1. planning AICPA auditing standards state:
Three main reasons that the auditor should properly plan the audit engagement:
Enable the auditor to obtain sufficient appropriate evidence for the circumstances.
Help keep audit costs reasonable.
Avoid misunderstandings with the client.
The eight major steps in audit planning are detailed in Figure 8-1.
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2. The first four steps in the planning process are covered in this chapter.
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3. planning Three risk terms relevant to audit planning:
Acceptable audit risk: A measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unmodified opinion has been issued.
Client business risk: The risk that the entity fails to achieve its objectives or execute its strategies.
Risk of material misstatement: The risk that the financial statements contain a material misstatement due to fraud or error prior to the audit.
All three types of risks must be considered by the auditor during the audit planning process.
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4. accept client and perform initial audit planning
Initial audit planning involves four things:
The auditor decides whether to accept a new client or continue serving an existing client.
The auditor identifies why the client wants or needs an audit.
To avoid misunderstandings, the auditor obtains an understanding with the client about the terms of the engagement.
The auditor develops the overall strategy for the audit, including engagement staffing and any required audit specialists.
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5. accept client and perform initial audit planning (cont.)
Identify Client’s Reasons for Audit
Risk factors associated with the client’s reasons for an audit include the likely statement users and the intended uses of the statements.
Obtain an Understanding with the Client
A clear understanding of the terms of the engagement should exist between the auditor and the client. Auditing standards require that there be an engagement letter which includes the engagement’s objectives. An example of an engagement letter is presented in Figure 8-2 on page 225.
The auditor must understand the client’s reasons for seeking an audit, because it helps the auditor to assess the risk of accepting the new client. Once the auditor understands the reasons for the audit, it is imperative that the terms of the audit engagement are carefully detailed in an engagement letter.
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6. accept client and perform initial audit planning (cont.)
Develop Overall Audit Strategy
After understanding the client’s reason for an audit, the auditor should develop and document a preliminary audit strategy.
Select Staff for Engagement and Evaluate Need for Outside Specialists
The CPA firm must select staff for the engagement who are knowledgeable about the client’s business. If the CPA firm lacks expertise, they may need to hire outside specialists.
The auditor will develop an overall audit strategy as soon as the terms of the engagement are clear. This includes assignment of personnel who will work on the audit, as well as determining if there is a need for outside specialists.
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7. understand the client’s business and industry
Auditing standards require the auditor to perform risk assessment procedures to obtain an understanding of the client’s business and its environment to assess risk of material misstatements.
An overview of the strategic approach to understanding the client’s business and industry is illustrated in Figure 8-3.
In order to conduct an effective audit, the auditor must have a clear understanding of the client’s business and the industry in which it operates.
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9. Perform preliminary analytical procedures
As noted in Chapter 7, auditors are required to perform preliminary analytical procedures as part of risk assessment. Key financial ratios, along with industry standards, are presented in Table 8-1. Common-size financial statements are also often used for one or more years for comparison as a preliminary analytical procedure. This is illustrated in Figure 8-4 on page 233.
Preliminary analytical procedures help in the development of the audit program through assessment of risk.
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10. Materiality
The fourth step in audit planning is to make a preliminary judgment about materiality for the audit. Auditing standards define materiality as the magnitude of misstatements that individually, or when aggregated with other misstatements, could reasonably be expected to influence the economic decision of users. There are five steps to applying materiality as noted in Figure 8-5. The first two are part of the planning process.
Because the audit opinion addresses the idea that the financial statements are free of material misstatements, applying materiality throughout the audit process is essential.
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12. Materiality for financial statements as a whole
Step 1 in Figure 8-5 is to set materiality for the financial statements as a whole as part of the planning process.
Factors Affecting Preliminary Materiality Judgment:
Materiality is a relative rather than an absolute concept.
Benchmarks are needed for evaluating materiality.
Qualitative factors also affect materiality.
Illustrative guidelines are shown in Figure 8-6 in the form of policy guidelines of a CPA firm.
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14. Determine performance Materiality
Step 2 in Figure 8-5 is to determine performance materiality, which can also be referred to as the allocation of the preliminary judgment about materiality to segments.
PCAOB standards refer to performance materiality as tolerable misstatement.
Performance materiality for an account is often set at 50–75 percent of overall materiality.
Auditors have three major difficulties when allocating materiality to balance sheet accounts:
Auditors expect certain accounts to have more misstatements than others.
Both overstatements and understatements must be considered.
Relative audit costs affect the allocation.
Figure 8-7 illustrates the allocation process.
Performance materiality refers to the materiality amount that is determined for specific segments of the audit.
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16. Estimate misstatement and compare with preliminary judgment
Auditors document all misstatements found for each audit segment. These may be known misstatements or likely misstatements.
Known misstatements are those that the auditor can determine the amount of misstatement in the account.
There are two types of likely misstatements:
Differences between management’s and the auditor’s judgment about estimates of account balances
Projections of misstatements based on the auditor’s tests of a sample
The last three steps in applying materiality are illustrated in Table 8-2.
At the end of the audit, the auditor must evaluate the amount of misstatements, both known and likely, and make a determination regarding the original preliminary materiality judgment.
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