Chapter 06 Audit Planning, Understanding the Client, Assessing Risks, and Responding McGraw-Hill/IrwinCopyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

Obtaining Clients  Submit a proposal Contact the audit committee Make fee arrangements  Communicate with the predecessor auditor Topics Integrity of management Disagreements over accounting principles Communications to those charged with governance regarding fraud and noncompliance with laws Communication to management and those charged with governance concerning internal control significant deficiencies and material weaknesses. Predecessor’s understanding of reason for change of auditors Other Overall procedure is important for evaluation of management integrity 6-2

The Audit Process--Steps 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. Plan the Audit  Establish an understanding with the client This is ordinarily accomplished through use of an engagement letter Related, determine that The firm meets professional independence requirements There are no issues relating to management integrity The client understands the terms of the engagement 6-4

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 6-5

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, rating organizations, journals. 6-6

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 6-7

Materiality Definitions  FASB (included in SASs)—The magnitude of an omission or misstatement of financial information that, in the light of surrounding circumstances, makes it probable that he judgment of a reasonable person relying on the information could have been changed or influenced by the omission or misstatement.  PCAOB interpretation of federal securities laws— A fact is material if there is a substantial likelihood that the… fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available. 6-8

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 Risks of material misstatement due to fraud (fraud risks)  Design further audit procedures 6-9

Assessing Fraud Risks  Two types Fraudulent financial reporting (management fraud) Misappropriation of assets (defalcations)  Procedures to assess fraud risks Discussion among engagement team Inquiries of management and other personnel Risk assessment analytical procedures (to aid in planning the audit) Considering fraud risk factors Incentives Opportunity Attitude 6-10

Assessing Fraud Risks – Identifying Fraud Risks  Considerations in identifying fraud risks Type Significance Likelihood that it will result in a material misstatement Pervasiveness 6-11

Responding to Fraud Risks  Overall response Professional skepticism and audit evidence Assigning personnel and supervision Accounting principles Predictability of auditing procedures  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 6-12

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 audit committee 6-13

Design Further Audit Procedures ( 1/2)  Types Tests of controls Analytical procedures Tests of details of transactions and balances  Audit procedures Inspection Observation Inquiry Confirmation Recalculation Reperformance 6-14

Design Further Audit Procedures (2/2)  Further audit procedures should include Substantive procedures for all relevant assertions Tests of controls when the auditors’ risk assessment includes an expectation that controls are operating effectively, or when substantive procedures alone are not sufficient  Procedures should be linked with the assessed risks of material misstatement at the relevant assertion level  Overall responses when assessed risks of material misstatement are high Heightened professional skepticism Assigning more experienced staff Assigning staff with specialized skills Providing more supervision 6-15

Audit Documentation  Audit Documentation Risk assessment Discussion of the audit team, elements of understanding, assessment of risk of material misstatement and risks identified Procedure results Overall responses, nature, timing and extent of further audit procedures, linkage of procedures with assessed risks, results of audit procedures, conclusions reached about operating effectiveness of controls, significant risk identified, circumstances in which substantive procedures alone will not provide sufficient evidence Consideration of fraud Similar to risk assessment as document discussion, procedures used to identify fraud risks, fraud risk and response, any other conditions that caused fraud-related procedures and communications with management or audit committee. 6-16

Direction of Audit Testing 6-17

Audit Program  Systems portion Deals with client’s internal control Evidence of test of controls and assessing control risk  Substantive test portion Deals with financial statement account balances Indirect and direct verification of income statement accounts 6-18