Chapter 3 Audit Planning, Types of Audit Tests, and Materiality.

Chapter 3Audit Planning, Types of Audit

Tests, and Materiality

The Phases of an Audit That Relate to Audit Planning

LO# 1

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Prospective Client Acceptance1. Obtain and review financial information.

2. Inquire of third parties regarding client integrity.

3. Communicate with the predecessor auditor.

4. Consider unusual business or audit risks.

5. Determine if the firm is independent (the determination is more stringent if it is a public company seeking an audit)

6. Determine if the firm has or can obtain the necessary skills and knowledge.

LO# 1

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Continuing Client RetentionEvaluate client

retention periodically

Typically evaluation is done right after completion of audit, before starting on

the next year’s audit

Conflicts over accounting and auditing issues (serious

issues)

Dispute over fees, need for a larger CPA firm due to growth of

the company, or other issues

LO# 1

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On February 5, 2001, Arthur Andersen partners met to discuss continuance of Enron as an audit client. Meeting minutes are hyperlinked in the

course schedule

Preliminary Engagement Activities

Determine the Audit Engagement Team

Requirements

Assess Compliance with Ethics and Independence

Requirements

LO# 2

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Establish Terms of the Engagement

The terms of the engagement, which are documented in the engagement letter (an example is shown on p. 73-74),

should include the objectives of the engagement, management’s responsibilities, the auditor’s

responsibilities, and the limitations of the engagement.

Who signs the engagement letter?

In establishing the terms of the engagement, three topics must be discussed:

1.The engagement letter;

2.Using the work of the internal auditors; and

3.The role of the audit committee.

LO# 3

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The Engagement LetterThe engagement letter formalizes the arrangement reached

between the auditor and the client.

In addition to the items in the sample engagement letter in Exhibit 3-1 in the

textbook, the engagement letter may include:

• Arrangements for use of specialists or internal auditors.

• Any limitations of liability of the auditor (however, the SEC, federal banking regulators and many state insurance departments prohibit this)

• Additional services to be provided.

LO# 4

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Internal AuditorsLO# 5

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Objectivity Whether the organization status of the IAF, including the function’s authority and accountability, supports the ability of the function to be

free from bias, conflict of interest, or undue influence of others to override professional judgments (e.g., the IAF reports to audit committee or an officer with appropriate authority, or if the function reports to management, whether it has direct access to audit committee).

Whether the IAF is free of any conflicting responsibilities (e.g., having managerial or operational duties ore responsibilities that are outside of the IAF).

Whether audit committee oversees employment decisions related to the IAF. Whether any constraints or restrictions placed on the IAF by management or audit committee exist, for example, in communicating the

IAF’s findings to the external auditor.

Whether the internal auditors are members of relevant professional bodies and their memberships obligate their compliance with relevant professional standards relating to objectivity or whether their internal policies achieve the same objectives.

Competence Whether the IAF is adequately and appropriately resourced relative to the size of the entity and the nature of its operations. Whether established policies for hiring, training, and assigning internal auditors to internal audit engagements exist. Whether the internal auditors have adequate technical training and proficiency in auditing (e.g., the internal auditors’ possession of a

relevant professional designation and experience).

Whether the internal auditors possess the required knowledge relating to the entity’s financial reporting and the applicable financial reporting framework and whether the IAF possesses the necessary skills to perform work related to the entity’s financial statements.

Whether the internal auditors are members of relevant professional bodies the oblige them to comply with the relevant professional standards, including continuing professional development requirements.

Systematic and Disciplined Approach The existence, adequacy, and use of documented internal audit procedures or guidance covering such areas as risk assessments, work

programs, documentation, and reporting, the nature and extent of which is commensurate with the size and circumstances of an entity. Whether the IAF has appropriate quality control policies and procedures or quality control requirements in standards set by relevant

professional bodies for internal auditors. Such bodies may also establish other appropriate requirements such as conducting periodic external quality assessments.

The Audit Committee

Subcommittee of the board of

directors

No specific requirements for privately

held companies

Section 301 of Sarbanes-Oxley Act requires the following for audit committee members of

publicly held companies:

• Member of board of directors and independent.

• Directly responsible for overseeing work of any registered public accounting firm employed by the company.

• Must preapprove all audit and nonaudit services provided by its auditors.

• Must establish procedures to follow for complaints.

• Must have authority to engage independent counsel.

LO# 6

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Audit Committee Members’ Knowledge

In the past, audit committees were often weak not only because of lack of independence – there also often was a lack of knowledge.

Thus all audit committee members must at least be "financially literate” or able to read and understand fundamental financial statements.

1 member must be a "financial expert“ i.e.– Understand GAAP and financials– Understand GAAP re estimates, accruals & reserves– Be experienced in preparing, auditing or analysis– Understand internal controls re financial reporting– Understand audit committee functions

Planning the Audit• The auditor will develop an overall audit strategy for

conducting the audit. This will help the auditor to determine what resources are needed to perform the engagement.

• Then an audit plan - more detailed than the audit strategy – is developed.

• The audit plan should consider how to conduct the engagement effectively and efficiently.

LO# 7

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Assess Business Risks

To understand the client’s business and transactions

To identify financial statement

accounts more likely to contain

errors

By understanding the client’s business and identifying the areas where errors are more likely to occur, the

auditor can disproportionately allocate more resources to investigate those areas.

LO# 7

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Establish overall materiality

(more on this later!)

Establish tolerable misstatement for specific accounts

Establish tolerable misstatement for

classes of transactions

LO# 7

Establish Materiality

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Use of Specialists

A major consideration in planning the audit is the need for a specialist.

The use of an IT specialist is a significant aspect of most audit engagements.

The presence of complex information technology

may require the use of an IT specialist.

LO# 7

What other types of specialists might be

needed?

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Illegal Acts

Illegal Acts

Direct and Material

Consider laws and regulations as part of audit

Material and Indirect

Be aware may have occurred;

investigate if brought to attention

LO# 7

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Illegal ActsLO# 7

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When auditing a public company, Section 10A of the Securities Act of 1934 requires the auditor to notify the SEC if a direct and material illegal act is discovered, if the company itself does not quickly notify the SEC. Note that Section 10A applies even if the illegality just makes the quarters misstated (this is not intuitive since after all the auditor is there to audit the annual financial statements).

Related Parties

Some 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.

• Other parties that can have significant influence.

How to Identify Related Parties

• Review board minutes.

• Review conflict-of-interest statements.

• Review transactions with major customers, suppliers, borrowers, and lenders.

• Review agreements with major customers, vendors, and management.

• Review loan agreements for guarantees.

LO# 7

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Additional Value-Added Services

Tax PlanningSystem

Design and Integration

Internal Reporting

Risk Assessment

BenchmarkingElectronic Commerce

LO# 7

Auditors who audit public companies are more limited re consulting services that they can provide to their audit client. More about this in Chapter 19.

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Document AuditStrategy and Plan

Nature

Timing

Extent

The strategy and plan are based in part on the auditor’s evaluation of the auditor’s risk and

materiality evaluations.

The documentation of the plan helps communicate to the staff auditors what exactly they need to do.

LO# 7

Document overall audit strategy and audit plan, which involves documenting

the decisions about

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

internal control processes) and the effects of the risks and

controls on the planned audit procedures.

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Supervision of the Audit• Engagement partner and other supervisory

members of the team:

• 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

LO# 8

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Types of Audit Tests

Risk Assessment Procedures

To understand the entity and its environment, including its internal

control.

Tests of ControlsTo evaluate the design and operating

effectiveness of internal controls.

Substantive Procedures

Tests of details of transactions and balances (more in Ch. 9) and

substantive analytical procedures (more in Ch. 5)

LO# 9

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Dual-Purpose Tests: Using one sample for 2 purposes

Substantive Tests of

Transactions

Tests of Controls

Dual-Purpose

Tests

LO# 9

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Materiality

The magnitude of an omission or misstatement of accounting information that makes it probable that

the judgment of a reasonable person relying on the information would be changed or influenced

by the omission or misstatement.

The magnitude of an omission or misstatement of accounting information that makes it probable that

the judgment of a reasonable person relying on the information would be changed or influenced

by the omission or misstatement.

Materiality is a concept. Auditors, like accountants, transform this into

numbers and percentages. But then we override the numbers and percentages sometimes, because we

cannot the numbers and percentages are only for the

purpose of implementing the concept.

LO# 10

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Steps in Applying Materialityon an Audit

Step 1: Determine overall financial statements materiality

Step 1: Determine overall financial statements materiality

Step 2: Determine tolerable misstatement

(allocation of materiality at individual account level)

Step 2: Determine tolerable misstatement

(allocation of materiality at individual account level)

Step 3:Evaluate auditing findings(near the end of the audit)

Step 3:Evaluate auditing findings(near the end of the audit)

LO# 11

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Step 1a – Calculate Overall Materiality (aka Planning Materiality aka Global Materiality aka financial statement

materiality)

Different “bases “can be used to calculate overall materiality , e.g.:• Income before taxes. (3% to 5%)• Income from continuing (5% typically)

operations.• Three year average income. (5% typically)• Total assets. (1/3 of 1% typically)• Total revenues.(1/2 of 1% typically)• Note that not all auditors agree on what base to use or what %

Different “bases “can be used to calculate overall materiality , e.g.:• Income before taxes. (3% to 5%)• Income from continuing (5% typically)

operations.• Three year average income. (5% typically)• Total assets. (1/3 of 1% typically)• Total revenues.(1/2 of 1% typically)• Note that not all auditors agree on what base to use or what %

LO# 11

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Step 1b – Consider qualitative factors. You may need to adjust lower (be more cautious and conservative) the

Overall Materiality

The quantitative amountsmay be adjusted lower forqualitative factors such as:• Material misstatements in prior years.• Potential for fraud or illegal acts.• Potential loan covenant violations. • High market pressures.• High fraud risk.• Higher than normal risk

of bankruptcy.

The quantitative amountsmay be adjusted lower forqualitative factors such as:• Material misstatements in prior years.• Potential for fraud or illegal acts.• Potential loan covenant violations. • High market pressures.• High fraud risk.• Higher than normal risk

of bankruptcy.

LO# 11

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Step 2 –Determine Tolerable Misstatement

Tolerable misstatement (50%-75% of overall materiality) is the amount of overall materiality allocated to one account or class of transactions. The various tolerable misstatements total more than planning materiality.

Tolerable misstatement (50%-75% of overall materiality) is the amount of overall materiality allocated to one account or class of transactions. The various tolerable misstatements total more than planning materiality.

LO# 11

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Step 3 – Evaluate Audit Findings, first one account at a time (Ch. 9); later in the aggregate (Ch. 17)

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 planning

materiality. If the aggregate misstatement is less than planning

materiality, the auditor can conclude that the financial statements 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 planning

materiality. If the aggregate misstatement is less than planning

materiality, the auditor can conclude that the financial statements are fairly presented, if not, an adjustment should be made.

LO# 11

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End of Chapter 3

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