagement will be performed in an effective manner.

Why auditor should obtained knowledge of business? ISA 315 Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement Why auditor should obtained knowledge of business? To enable the auditor to identify and understand the events, transactions and practices that, in the auditor’s judgment, may have a significant effect on the financial statements or on the examination of audit report.

Does the auditor need to know more than the management? ISA 315 Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement Does the auditor need to know more than the management? Generally no How should auditor obtain the knowledge? Preliminary knowledge prior to engagement Further knowledge following year Update and enhance information in subsequent years

Where are the sources of knowledge of the business? ISA 315 Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement Where are the sources of knowledge of the business? External sources Prior years experience Publication Discussion with knowledgeable people Internal sources Discussion with management and staff Documents produced by the entity

The general level of competence of management ISA 315 Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement General economic factors and industry conditions affecting the entity’s business Important characteristics of the entity, its business, its financial performance and its reporting requirements including changes since the date of the prior audit. The general level of competence of management

General Economic Factors ISA 315 Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement General Economic Factors General Level of economic activity Interest rates and availability of financing Inflation, currency revaluation Government policies (financial incentives Foreign currency rates and controls

ISA 315 Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement The industry The market and competition Cyclical or seasonal activity Changes in product technology Business risk (ie high tech, high fashion) Declining or expanding operations Environmental requirements

The Entity - Management and ownership ISA 315 Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement The Entity - Management and ownership Corporate structure – private,public, government Related parties Capital structure Organization structure Management objectives, philosophy… Board of Directors i.e. composition Operating management Internal audit function

ISA 315 Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement The Entity – Business Nature of business Location Employment i.e. union, supply, pension Products or services and markets i.e. major customers, contract, market share Important suppliers of goods and services Inventories i.e. location and quantities Licenses, patents

ISA 315 Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement Legislation Regulatory environment and requirements Taxation Measurement and disclosure issues peculiar to the business Audit reporting requirements Users of financial statements

Understanding the Accounting and Internal Control Systems ISA 315 & ISA 400 The accounting policies adopted by the entity and changes in those policies The effect of new accounting or auditing pronouncements The auditor’s cumulative knowledge of accounting and internal control systems and the relative emphasis expected to be placed on tests of control and substantive procedures

Nature, Timing and Extent of Procedures Possible change of emphasis on specific audit areas The effect of information technology on the audit The work of internal auditing and its expected effect on external audit procedures.

Coordination, Direction, Supervision and Review The involvement of other auditors in the audit of components for example subsidiaries, branches and divisions The involvement of experts The number of locations Staffing requirements Interim Audit and Pre-Final Audit

Other Matters The possibility that the going concern assumption may be subject to questions Conditions requiring special attention, such as the existence of related parties The terms of the engagement and any statutory responsibilities The nature and timing of reports or other communication with the entity that are expected under the engagement Assessing risk of material misstatement

Audit Planning Discuss overall audit plan and certain audit procedures with audit committee management Staff In order to improve effectiveness and efficiency of audit. However the overall audit plan and audit program remain the auditor’s responsibility.

Audit Program The auditor should => develop and document an audit program setting out the nature, timing and extent of planned audit procedures required to implements the overall audit plan.

Audit Program What is audit program? Purpose of Audit Program? An audit program consists of specific audit procedures are usually prepared for specific component of audit. Purpose of Audit Program? Example of an audit program Standard?

Audit Program In preparing audit program, the auditor would consider the specific assessments of inherent and control risks and the required level of assurance to be provided by substantive procedures

Changes of overall audit plan and audit program The auditor should Revised as necessary during the course of audit (because planning is continuous through the engagements) Record reasons for significant changes

Analytical Procedures To conduct review of financial statements in order to provide an insight into the financial positions of the business and to provide sufficient corroborative evidence to supports conclusion drawn from other source of evidence collected.

Analytical Procedures – ISA 520 para.8 The auditor should apply analytical procedures at the planning stage to assist in understanding the business and in identifying area of potential risk.

Analytical Procedures Purposes of Analytical Procedures Planning Substantive Procedures Overall review in final review stage of audit Type of Analytical Procedures Current year v. Prior Year Current year v. budget/ projection or forecasts Client Financial Info v. Industry data Financial info v. Non Financial Info

Analytical Procedures Short Term Liquidity Ratios Current Ratio Quick Ratio Operating Cash Flow Ratio Activity Ratios Receivables Turnover and Days Outstanding in Account Receivables Inventory Turnover and Days of Inventory on Hand

Analytical Procedures Profitability Ration Gross Profit Percentage Profit Margin Return on Assets Return on Equity Coverage Ratio Debt to Equity Times Interest Earned

Analytical Procedures Effectiveness and Efficiency (especially for substantive procedures) The nature of assertion or audit objective (unable to test ownership and individual transaction but effective to detect omission) The plausibility and predictability of the relationship The availability and reliability of data The precision of the expectation

Analytical Procedures Advantages To improve the auditor’s understanding of the entity To enable auditors to identify recorded value which varies from the auditor’s expectation Identify unusual transactions, trends and events Simple and easy to use Limitations Provides conclusions on reasonableness of data rather than precision Less persuasive than test of details Cannot easily be linked to specific assertions Financial data analysis only Require comparative figures/ratio to be meaningful

Analytical Procedures From the industries below, what are the differences you would expect in relation to the components of its individual company’s financial statement (balance sheet/ income statement): Trading Services Property Development Bank Trading - Stocks Services - Human resources Property Development - Property Development Account Bank - Cash/Investment

Fundamental Concepts in Audit Materiality Audit Risk (Inherent/Control/Detection) Reasonable Assurance Going Concern True and Fair View Independence

Materiality AI 320 Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement.

Materiality ISA 320 Materiality provides a threshold or cut off point rather than being a primary qualitative characteristic which information must have if it is to be useful. There is an inverse relationship between Materiality & level of Audit Risk Eg: M AR Auditor need to CR or DR

Common Bases and Qualitative Factors for Considering Materiality Common Bases for Establishing Materiality: Total Assets Total Revenues Net Income before Tax Gross Profit Average of 3 years’ Income before Tax Selected Qualitative Factors for Assessing Materiality Fraud or Non-Compliance with Laws or Regulations Small amounts that might violate covenants in a contracts Amounts that might affect the trend in earnings

Audit Risk ISA 400 Risk is a fundamental concept that underlies the audit process Audit Risk = Inherent Risk X Control Risk X Detection Risk

Detection Risk Assessment Having Determined Audit Risk Inherent Risk Control Risk Detection Risk is just a balancing figures DR = AR/ (IR X CR)

Assessment of Control Risk Interrelationship of The Components of Audit Risk AUDIT RISK Assessment of Control Risk High Medium Low Assessment of Inherent Risk Lowest Lower Higher Highest Acceptable level of Detection Risk

Significant Risks ISA 315 Significant Audit Risks that require special audit considerations Fraud Related to recent significant economic, accounting or other development Complexity of transactions Related parties Involved in measurement uncertainty Outside normal course of business for the entity

Concept of Reasonable Assurance A term that implies some risk that a material misstatement could be present in the financial statements without the auditor detecting it. By expressing reasonable assurance, the auditor does not guarantee that material misstatements will be detected in an audit. Hence, no absolute assurance due to certain inherent limitations in audit.

Concept of Reasonable Assurance Factors that cause auditor to express reasonable assurance (pg 34 -35 of Messier and Margaret): Use of testing in audit Inherent limitations of internal control\ Audit Evidence is Persuasive and Not Conclusive Use of Judgment

Types of Audit Tests Test of Controls Substantive Procedures

Test of Controls The category of procedures aimed specifically to test the operating effectiveness of controls in preventing, detecting and correction material misstatements at the assertion level. Ensure internal controls are operating in the manner intended

Substantive Procedures Test performed to obtain audit evidence to detect material misstatements in the financial statement Test of detail of transactions and balances Analytical procedures

Working Papers - Overview Permanent File Correspondence File Tax File Current Audit File

Current Audit File - Overview Planning Overview Risk Area Materiality Audit Objectives/Procedures Analytical Review Budget/ Team Members

Current Audit File - Overview Secretarial Audit Minutes/ Directors Resolutions Audit Summary Memorandum Audit Adjustments Trial Balance Audit Programme for respective section Detail of working paper

Current Audit File - Overview Detail Working Papers Heading Indexing and Cross Referencing Tick Marks Organization of working papers