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Audit Planning, Understanding the
Client, Assessing Risks and Responding
Chapter 6
6-2
Three standards of field work
Acronym PIE
1. Planning (Ch. 6)
2. Internal Control (Ch. 7)
3. Evidence (Ch. 5)
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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!)
The Audit Process--Steps
After obtaining a client, the audit process includes:
1. Plan the audit2. Obtain an understanding of the client and its environment,
including internal control3. Assess the risks of material misstatement and design
further audit procedures4. Perform further audit procedures5. Complete the audit6. Form an opinion and issue the audit report
This chapter emphasizes obtaining a client and steps 1-3.
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.
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
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.
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.)
The Audit Process--Steps
After obtaining a client, the audit process includes:
1. Plan the audit2. Obtain an understanding of the client and its
environment, including internal control3. Assess the risks of material misstatement and design
further audit procedures4. Perform further audit procedures5. Complete the audit6. Form an opinion and issue the audit report
This chapter emphasizes obtaining a client and steps 1-3.
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.
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 A
Auditor has to be super human
Understanding the Client’s Business,Industry, Regulatory, and Other Factors
Competitive environment Supplier and customer relationships Technology developments Major laws and regulations Economic conditions
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
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
Understanding the Client’s Business--Basic Strategy
Product differentiation Cost leadership
A
Auditor has to be super human
Understanding the Client’s Business—Measuring and Reviewing Performance
Budgets Key performance indicators Segment performance reports Balanced scorecard External parties
A
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
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
The Audit Process--Steps
After obtaining a client, the audit process includes:
1. Plan the audit2. Obtain an understanding of the client and its environment,
including internal control3. Assess the risks of material misstatement and design
further audit procedures4. Perform further audit procedures5. Complete the audit6. Form an opinion and issue the audit report
This chapter emphasizes obtaining a client and steps 1-3.
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
Assessing Fraud Risks Two types
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
Assessing Fraud Risks—Identifying Fraud Risks
Considerations in identifying fraud risks Type Significance Likelihood that it will result in a material
misstatement Pervasiveness
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
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
The Audit Process--Steps
After obtaining a client, the audit process includes:
1. Plan the audit2. Obtain an understanding of the client and its environment,
including internal control3. Assess the risks of material misstatement and design
further audit procedures4. Perform further audit procedures, including
substantive and control tests5. Complete the audit6. Form an opinion and issue the audit report
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
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.
Audit procedures (cont.) Audit procedures include
Inspection Observation Inquiry Confirmation Recalculation Reperformance
Objectives of Substantive Programs for Asset Accounts
Remember the six financial statement assertions and the acronym PERCCV?What are they?
Blue Mountain Storage
Audit Program
Cash & Cash Equivalents
March 31, 2009
PB:
RB:
Ref Audit ProceduresCompleted
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) doeach of these steps test?
The Audit TrailDirection of Audit Testing
Tracing
Vouching
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1. Tests for unrecorded assets (completeness) typically involve tracing from source documents to the books (journals/ledgers)
2. The direction of testing for unsupported entries in books starts with the supporting documents that are then traced to the books
3. Moving from the supporting documentation to the journals/ledgers is called tracing; and moving from the books to the supporting documentation is called vouching.
TRUE OR FALSE:
Transaction Cycles1. Revenue (sales & collections)
2. Acquisition (purchases & disbursements)
3. Conversion (production & inventory)
4. Payroll
5. Investing
6. 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.
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
Transactions Affecting Accounts Receivable
The Audit Process--Steps
After obtaining a client, the audit process includes:
1. Plan the audit2. Obtain an understanding of the client and its environment,
including internal control3. Assess the risks of material misstatement and design
further audit procedures4. Perform further audit procedures5. Complete the audit6. Form an opinion in all material respects and issue the
audit report
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.
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
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.
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