Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-1 Chapter Five Audit Planning and Types of Audit Tests Chapter Five Audit Planning and Types of Audit Tests

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-2 The Phases of an Audit That Relate to Audit Planning Preplanning Assess risks and establish materiality Plan the audit Client acceptance and continuance Establish the terms of the engagement

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-3 Prospective Client Acceptance 1.Obtain and review financial information. 2.Inquire of third parties. 3.Communicate with the predecessor auditor. 4.Consider unusual business or audit risks. 5.Determine if the firm is independent. 6.Determine if the firm has the necessary skills and knowledge. 7.Determine if acceptance violates any applicable regulatory or ethical requirements.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-4 Continuing Client Retention Evaluate client retention periodically Near audit completion or after a significant event Conflicts over accounting & auditing issues Dispute over fees

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-5 Establish Terms of the Engagement The terms of the engagement, which are documented in the engagement letter, should include the objectives of the engagement, management’s responsibilities, the auditor’s responsibilities, and the limitations of the engagement. In establishing the terms of the engagement, three topics must be discussed: 1.The engagement letter 2.The internal auditors 3.Those charged with governance.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-6 The Engagement Letter The engagement letter formalizes the arrangement reached between the auditor and the client. In addition to the items mentioned in the sample engagement letter in Exhibit 5-1 in the textbook, the engagement letter may include: Arrangements for use of experts or internal auditors. Any limitations of liability of the auditor or client. Additional services to be provided. Arrangements regarding other services.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-7 Internal Auditors

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-8 Internal Auditors

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-9 Those Charged with Governance Board of Directors Audit Committee

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-10 Preplanning Determine the Audit Engagement Team Requirements Assess Independence

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-11 Assess Risks and Establish Materiality Use audit risk model Restrict risk at account balance level Achieve acceptable level of audit risk You may want to review the detailed discussion in Chapter 3 of the process used to assess the client’s business risks and to establish materiality.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-12 Planning the Audit When planning the audit, the auditor should be guided by the results of the risk assessment procedures performed to gain an understanding of the entity. Additional steps: Assess a preliminary level of control risk by account and assertion. Consider the possibility of non-compliance (illegal) acts. Identify related parties. Conduct preliminary analytical procedures. Develop an overall audit strategy and prepare an audit plan. Consider additional value-added services. Let’s look at each of these steps.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-13 Assess a Preliminary Level for Control Risk by Account and Assertion Control risk is the risk that material misstatements will not be prevented or detected by internal controls. A preliminary assessment of control risk is necessary for the auditor to plan the nature, timing, and extent of testing. The presence of complex information technology may require the use of an IT specialist.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-14 Assess the Possibility of Non-compliance (Illegal) Acts Non- compliance Acts Materially affecting the financial statements Obtain evidence of compliance Not materially affecting the financial statement Be aware may have occurred; investigate if brought to attention

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-15 Assess the Possibility of Non-compliance Acts

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-16 Identify Related Parties Some examples from IAS 24 Related Party Disclosure Parents and subsidiaries. Significant influence. Joint control. Associate entity. Joint venture. Management. Close family of the principal owners & management. Other parties that can have significant influence. How to Identify Related Parties in Addition to Request Management Review contracts and agreements. Review bank and legal confirmations. Review transactions with major customers, suppliers, borrowers, and lenders. Review large, unusual, or non-recurring transactions especially at year end. Review minutes of meetings of boards and management.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-17 Conduct Preliminary Analytical Procedures To understand the client’s business and transactions To identify financial statement accounts likely to contain errors By understanding the client’s business and identifying where errors are likely to occur, the auditor can allocate more resources to investigate necessary accounts.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-18 Develop an Overall Audit Strategy Scope Timing Direction Complete other planning steps. Compile knowledge about the client’s business objectives and strategies, business risks, audit risks, and controls. Document effects of identified risks and controls on planned audit procedures.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-19 Prepare Audit Plan Nature Timing Extent The audit plan addresses in more detail the matters identified in the audit strategy. An audit plan contains the nature, timing and extent of specific audit procedures.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-20 Consider Additional Value-Added Services Tax Planning IT Consultancy Internal Reporting Risk Assessment Benchmarkin g Electronic Commerce

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-21 Types of Audit Tests Risk Assessment Procedures Used to obtain an understanding of the entity and its environment, including internal controls. Tests of Controls Performed to obtain audit evidence about the operating effectiveness of controls in preventing, detecting and correcting material misstatements. Substantive Procedures Detect material misstatements in a transaction class, account balance, and disclosure component of the financial statements.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-22 Tests of Controls InquiryInspection Walk Through Reperformance Observation

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-23 Tests of Controls

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-24 Substantive Procedures Analytical Procedures Obtains evidence about particular assertions related to account balances or classes of transactions Tests of Details Tests for errors or fraud in individual transactions

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-25 Dual Purpose Tests Substantive Tests Tests of Controls Dual Purpose Test

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-26 Purposes of Analytical Procedures Preliminary Analytical Procedures Used as risk assessment procedure to assist the auditor to better understand the business and to plan the nature, timing, and extent of audit procedures. Substantive Analytical Procedures Used to obtain evidence about particular assertions related to account balances or classes of transactions. Final Analytical Procedures Used as an overall review of the financial information in the final review stage of the audit.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-27 Purposes of Analytical Procedures Trend Analysis Ratio Analysis Reasonableness Analysis

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-28 Substantive Analytical Procedures Decision Process

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-29 Define a Tolerable Difference The size of the tolerable difference depends on: The significance of the account. The desired degree of reliance on the substantive analytical procedures. The level of disaggregation in the amount being tested. The precision of the expectation.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-30 The Investigation of Differences for Planning and Final Analytical Procedures Preliminary Analytical Procedures Differences Corroboratin g evidence not required Final Analytical Procedures Differences Corroboratin g evidence is required

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-31 Audit Testing Hierarchy

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-32 Filling the Assurance Bucket

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-33 Accounts Payable Example of Filling the Assurance Buckets for Each Assertion

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-34 Short-Term Liquidity Ratios Current Ratio Quick Ratio Operating Cash Flow Ratio

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-35 Activity Ratios Receivables Turnover Days Outstanding in Accounts Receivable Inventory Turnover Days of Inventory on Hand

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-36 Profitability Ratios Gross Profit Percentage Profit Margin Return on Assets Return on Equity

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-37 Coverage Ratios Debt to Equity Times Interest Earned

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5-38 End of Chapter 5