1. Chapter 6
Audit Planning, Understanding the Client, Assessing Risks and Responding 1

2. Three standards of field work
Acronym PIE
Planning (Ch. 6)
Internal Control (Ch. 7)
Evidence (Ch. 5)
6-2

4. Obtaining Clients Submit a proposal
Contact the audit committee
Make fee arrangements
Communicate with the predecessor auditors
Must attempt to get client’s permission to talk to auditors
Evaluate the integrity of client
Discuss any disagreements over accounting principles
Predecessor’s understanding of reason for change of auditors
Change in auditors reported on SEC Form 8-K
Overall procedure is important for evaluation of management integrity
New companies are more risky (e.g. ZZZ Best!)

5. 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. 9

6. 1. Planning the Audit Establish an understanding with the client
This is ordinarily accomplished through use of an engagement letter
Determine that
The firm meets professional independence requirements
There are no issues relating to management integrity
The client understands the terms of the engagement
Deal with audit committee (consisting of at least 3, non-employee or non-officer directors) – Also see SOX requirements.

7. Items in Engagement Letters
AGREEMENT SHOULD BE CLEARLY MADE IN WRITING (1136 Tenants)
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 2 2

8. 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
See example shown in class. 3

9. 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
Tour of office and plant (memorize personnel names, copyroom, thermostat, restroom, dusty inventory, etc.)

10. 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. 9

11. 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, ratings, trade journals.

12. 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
Auditor has to be super human A

13. Competitive environment Supplier and customer relationships
Understanding the Client’s Business, Industry, Regulatory, and Other Factors
Competitive environment
Supplier and customer relationships
Technology developments
Major laws and regulations
Economic conditions

14. Understanding the Client’s Business—Attractiveness of the Industry
Barriers to entry
Strength of competitors
Bargaining power of suppliers of raw materials and labor
Bargaining power of customers 5

15. Objectives—Overall plans
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

16. Understanding the Client’s Business--Basic Strategy
Product differentiation
Cost leadership
Auditor has to be super human A 6

17. A Budgets Key performance indicators Segment performance reports
Understanding the Client’s Business—Measuring and Reviewing Performance
Budgets
Key performance indicators
Segment performance reports
Balanced scorecard
External parties A

18. 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
6-18

19. 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 (Google!!)
Tour of plant and offices
Analytical procedures

20. 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. 9

21. 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
Control risks
Risks of material misstatement due to fraud
Design further audit procedures

22. Assessing Fraud Risks Two types Procedures to assess fraud risks
Fraudulent financial reporting (management fraud)
Misappropriation of assets (defalcations, theft)
Procedures to assess fraud risks
Discussion among engagement team
Inquiries of management and other personnel
Planning analytical procedures
Considering fraud risk factors (fraud triangle)
Incentives/Pressure
Opportunity
Rationalization

23. Assessing Fraud Risks—Identifying Fraud Risks
Considerations in identifying fraud risks
Type
Significance
Likelihood that it will result in a material misstatement
Pervasiveness

24. Responding to Fraud Risks
Overall response
Professional skepticism and audit evidence
Assigning personnel and supervision
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

25. 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 the audit committee of the board

26. 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, including substantive and control tests
5. Complete the audit
6. Form an opinion and issue the audit report 9

27. Audit procedures Two Main Types of Audit Tests
1. Tests of controls (often called systems tests or cycles tests or tests of transactions)
Examples:
pick 25 checks at random and test for proper authorization and proper documentation
pick 25 receipts and check for timely deposit at the bank
pick 25 expense reports and test for adherence to company policy

28. Audit procedures (cont.)
Two Main Types of Audit Tests
2. Substantive tests (often called test of balances)
Examples:
confirm cash balance with the bank
physically inspect inventories or fixed assets
perform analytical review to test reasonableness of balances
Dual Tests - some tests have characteristics of both test of controls and substantive tests
Example: test Dec’s payroll for compliance with rules and in the process verify calculations of payroll expenses and taxes payable at year-end.

29. Audit procedures (cont.)
Audit procedures include
Inspection
Observation
Inquiry
Confirmation
Recalculation
Reperformance

30. Objectives of Substantive Programs for Asset Accounts
Remember the six financial statement assertions and the acronym PERCCV? What are they? 4 7

31. Cash & Cash Equivalents
Blue Mountain Storage
Audit Program
Cash & Cash Equivalents
March 31, 2009
PB:
RB:
Ref
Audit Procedures
Completed by:
1. Confirm bank accounts using the standard bank confirmation forms, which will be supplied.
2. Review bank reconciliations done by client. Complete any bank recs not done by client. For at least one month of your choice, a four-column proof of cash must be completed.
3. Reclassify any cash that cannot be used for current purposes.
4. Count petty cash and complete the worksheet. Prepare an adjusting entry to record any cash used, if material.
5. Age the outstanding checks, listing all checks older than 90 days. Checks older than 90 days should be reclassified as a current liability, if material.
6. Review bank transfers, if any, around March 31 for kiting.
Which assertion(s) do each of these steps test?

32. The Audit Trail Direction of Audit Testing
Tracing
Vouching

33. TRUE OR FALSE:
Tests for unrecorded assets (completeness) typically involve tracing from source documents to the books (journals/ledgers)
The direction of testing for unsupported entries in books starts with the supporting documents that are then traced to the books
Moving from the supporting documentation to the journals/ledgers is called tracing; and moving from the books to the supporting documentation is called vouching.

34. Transaction Cycles Revenue (sales & collections)
Acquisition (purchases & disbursements)
Conversion (production & inventory)
Payroll
Investing
Financing
NOTE: Although understanding cycles is important, audits are done primarily via the balance sheet. In other words, the income stmt and other activities accounts are audited in conjunction with their related balance sheet accounts. Your textbook was selected because it follows the balance sheet approach.

35. Relationships Between Bal. Sheet & Income Statement Accounts
Balance Sheet Item
Revenue
Expenses
Accounts receivable
Notes receivable
Securities and
investments
Sales
Interest,
Interest, dividends,
gains, investee’s income
Uncollectible
accounts Uncollectible notes Losses
Inventories
Purchases, cost of goods sold, payroll
Property, plant and
equip.
Intangible assets Prepaid expenses Accrued liabilities
Rent, gains
Royalties
Depreciation; repairs
Amortization Various expenses Various expenses
Interest-bearing debt
Interest 2 2

36. Transactions Affecting Accounts
Receivable

37. 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 in all material respects and issue the audit report 9

38. Materiality in Perspective
The audit report says the financial statements are fairly stated in all material respects. What does this mean?
Materiality is very hard for new auditors to accept. If it’s wrong, it needs to be corrected, right? Not if it’s not considered material (NCM).
The public doesn’t understand materiality either (would you stand before a judge and say “Your Honor, you’re worried about a little thing like that?”
Materiality is indirectly related to the time left to finish the audit.

39. 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

40. Planning Materiality
Rules of thumb help but ultimately it is a judgment call
5-10% of net income
0.5%-1.0% of total assets or total revenues
1.0% of total equity
Planning materiality is really the amount that the big picture accounting equation can be off before you think the fin. stmts. are not fairly stated in all material respects.