1. Chapter 06 Audit Planning, Understanding the Client,
Assessing Risks and
Responding
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2. 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
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3. 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 1-3.
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4. Stages of an Audit—Diagram Figure 6.1
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5. 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
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6. Items Included in Engagement Letters
Name of the entity
Management responsibilities
Financial statements
Establishing effective internal control over financial reporting
Compliance with laws and regulations
Making records available to the auditors
Providing written representations at end of the audit, including that adjustments discovered by the auditors and not recorded to the financials are not material
Auditor responsibilities
Conducting an audit in accordance with GAAS
Obtaining an understanding of internal control to plan audit and to determine the nature, timing and extent of procedures
Making communications required by GAAS
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7. Engagement Letters—Optional Items
Arrangements regarding
Conduct of the audit (e.g., timing, client assistance)
Use of specialists or internal auditors
Obtaining information from predecessor auditors
Fees and billing
Other services to be provided, such as examination of internal control over financial reporting
Limitation of or other arrangements regarding liability of auditors or client
Conditions under which access to the auditors’ working papers may be granted to others
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8. 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
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9. 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.
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10. Understanding the Client’s Business—Nature of the Client
Competitive position
Organizational structure
Accounting policies and procedures
Ownership
Capital structure
Product and service lines
Critical business processes
Internal control
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11. Understanding the Client’s Business, Industry, Regulatory, and Other Factors
Competitive environment
Supplier and customer relationships
Technology developments
Major laws and regulations
Economic conditions
Attractiveness of the industry
Barriers to entry
Strength of competitors
Bargaining power of suppliers of raw materials and labor
Bargaining power of customers
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12. Understanding the Client’s Business—Objectives, Strategies & Business Risks
Objectives—Overall plans
Operating and financial strategies—Operational actions to achieve objectives
Business risks—Threats to achieving objectives
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13. Understanding the Client’s Business—Measuring and Reviewing Performance
Budgets
Key performance indicators
Variance analysis
Segment performance reports
Balanced scorecard
External parties
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14. Understanding the Client’s Business — Internal Control
Need knowledge and understanding of how a client’s internal control works:
What controls exists
Who performs them
How various types of transactions are processed and recorded
What accounting records and supporting documentation exist
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15. Understanding the Client’s Business—Sources of Information
Inquiries of management
Industry Accounting and Auditing Guides
Industry Risk Alerts
Trade journals and news stories
Government publications
Prior company annual reports and SEC filings
Prior tax returns
Electronic sources
Ex. web pages for company
Tour of plant and offices
Analytical procedures
The statement of cash flows and obtaining an understanding of the client
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16. 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
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17. 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.
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18. Particularly consider
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
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19. Assessing Fraud Risks Two types Procedures to assess fraud risks
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
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20. Assessing Fraud Risks – Identifying Fraud Risks
Considerations in identifying fraud risks
Type
Significance
Likelihood that it will result in a material misstatement
Pervasiveness
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21. 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
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22. 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
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23. 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
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24. 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
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25. 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.
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26. Audit Trail
A trail of evidence that links source documents, journal entries and ledger entries
Auditor may follow the audit trail in either of two directions related to the direction of testing
Test for existence or occurrence
Test for completeness
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27. Direction of Audit Testing Figure 6.4
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28. Transaction cycles
Auditors’ consideration of internal control is often organized around client’s major transaction cycles (examples)
Revenue cycle
Acquisition cycle
Conversion cycle
Payroll cycle
Investing cycle
Financing cycle
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29. Transactions Affecting Accounts Receivable Figure 6.5
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30. Audit Plan Systems portion Substantive test 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
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31. Indirect Verification of Income Statement Accounts Figure 6.6
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32. Objectives of Substantive Programs for Asset Accounts
Establish the existence of assets
Establish that the company has rights to the assets
Establish the completeness of recorded assets
Verify the cutoff of transactions
Determine the appropriate valuation of the assets and accuracy of related transactions
Determine the appropriate financial statement presentation and disclosure of the assets
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33. Relationship of Financial Statement Assertions to the Audit Figure 6.7
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34. Relationships among Audit Objectives, Risks of Material Misstatement, and Audit Procedures Figure 6.8
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