Auditing Principles - CH6 - Audit Planning Understaning Client, Assessing Risks

• ØSubmit a proposal
• ØCommunicate with the predecessor auditor

• 1. Plan the audit
• 2. Obtain an understanding of the client and its environment, including internal control
• 3. Assess the risks of material misstatement and design further audit procedures
• 4. Perform further audit procedures
• 5. Complete the audit
• 6. Form an opinion and issue the audit report

ØEstablish an understanding with the client

lThis is ordinarily accomplished through use of an engagement letter

• lRelated, determine that
• •The firm meets professional independence
• requirements
• •There are no issues relating to management integrity
• •The client understands the terms of the
• engagement

ØName of the entity

• ØManagement responsibilities:
• lFinancial statements
• lEstablishing effective internal control over financial reporting
• lCompliance with laws and regulations
• lMaking records available to the auditors
• lProviding written representations at end
• of the audit, including that adjustments discovered by the auditors and not recorded
• to the financials are not material

• ØAuditor responsibilities:
• lConducting an audit in accordance with
• GAAS
• lObtaining an understanding of internal
• control to plan audit and to determine the nature, timing and extent of procedures
• lMaking communications required by GAAS

ØDevelop an overall audit strategy and an audit plan

ØPlan use of client’s staff

ØPlan involvement of other CPAs

ØArrange for specialists

• ØOn first year audits:
• lCommunicate with predecessor auditors
• lEstablish opening balances on the
• financial statements

ØPerform risk assessment procedures, including:

• lInquiries of management and others within the entity
• lAnalytical procedures
• lObservation and inspection relating to client activities, operations, documents, reports
• and premises.
• lOther 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, rating organizations, journals.

ØCompetitive position

ØOrganizational structure

ØAccounting policies and procedures

• ØOwnership: 
• lCapital structure
• lProduct and service lines
• lCritical business processes
• lInternal control

• ØNeed knowledge and understanding of how a client’s internal control works:
• lWhat controls exists
• lWho performs them
• lHow various types of transactions are processed and recorded
• lWhat accounting records and supporting documentation exist

ØInquiries of management

ØIndustry Accounting and Auditing Guides

ØIndustry Risk Alerts

ØTrade journals and news stories

ØGovernment publications

ØPrior company annual reports and SEC filings

ØPrior tax returns

• ØElectronic sources
• lEx. www.fasb.org, web pages for company

ØTour of plant and offices

ØAnalytical procedures

ØThe statement of cash flows and obtaining an understanding of the client

ØUse professional judgment and based on reasonable person

• ØConsiders both:
• lQuantitative and qualitative factors

• ØFASB (reasonable person)
• (included in SASs)—The magnitude of an omission or misstatement of financial
• information that, in the light of surrounding circumstances, makes it probable
• that the judgment of a reasonable person relying on the information could have
• been changed or influenced by the omission or misstatement.

• ØPCAOB (investor)
• interpretation of federal securities laws—A fact is material if there is a substantial likelihood that the… fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made
• available

At beginning of of planning stage so scope of audit can be determined

Audit procedures should be designed to detect material misstatements so that the auditors do not waster time searching for immaterial misstatements that cannot affect the auditors report.

Materiality allocated to a paticular account

Involves circumstances in which one or more misstatements have been identified and the auditors should evaluate whether the amounts involved are material.

ØOverall approach

lWhat could go wrong?

lHow likely is it that it will go wrong?

lWhat are the likely amounts involved?

• ØParticularly consider
• lInherent risks
• lRisks of material misstatement due to
• fraud (fraud risks)

ØDesign further audit procedures

• lFraudulent financial reporting
• (management fraud)

lMisappropriation of assets (defalcations)

lType

lSignificance

lLikelihood that it will result in a material misstatement

lPervasiveness

• Incentives
• Opportunity
• Attitude

lProfessional skepticism and audit evidence

lAssigning personnel and supervision

lAccounting principles

lPredictability of auditing procedures

lMore reliable evidence

lShifting timing to year end

lIncreasing sample sizes

lExamining journal entries

lReview accounting estimates for biases

• lEvaluating the business rationale for
• significant unusual transactions

Usually 1 level above

• ØTypes:
• lTests of controls

lAnalytical procedures

• lTests of details of transactions and
• balances 

ØAudit procedures

lInspection

lObservation

lInquiry

lConfirmation

lRecalculation

lReperformance

• ØA trail of evidence that links source documents, journal entries and ledger
• entries

ØAuditor may follow the audit trail in either of two directions related to the direction of testing

• lTest for existence or occurrence
• lTest for completeness

• Left to Right
• From end to origin 
• financial statements to source documents

• Right to left
• From origin to end
• source documents to financial statements

• ØAuditors’ consideration of internal control is often organized around client’s major
• transaction cycles (examples)
• lRevenue  cycle
• lAcquisition cycle
• lConversion cycle
• lPayroll cycle
• lInvesting cycle
• lFinancing cycle

• ØSystems portion:
• lDeals with client’s internal control
• lEvidence of test of controls and assessing control risk

• ØSubstantive test portion
• lDeals with financial statement account balances
• lIndirect and direct verification of income statement accounts

• cash receipts from customers 
• - Begin Balance of AR
• + Ending balance of AR

• Cash Payments for merchandise
• - Beg bal AP
• +End bal AP
• + Beg bal Inventory
• - End bal Inventory

• Cash payments for expenses
• - beg bal accrued expenses
• + end bal accrued expenses
• + beg bal prepaid expenses
• - end bal prepaid expenses

ØEstablish the existence of assets

• ØEstablish that the company has rights to
• the assets

ØEstablish the completeness of recorded assets

ØVerify the cutoff of transactions

• ØDetermine the appropriate valuation of
• the assets and accuracy of related transactions

• ØDetermine the appropriate financial statement presentation and disclosure of
• the assets

• Financial Statements
• (following GAAP)

• Management Assertions
• (Existence, Rights, Completeness, Cutoff, Valuation, Presentation)

• Audit Objectives
• (Designed based on Mgmt Assertions)

• Audit Procedures
• (Determined based on the risks of material misstatement at the Assertion level)

• Audit Evidence
• (Summarized in audit documentation)

Audit report on financial statements