Chapter 3Chapter 3Audit Planning, Audit Planning, Types of Audit Types of Audit

Tests, and Tests, and MaterialityMateriality

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Phases Related to Phases Related to Audit PlanningAudit Planning“The work is to be adequately planned

and assistants, if any, are to be properly supervised.”

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Client Client AcceptanceAcceptance1. Obtain and review financial information.

2. Inquire of third parties regarding client integrity.

3. Consider unusual business or audit risks.

4. Determine if the firm is independent.

5. Determine if the firm has the necessary technical skills and knowledge.

6. Determine if acceptance violates any applicable regulatory agency requirements or the Code of Professional Conduct (e.g. independence issues)

7. Communicate with the predecessor auditor (must get client’s permission first)

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Client Client ContinuanceContinuance

Evaluate client retention periodically

Near audit completion or after a significant

event

Conflicts over accounting and auditing issues

Dispute over fees

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PreliminaryPreliminary Engagement Activities Engagement Activities

Determine the Audit Engagement Team

Requirements

Assess Compliance with Ethical and Independence

Requirements

If applicable, ask predecessor auditor for

working papers to establish Beg.

Balances and GAAP

consistency

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Establishing the Establishing the UnderstandingUnderstanding

The terms of the engagement, documented in the engagement letter, should include the objectives of the

engagement, management’s responsibilities, the auditor’s responsibilities (reasonable, not absolute assurance), audit

fees, and the limitations of the engagement.

Who signs the engagement letter?

In forming the understanding, 3 topics must be discussed:

1. The engagement letter;

2. Using the work of the internal audit function;

3. The role of the audit committee.

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The The EngagementEngagement Letter LetterThe engagement letter formalizes the arrangement between auditor and client (basically a written and

legal contract signed by the audit partner and chair of the client’s audit committee).

In addition to the items mentioned in the sample engagement letter in, the letter may include:

• Arrangements for use of specialists or internal auditors.

• Any limitations of liability of the auditor or client.

• Any additional services to be provided.

•Arrangements regarding other services.

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The Audit Committee

SOX requires audit committee membersof publicly held companies to:

• Be members of the BODs and independent.

• Be directly responsible for overseeing work of the registered public accounting firm employed by the company.

• Preapprove all audit and non-audit services provided by its auditors.

• Establish procedures to follow for complaints.

• Have authority to engage independent counsel.

• No specific requirements for privately held companies

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Planning the Audit

• The auditor will start by developing an overall audit strategy for conducting the audit to help the auditor to determine what resources are needed to perform the engagement, the scope of the engagement, and where to apply the audit team’s efforts.

• An audit plan is more detailed than the audit strategy. Basically, the audit plan should consider how to conduct the engagement in an effective and efficient manner and what audit procedures are planned to be performed (i.e., the audit programs detail the NTE: nature, timing and extent of audit procedures).

• The strategy and plan can be modified as new evidence is collected.

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Strategies and PlanningStrategies and PlanningWhen preparing the audit plan, the auditor should be guided by

the results of the client acceptance/continuance process, procedures performed to gain the understanding of the entity, and

preliminary engagement activities. For example:

Assess business risks and the need for specialists.

Establish materiality. Consider multi-locations.

Consider possible violations of laws and regulations.

Identify related parties.

Consider additional value-added services.

Document the overall audit strategy, audit plan, and prepare audit programs.

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Assess Assess ClientClient Business RisksBusiness Risks

To understand the entity’s

business and transactions

To identify F/S accounts likely

to contain errors

By understanding the entity’s business and identifying where errors are likely to occur, the auditor can allocate

more resources to investigate more risky accounts.

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Assess the Need for Assess the Need for SpecialistsSpecialistsA major consideration in planning is the need for specialists

The presence of complex information

technology may require the use of an

IT specialist.

What other types of specialists might be

needed?

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Establish overall materiality

(more on this later!)

Establishing MaterialityEstablishing Materiality

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Consolidated F/S

Consider Consider MultilocationsMultilocations or or Business UnitsBusiness Units

Low Risk

The auditor correlates the amount of audit attention devoted to the location or business unit with the level of risk present.

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Violations of Laws and RegulationsViolations of Laws and Regulations

Illegal Acts

Direct and Material

Consider laws and regulations as part of audit (tax laws)

Material and Indirect

Be aware of what may have occurred;

investigate if brought to attention

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Related PartiesRelated PartiesSome examples from FASB ASC Topic

850, “Related Party Disclosures”

• Affiliates of the enterprise.

• Entities using equity method to account for investments.

• Trusts for benefit of employees.

• Principal owners of enterprise.

• Management.

• Immediate families of the principal owners and management.

• In sum: parties with significant influence or can be influenced.

How to Identify Related Parties

•Review board minutes.

•Review conflict-of-interest statements.

•Financial and reporting information provided to creditors, investors, and regulators.

•Contracts or other agreements with major customers, vendors, and management.

•Scanning for and reviewing significant unusual transactions.

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AdditionalAdditional Value-AddedValue-Added ServicesServices

Tax PlanningSystem

Design and Integration

Internal Reporting

Risk Assessment

BenchmarkingElectronic Commerce

Auditors who audit public companies are limited in the types of other services that they can offer their auditees. Generally,

this means only tax services.

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DocumentDocument AuditAudit StrategyStrategy, , AuditAudit PlanPlan,, and Audit and Audit ProgramsPrograms

Nature

Timing

Extent

Auditors ensure they have addressed the risks they identified by documenting the linkage from the

entity’s business, objectives, and strategy to the audit plan.

The auditor’s preliminary decision concerning control risk determines the level of control testing, which in turn affects the auditor’s substantive tests

of the account balances and transactions.

Document overall audit strategy and audit plan, which involves documenting

the decisions about

The auditor documents how the entity is managing its risk (via

internal control processes) and the effects of the risks and

controls on the planned audit procedures.

A

U

D

I

T

T

E

S

T

S

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SupervisionSupervision of the Auditof the Audit“The work is to be adequately planned and assistants,

if any, are to be properly supervised.”

• The engagement partner and other supervisory members of the team need to:

• Inform engagement team members of their responsibilities

• Direct engagement team members to identify and communicate audit issues

• Review the work of the engagement team members

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33 Types of Types of Audit TestsAudit Tests

Risk Assessment Procedures

Used to obtain an understanding of the entity and its environment, including its internal control.

Tests of ControlsDirected toward the evaluation of the

effectiveness of the design and operation of internal controls.

Substantive Procedures

Detect material misstatements in a transaction class, account balance,

and disclosures of the F/S.

Look at the various workpapers in the classdat folder

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Risk Assessment 1-4Risk Assessment 1-4and Tests of Controls 1-5and Tests of Controls 1-5

1. Inquiry Oral/Written

2. Inspection Initials/Signatures

4. Walkthrough Design/Implemented

5. Reperformance Auditor Re-tests

3. Observation Actions/Processes

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Substantive Substantive ProceduresProcedures

Analytical Procedures

Evaluations of financial information through analysis of

plausible relationships among financial and

non-financial data

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Dual-PurposeDual-Purpose TestsTests

Substantive Tests of

Transactions

Tests of Controls

Dual-Purpose Tests

Look at the various workpapers in the classdat folder

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MaterialityMateriality

The Supreme Court interpretation of materiality is: a fact is material if there is “a substantial likelihood

that the…fact (or omission) would have been viewed by the reasonable investor as having

significantly altered the ‘total mix’ of information made available.”

The Supreme Court interpretation of materiality is: a fact is material if there is “a substantial likelihood

that the…fact (or omission) would have been viewed by the reasonable investor as having

significantly altered the ‘total mix’ of information made available.”

Materiality is not an absolute!The determination of materiality requires professional judgment.

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Steps in Applying Steps in Applying MaterialityMateriality

Step 1: Determine overall materiality

(planning materiality at the F/S level)

Step 1: Determine overall materiality

(planning materiality at the F/S level)

Step 2: Determine tolerable misstatement

(allocation of materiality at individual account/class of transactions level)

Step 2: Determine tolerable misstatement

(allocation of materiality at individual account/class of transactions level)

Step 3:Evaluate auditing findings

(near the end of the audit at both levels)

Step 3:Evaluate auditing findings

(near the end of the audit at both levels)

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Step 1 – Determine Step 1 – Determine OverallOverall MaterialityMateriality

The quantitative base formateriality is a percentage of:

• Income (loss) before taxes.

• Income from continuing operations.

• Three year average income.

• Total assets.

• Net assets.

• Total revenues.

• Gross profit.

• Total equity

The quantitative base formateriality is a percentage of:

• Income (loss) before taxes.

• Income from continuing operations.

• Three year average income.

• Total assets.

• Net assets.

• Total revenues.

• Gross profit.

• Total equity

The quantitative amounts may be adjusted lower for qualitative factors:

• Material misstatements in prior years.

• High risk of fraud.

• Potential loan covenant violations.

• High market pressures.

• Volatile business environment.

• Higher than normal risk of bankruptcy.

The quantitative amounts may be adjusted lower for qualitative factors:

• Material misstatements in prior years.

• High risk of fraud.

• Potential loan covenant violations.

• High market pressures.

• Volatile business environment.

• Higher than normal risk of bankruptcy.

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Step 2 –Determine Step 2 –Determine Tolerable MisstatementTolerable Misstatement

Tolerable misstatement is the amount of planning materiality allocated to a specific account or class of transactions. Combined tolerable misstatement is generally greater than planning materiality because:

Not all accounts will be misstated by their full tolerable misstatement allocation.

If errors are identified, additional testing is typically performed in that account and related accounts.

Audits of some individual accounts are conducted simultaneously. Materiality is often a small fraction of the account being audited and

planned procedures will be sufficiently precise to identify significant misstatements.

Overall materiality serves as a “safety net.”

Tolerable misstatement is the amount of planning materiality allocated to a specific account or class of transactions. Combined tolerable misstatement is generally greater than planning materiality because:

Not all accounts will be misstated by their full tolerable misstatement allocation.

If errors are identified, additional testing is typically performed in that account and related accounts.

Audits of some individual accounts are conducted simultaneously. Materiality is often a small fraction of the account being audited and

planned procedures will be sufficiently precise to identify significant misstatements.

Overall materiality serves as a “safety net.”

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Step 3 – Evaluate Step 3 – Evaluate AuditAudit FindingsFindings

When the audit evidence is gathered, the auditor: Aggregates misstatements from each account or class of

transactions (including known and likely misstatements). Considers the effect of misstatements not adjusted in the

prior period. Compares the aggregate misstatement to overall

materiality. If the aggregate misstatement is less than overall

materiality, the auditor can conclude that the F/S are fairly presented, if not, an adjustment should be made.

When the audit evidence is gathered, the auditor: Aggregates misstatements from each account or class of

transactions (including known and likely misstatements). Considers the effect of misstatements not adjusted in the

prior period. Compares the aggregate misstatement to overall

materiality. If the aggregate misstatement is less than overall

materiality, the auditor can conclude that the F/S are fairly presented, if not, an adjustment should be made.