Audit Planning, Understanding the

Client, Assessing Risks and Responding

Chapter 6

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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

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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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