1. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. Chapter 4 Engagement Planning

2. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. I. Pre-Engagement Arrangements A.Client selection and retention B.Communication between predecessor and successor auditors C.Engagement letters D.Staff assignment E.Time budget

3. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. A. Client Selection and Retention Professional service firms are not obligated to accept undesirable clients, nor are they obligated to continue to serve clients when relationships deteriorate or when management comes under a cloud of suspicion. (See Auditing Insight on p. 101 of text.)

4. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. B. Communication between Predecessor and Successor Auditors (SAS 84) Attempt to communicate required If client permits, issues to discuss –Disagreements about accounting principles or audit procedures. –Communications the predecessor gave the former client about fraud, illegal acts, and internal control recommendations. –The predecessor’s understanding about the reasons for the change of auditors (particularly about the predecessor’s termination).

5. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. C. Engagement Letters Recommended procedure to establish understanding with client regarding:  Engagement objectives  Management responsibilities  Auditor responsibilties  Engagement limitations

6. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. D. Staff Assignment  Typical team includes:  Engagement partner with final responsibility  Audit manager  Industry specialist  Senior auditors  Computer specialists  Tax partner  Concurring partner  Concurring partner required for SEC audits.  Engagement partner must rotate off every 5 years.  New or complex clients are assigned more experienced staff.

7. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. E. Time Budget  Number of hours for each audit segment is set out in a time budget.  Interim audit work is done several weeks or months before the balance sheet date.  Year-end work is done shortly before or after the balance sheet date.  Staff are to maintain time records of their work to allow for future planning and determining audit efficiency.

8. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. II. Understanding the Client’s Business A.Enterprise Risk Management (ERM) B.Risk-Based Auditing (RBA) C.Minutes of Board of Directors D.Related Parties E.Tolerable Misstatement F.Specialists G.Analytical Procedures H.Planning Memorandum

9. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. A.Enterprise Risk Management Framework (See discussion on pp. 107-108 of text) Internal Environment Monitoring Information and Communication Risk Response Risk Assessment Objective Setting Event Identification Control Procedures

10. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. B. Risk-Based Auditing (RBA) Business risk is the risk that the client will fail to achieve its objectives.  Account-based auditing involves understanding control risk for certain types of errors or fraud in specific accounts. Account Balances Identified Risks  Risk-based auditing involves understanding control risk that the client will not meet their objectives and seeing if management has controls in place to mitigate these risks. Control Procedures Identified Risks

11. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. C. Minutes of Board of Directors  Auditors take notes or make copies of important parts of these minutes and compare them to information in the accounts and disclosures.  A company’s failure to provide minutes is a significant scope limitation that could result in a disclaimer of opinion on the financial statements. Board Minutes

12. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. D. Related Parties  Related parties are those individuals or organizations that are closely tied to the auditee, possibly through family ties or investments.  Evidence from related parties can be biased.  See Auditing Insight on p. 112 of text.

13. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. E. Tolerable Misstatement  Tolerable misstatement is the amount by which a particular account may be misstated, yet still not cause the financial statements taken as a whole to be materially misleading.  Top-down approach is preferable because it forces the audit team to think about the financial statements taken as a whole. TM 1,000 Direct Projection 630 Allowance for sampling risk 200 (70 net overstatement error found in sample / 1,000 dollar value of sample) x 10,000 dollar value of population – 70 net overstatement error in sample

14. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. F. Specialists  Specialists are persons skilled in fields other than accounting and auditing who are not members of the audit firm, but are used by auditors in the audit.  The specialist should be unrelated to the company.  Auditors should have an understanding of the specialist’s methods and assumptions.  Specialists are not referred to in the audit report unless their findings indicate a GAAP departure causing the audit report to be modified.

15. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. G. Analytical Procedures Five steps when creating analytical procedures: 1.Develop an expectation 2.Define a significant difference 3.Calculate predictions and compare them with the recorded amount 4.Investigate significant differences 5.Document each of the preceding steps Example: See question regarding collectibility of accounts receivable on p. 118 of text.

16. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. H. Planning Memorandum  Summary of planning procedures  Considerations 1. Investigation or review of the prospective or continuing client relationship. 2. Provision of special services or reports and needs for special technical or industry expertise. 3. Staff assignment and timing schedules. 4. Assessed level of control risk. 5. Significant industry or company risks. 6. Computer system control environment. 7. Utilization of the company’s internal auditors. 8. Identification of unusual accounting principles problems. 9. Schedules of work periods, meeting dates with client personnel, and completion dates.  Basis for audit program

17. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. III. Planning in an Electronic Environment A.Items Unchanged by Electronic Processing B.Effects of Computer Processing on Audit C.Computer-Assisted Audit Tools and Techniques (CAATTs)

18. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. A. Items Unchanged by Electronic Processing  The definition of auditing.  The purposes of auditing.  The generally accepted auditing standards.  The assertions of management embodied in financial statements.  The requirement to gather sufficient competent evidence.  The independent auditor's report on financial statements.

19. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. B. Effects of Computer Processing on Audit  The auditor must evaluate the impact of technology on the client’s operations (see points on pp. 122- 123 of text).  The auditor must evaluate computer controls implemented by the client in the auditor’s study and evaluation of the client’s internal controls.  The auditor can use the computer’s speed and accuracy to assist in the audit.

20. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. C. Computer-Assisted Audit Tools and Techniques (CAATTs)  CAATTS are used on most audits where accounting records are stored in computer files or in a database.  Advantages include:  Preprogrammed editing, operating, and output subroutines.  Same software can be used with various clients.  A week of intensive training is generally sufficient.  See Auditing Insight on p. 126 of text for typical audit procedures performed by CAATTS.

21. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. IV. Audit Documentation A.Audit Documentation Defined B.Audit Documentation Files C.Current Audit Documentation File Format D.Illustrative Audit Documentation E.Document Completion and Retention F.Audit Documentation Ownership and Confidentiality

22. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. A. Audit Documentation Defined  Definition The written record of the basis for the auditor’s conclusions that provides the support for the auditor's representations, whether those representations are contained in the auditor's report or otherwise.  Objectives  Improve audit quality  Enhance public confidence  Contents  Planning and performance of the work  Procedures performed  Evidence obtained  Conclusions reached by the auditor

23. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. B. Audit Documentation Files  Current  Audit Administrative Files - contain documentation of the early planning phases of the audit. See examples on p. 128 of text.  Audit Evidence Files – contain the specific assertions under audit, a record of the procedures performed, the evidence obtained, and decisions made in the course of the audit. The most important facet of audit evidence is showing decision problems and conclusions.  Permanent file contains information of continuing audit significance over many years. See examples on p. 128 of text.  Prior Year Working Papers

24. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. C. Current Audit Documentation File Format  Documentation is grouped behind the trial balance according to balance sheet and income statement captions.  Current assets usually appear first, followed by fixed assets, other assets, liabilities, equities, income, and expense accounts.  A lead schedule is a summary of the accounts or components in an account group. Amounts on these schedules should agree with adjusted ledger and financial statement balances.

25. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. D. Illustrative Audit Documentation (Review bulleted items on p. 130 of text) Information on Workpaper  Name, date, purpose, page number  Procedures performed and conclusions reached by the auditor  Evidence that auditor followed general standards and standards of field work  Audit Mark Legend  Reviewers’ initials Insert Exhibit 4.7

26. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. E. Documentation Completion and Retention  PCAOB regulations require that all documentation must be finalized within 45 days of the audit report’s release  AS 3 requires that audit documentation, including workpapers and other documents that form the basis of the engagement, be retained for seven years following the conclusion of the engagement (usually the audit report date).  Additions/Amendments  Documentation may not be deleted or discarded after report release date.  Additions must indicate Date the information was added, Name of preparer Reason

27. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. F. Audit Documentation Ownership and Confidentiality  Ownership Auditors maintain ownership, even after auditor-client relationship is over.  Confidentiality Only can be made public with permission, or if subpoenaed, or as part of a peer review of firm practices, or as part of an ethics investigation of firm personnel.

28. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. Summary  Client acceptance and audit planning  Understanding the client’s business and establishing planning memorandum  Influence of electronic processing on the audit process  Form of audit documentation  Documentation retention, ownership, and confidentiality