Slide 6- 1 © The McGraw-Hill Companies, Inc., 2006 Chapter 6 Audit Planning, Understanding the Client, Assessing Risks, and Responding.

Slide 6- 1 © The McGraw-Hill Companies, Inc., 2006

Chapter 6Audit Planning, Understanding

the Client, Assessing Risks, and Responding


PACBO 2nd Standard of Field Work

The auditor must obtain a sufficient understanding of the entity and its environment, including its internal control, to assess the risk of material misstatement of the financial statements whether due to error or fraud, and to design the nature, timing, and extent of further audit procedures.


Overall Audit Planning Process

Decide whether or not to accept a

prospective client;keep existing client


Keys to Client Screening

Research Client and its Reputation, including Key Executives

Visit Client Facilities

Assess CPA Firm Competence & Independence

Always Contact Prior CPA (w/ Client OK)

Assess Riskiness of the Client and Consider Avoiding the Riskiest Clients


Risky Clients Key executives appear uncooperative or

reputation for questionable integrity

Financial problems

Growing much faster than others in the industry

Shopping for lowest price

Refuse to sign engagement letter or management representation letter

High IR and CR factors for fraud





Initial Overall Audit Planning

Establish an understanding with the client as to the nature of the engagement. (Engagement Letter)

Develop an initial:Audit strategy, plan or approach

(Reliance on internal controls?)Audit Program

(testing procedures – nature, timing & extent)


Items in Engagement Letters

Name of the Entity Management Responsibilities

Financial statementsEstablishing effective internal control over financial reportingCompliance with laws and regulationsMaking records available to the auditorsProviding written representations at end of the audit (including

that adjustments discovered by the auditors and not made to books and financial statements are not material)

Auditor ResponsibilitiesConducting an audit in accordance with GAAS or PCAOB StdsObtaining an understanding of internal control to plan audit and

to determine the nature, timing and extent of proceduresMaking communications required by GAAS or PCAOB Stds


Engagement Letter Items (con’t)

Arrangements RegardingConduct of the audit (e.g., timing, client assistance)Use of specialists or internal auditorsObtaining information from predecessor auditors (if not done)Fees and billingOther services to be provided

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.

SAS 89: Management confirms immateriality of unrecorded misstatements.

SAS 99: Management to share knowledge on fraud.






Obtain Understanding of the Client, its Environment, including Internal Controls

Primary Sources:• Inquiries of Mgmt and Client Policies & Procedures• Tour client facilities• AICPA Audit & Accounting Guides• Internet [several text problems(6-36)]• Library• Industry Associations• Prior F.S. and Annual Reports• Analytical Procedures


Understanding the Client’s Business - Nature of the Client

Client’s competitive position

Organizational structure

Accounting policies and procedures

Ownership & Capital structure

Product and service lines

Critical business processes

Overall internal control structure


Understanding the Client’s Business - Nature of the Client (con’t)

Product differentiation

Cost leadership

Objectives—Overall plans

Operating and financial strategies - Operational actions to achieve objectives

Business risks - Threats to achieving objectives


Understanding the Client’s BusinessIndustry, Regulatory, and Other Factors

Industry competitive environment

Supplier and customer relationships

Technology developments

Major laws and regulations

Industry economic conditions







Assess Misstatement Risks (IR & CR)

(including fraud risks)


Assess the Risks ofMaterial Misstatement (IR &

CR) Overall Approach

What could go wrong?How likely will it go wrong?What are the likely amounts involved?

Consider ParticularlyInherent risksControl RisksRisks of material misstatement due to

fraud (fraud risks)


Assessing Fraud Risks

Two TypesFraudulent Financial Reporting Misappropriation of Assets (Defalcations)

Procedures to Assess Fraud RisksDiscussion among engagement team Inquiries of management and other personnelPlanning analytical proceduresConsidering existence of fraud risk factors

1. Incentives2. Opportunity3. Attitude

Chapter Appendix 6B


Assessing Fraud Risks (con’t)

Assessing Extent of Fraud Risks

Type of risk

Significance of accounts impacted

Likelihood that it could result in a material misstatement

Pervasiveness


Responding to Fraud Risks

Overall ResponseProfessional skepticism and audit evidenceAssigning personnel and supervisionAccounting principlesPredictability of auditing procedures

Alterations in Audit Procedures (Don’t be predictable)More reliable evidenceShifting timing to year endIncreasing sample sizes

Response to the Possibility of Management OverrideExamining journal entriesReview accounting estimates for biasesEvaluating business rationale for significant unusual transactions







Assess Misstatement Risks (IR & CR)

(including fraud risks)

Develop Further Audit Procedures (Tests of Controls

& Substantive Tests)


Designing Further Audit Procedures

Types of TestsTests of Controls for Placed in Operations &

Operating Effectiveness IF Reliance is Desired

Substantive Tests:Analytical Procedures to Assess Balance as to

Reasonableness/Fairness

Tests of Details of Balances or Transactions

Audit Procedures (chapter 5)Inspection, Observation, Inquiry, Confirmation,

Recalculation & Reperformance


Further Audit Procedures

Procedures should be linked with the assessed risks of material misstatement at the relevant assertion level.

When assessed risks of material misstatement are high, include:Heightened professional skepticismAssigning more experienced staffAssigning staff with specialized skillsProviding more supervision







Assess Misstatement

Risks (IR & CR)

Develop Further Audit Procedures (Tests of Controls & Substantive

Tests)

Tweaking the Audit Plan During Further Audit Procedures


Audit Documentation-Planning

1. Discussion of the Audit Team concerning the risk of material misstatements due to the error or fraud,

2. Key Elements of Understanding of the Entity & its Environment,

3. Assessment of Risk of Material Misstatement at both the financial statement level and at the relevant assertion level, and

4. Risks Identified.


Documenting Planning – Fraud Risks

1. Discussion among engagement team personnel about fraud risks,

2. Procedures performed to identify fraud risks,

3. Fraud risks identified and the auditor’s response to those risks,

4. Any other conditions that caused the auditors to perform additional fraud-related procedures

and

5. Nature of any communications made to mgmt, audit committee, or others about fraud.


Documenting Planning’s Effect

After the audit procedures have been performed, the auditors should document:1. The auditors’ overall responses to address the assessed

risk of misstatement at the financial statement level.

2. The nature, timing, and extent of further audit procedures performed.

3. The linkage of those procedures with the assessed risks at the relevant assertion level.

4. The results of the audit procedures.

5. The conclusions reached with regard to the use of audit evidence about the operating effectiveness of controls that was obtained in a prior audit.


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.”

Source: FASB’s Statement of Financial Accounting Concepts No. 2.


Materiality Terminology

Material

Tolerable Misstatement

Individually

Significant Item

– At the F.S. /Account Level

– At the Assertion Level

– At the Transaction Level


Materiality and F.S. Users

Users are assumed to: Have an appropriate knowledge of business, economic

activities & accounting and a willingness to study the information in the F.S. with an appropriate diligence,

Understand that F.S. are prepared and audited to levels of materiality,

Recognize the uncertainties inherent in the measurement of amounts based on the use of estimates, judgment, and the consideration of future events and

Make appropriate economic decisions on the basis of the information in the financial statements.


What is a Misstatement?

Inaccuracy in gathering or processing data from which F.S. are prepared. (in maintaining accounting records or preparing F.S.)

Difference between the amount, classification, or presentation of a reported F.S. element, account, or item and that would have been reported under GAAP. (Violation of GAAP)

Omission of a F.S. element, account, or item or F.S. disclosure.

F.S. Disclosure that is not presented in conformity with GAAP.

Incorrect accounting estimate. (errors in computing)

Management’s Judgments concerning an accounting estimate or the selection or application of accounting policies that the auditor considers unreasonable or inappropriate.


Timing of the Audit Work

Interim Final

Consider & Substantive Substantive Planning Test ICS Tests Tests I__________________________I_________I

Beg of End of Last FY FY Audit

I ---------------------Interim Period---------------I Field Work


Category of Audit Steps

1. Planning: Initial Planning of the Audit

Obtain an Understanding of the Client, its Environment and the Client’s Internal Controls

2. Assess Risks of Material Misstatements & Design Further Audit Procedures (Tests of Controls and Substantive Tests)

3. Perform Test of Controls, if appropriate (chapter 7)

4. Perform Substantive Tests of Balances, Transactions & Disclosures

5. Complete the Audit (Final Tests after Yearend) (chapter 16)

6. Form an Opinion & Issue the Audit Report (chapter 17)


Direction of Audit Testing

Finish StartTest for Existence

Source Source DocumentsDocuments

JournalsJournals LedgersLedgers

Start FinishTest for Completeness


Directional Testing Relates to testing existence/occurrence and

completeness assertions. Audit conclusions relate only to the universe

from which sample is taken. To test completeness, we go in direction of the

normal accounting transaction recording. (e.g., From source documents to the recording in journals and ledgers.)

To test existence, we go in opposite direction. (e.g., From the recording in journals and ledgers to source documents.)


Tests for Existence (Validity)

(to detect F.S. overstatements)

Source Documents RecordingTo Detect Overstated or False Sales

Go To Sample FromSales Invoice Sales JournalSales Order

Bill of Lading

To Detect Nonexistent PP&E Go To Sample From Invoice PP&E Sub LedgerObservations


Tests for Existence (Validity)

(to detect F.S. overstatements)

Source Documents RecordingTo Detect Overstated Purchases

Go To Sample FromReceiving Reports Purchases Journal

To Detect Nonexistent Employees/Salaries Go To Sample From

HR Records Payroll RegisterObservations


Tests for Completeness

(to detect F.S. understatements)

Source Documents RecordingTo Detect Understated Sales

Sample From Go ToSales Invoices Sales JournalSales OrdersBills of Lading

To Detect Unrecorded Liabilities Sample From Go To Receiving Reports Purchases JournalVendor Invoices

Slide 6- 1 © The McGraw-Hill Companies, Inc., 2006 Chapter 6 Audit Planning, Understanding the Client, Assessing Risks, and Responding.

Documents

existing client slide

fraud slide

mcgrawhill companies

timing extent slide

prospective client

audit procedures

pcaob stds slide

client screening