Auditing Concepts and Methods Chapter 5 - Transparency 5- 1

Understanding the Client and

General Planning

Auditing Concepts and Methods Chapter 5 - Transparency 5- 2

Client Acceptance

Quality control policies and procedures

Communication with predecessor auditor

Engagement letters

Conferences with client personnel

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Engagement Letter

CPA Firm555 State StreetHouston, Texas

October 23, 19X3

Board of Directors Billings Corporation 12 Main Street Houston, Texas

Ladies and Gentlemen:

This letter is written to confirm our understanding concerning the conference held October 20, 19X3, in our office between Billings Corporation, represented by Mr. L.C. James, and our firm, represented by Mr. Ben Green.

Our understanding is that we are hereby engaged to audit the balance sheet of Billings Corporation at December 31, 19X3, and the statements of income, retained earnings, and cash flow for the period then ended.

We will conduct our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.

Our audit will be designed to provide a basis for expressing an opinion on the financial statements. We are aware of the possibility that such matters as fraud,

CPA Firm555 State StreetHouston, Texas

October 23, 19X3

Board of Directors

Ladies and Gentlemen:

This letter is written to confirm our understanding

Our understanding is that we are hereby engaged to audit

We will conduct our audit in accordance with generally

Our audit will be designed to provide a basis for

Auditing Concepts and Methods Chapter 5 - Transparency 5- 4

Engagement Letter (continued)

illegal acts, or related party transactions may have a material effect on the financial statements. Accordingly, our audit is planned and conducted with due consideration of such matters as specified in Statements on Auditing Standards of the AICPA. However, your management is responsible for the financial statements and for adopting sound accounting policies, for maintaining an adequate and effective system of accounts, for safeguarding of assets, and for devising an internal control structure that will, among other things, help assure the production of proper financial statements.

Our fees for this audit will be based on the time spent by various members of our staff based on our standard billing rates. These amounts vary on an hourly basis in accordance with the experience and expertise of our staff members.

In order for us to work as efficiently as possible, it is understood that your staff will provide us with as much information and assistance as we need.

Our work will commence within one week of your acceptance of this proposal.

This proposal, in duplicate, is submitted this 23rd day of October, 19X3.

CPA Firm

By_______________________ Partner

Accepted at Houston, Texas, this____day of________, 19X3.

BILLINGS CORPORATION

By:_________________________ Chief Financial Officer

Our fees for this audit will be based on the time spent by

In order for us to work as efficiently as possible, it is

Our work will commence within one week of your acceptance of

This proposal, in duplicate, is submitted this 23rd day of

Auditing Concepts and Methods Chapter 5 - Transparency 5- 5

Knowledge of the Business

Organization structure Operations and legal

structure• Knowledge of operations• Tour of plant• Legal documents• Minutes, contracts, and

correspondence Industry and economic

conditions

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General Planning Decisions

Anticipated assessed level of control risk

Preliminary estimates of materiality

Risk conditions or financial statement items likely to require adjustment

Overall timing of audit work Extent of involvement of

specialists and internal auditors Staffing

Result: Preliminary audit plan and time budget

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Knowledge -- Preliminary Audit Plan

Business

Industry

Control environment, risk assessment, and monitoring

Accounting system

Control activities

Management integrity

Auditing Concepts and Methods Chapter 5 - Transparency 5- 8

At the CPA Firm

Review of files• Correspondence files• prior year’s work papers• permanent files• prior years’ financial statements

and audit reports

Discussion with firm personnel• nonaudit services provided to

client• experts in the industry

Auditing Concepts and Methods Chapter 5 - Transparency 5- 9

At the CPA Firm (continued)

Review of industry information• AICPA industry guides

• Trade publications

• Annual reports of other companies in industry

Review of authoritative pronouncements• Existing or new

• Accounting or auditing

Identify reports to be issued• SEC filings

• Special report on contractual compliance

• etc.

Auditing Concepts and Methods Chapter 5 - Transparency 5- 10

At the Client

Inquiry of management Reading current year’s

interim financial statements

Agreement on engagement• Type

• Scope

• Timing Tour facilities

Auditing Concepts and Methods Chapter 5 - Transparency 5- 11

At the Client (continued)

Reading legal documents and minutes• corporate charter, bylaws

• major contracts

• minutes of directors’ and stockholders’ meetings

Analytical procedures - calculating general profitability, liquidity, and solvency ratios and trends and comparing to:• client experience

• client plans

• industry ratios and trends

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Audit Decisions in Preliminary Planning

Control risk

Audit risk

Materiality

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Materiality

The magnitude of an omission or misstatement of accounting information that in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement

Auditing Concepts and Methods Chapter 5 - Transparency 5- 14

Materiality

RULES-OF-THUMB FOR PLANNING MATERIALITYCommon Range of percentages Relativebases applied to base advantages

Income before taxes* 5.0 to 10% Relevance

Total revenue 0.5 to 2% Stability

Total assets 0.5 to 2% Predictability and Stability

*Income before tax is used rather than net income to neutralize the tax effectof transactions.

RULES-OF-THUMB FOR PLANNING MATERIALITYCommon Range of percentages Relativebases applied to base advantages

*Income before tax is used rather than net income to neutralize the tax effect

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Audit Risk

The risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated

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Special Audit Risks

Management fraud

Related-party transactions

Illegal acts

Business failure

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Fraud - Terminology

Errors Irregularities Management fraud Employee fraud Red flags

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Red Flags Management Characteristics

• Management operating and financing decisions are dominated by a single person.

• Management’s attitude toward financial reporting is unduly aggressive.

• Management (particularly senior accounting personnel) turnover is high.

• Management places undue emphasis on meeting earnings projections.

• Management’s reputation in the business community is poor.

Auditing Concepts and Methods Chapter 5 - Transparency 5- 19

Red Flags (continued)

Operating and Industry Characteristics:

• Profitability of entity relative to its industry is inadequate or inconsistent.

• Sensitivity of operating results to economic factors (inflation, interest rates, unemployment, etc.) is high.

• Rate of change in entity’s industry is rapid.

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Red Flags (continued)

Operating and Industry Characteristics (continued):

• Direction of change in entity’s industry is declining with many business failures.

• Organization is decentralized without adequate monitoring.

• Internal or external matters that raise substantial doubt about the entity’s ability to continue as a going concern are present.

Auditing Concepts and Methods Chapter 5 - Transparency 5- 21

Red Flags (continued)

Engagement Characteristics:

• Many contentious or difficult accounting issues are present.

• Significant difficult-to-audit transactions or balances are present.

• Significant and unusual related-party transactions not in the ordinary course of business are present.

Auditing Concepts and Methods Chapter 5 - Transparency 5- 22

Red Flags (continued)

Engagement Characteristics (continued):

• Nature, cause (if known), or the amount of known and likely misstatements detected in the audit or prior period’s financial statements is significant.

• It is a new client with no prior audit history or sufficient information is not available from the predecessor auditor.

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Related-Party Transactions

Identify related parties Identify material transactions Examine identified material

related-party transactions Evaluate disclosure

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Illegal Acts

SAS 53 vs. SAS 54

“direct and material effect on the determination of a financial statement line item amount”

Violations with indirect effects• loss contingencies

• effect on audit

Communication responsibilities

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Business Failure

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Engagement Timing

Basic time segments

Efficiency and effectiveness in timing

Timing decisions

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Involving Specialists

Engaged or employed by client

CPA firm

industry specialists CPA firm functional

specialists CPA firm technical

specialists

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Analytical Procedures

In planning the audit*• To understand the client and

industry

• To identify transactions and events since the last audit date

• To identify a risk requiring more than normal audit attention

To plan the nature, timing, and extent of other audit procedures.

*Required by SAS No. 56

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Analytical Procedures (continued)

As substantive testsTo obtain evidential matter about assertions

In overall review at end*• Identify any unusual or unexpected

balances not previously noted• Consider going concern status

To assess the conclusions the auditor has reached

To evaluate overall financial statement presentation

* Required by SAS No. 56