2 Obtaining Clients Submit a proposal Contact the audit committeeMake fee arrangementsCommunicate with the predecessor auditorTopicsIntegrity of managementDisagreements over accounting principlesCommunications to those charged with governance regarding fraud and noncompliance with lawsCommunication to management and those charged with governance concerning internal control significant deficiencies and material weaknesses.Predecessor’s understanding of reason for change of auditorsOtherOverall procedure is important for evaluation of management integrity
3 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 reportThis chapter emphasizes obtaining a client and steps 1-3.9
5 1. Plan the Audit Establish an understanding with the client This is ordinarily accomplished through use of an engagement letterRelated, determine thatThe firm meets professional independence requirementsThere are no issues relating to management integrityThe client understands the terms of the engagement
6 Items Included in Engagement Letters Name of the entityManagement responsibilitiesFinancial 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 recorded to the financials are not materialAuditor responsibilitiesConducting an audit in accordance with GAASObtaining an understanding of internal control to plan audit and to determine the nature, timing and extent of proceduresMaking communications required by GAAS22
7 Engagement Letters--Optional Items Arrangements regardingConduct of the audit (e.g., timing, client assistance)Use of specialists or internal auditorsObtaining information from predecessor auditorsFees and billingOther services to be provided, such as examination of internal control over financial reportingLimitation of or other arrangements regarding liability of auditors or clientConditions under which access to the auditors’ working papers may be granted to others3
8 Audit Planning—Overall Develop an overall audit strategy and an audit planPlan use of client’s staffPlan involvement of other CPAsArrange for specialistsOn first year audits:Communicate with predecessor auditorsEstablish opening balances on the financial statements
9 2. Obtain an Understanding of the Client and its Environment Perform risk assessment procedures, includingInquiries of management and others within the entityAnalytical proceduresObservation 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, rating organizations, journals.
10 Understanding the Client’s Business—Nature of the Client Competitive positionOrganizational structureAccounting policies and proceduresOwnershipCapital structureProduct and service linesCritical business processesInternal control
11 Understanding the Client’s Business, Industry, Regulatory, and Other Factors Competitive environmentSupplier and customer relationshipsTechnology developmentsMajor laws and regulationsEconomic conditionsAttractiveness of the industryBarriers to entryStrength of competitorsBargaining power of suppliers of raw materials and laborBargaining power of customers
12 Understanding the Client’s Business—Objectives, Strategies & Business Risks Objectives—Overall plansOperating and financial strategies—Operational actions to achieve objectivesBusiness risks—Threats to achieving objectives
13 Understanding the Client’s Business—Measuring and Reviewing Performance BudgetsKey performance indicatorsVariance analysisSegment performance reportsBalanced scorecardExternal parties
14 Understanding the Client’s Business – Internal Control Need knowledge and understanding of how a client’s internal control works:What controls existsWho performs themHow various types of transactions are processed and recordedWhat accounting records and supporting documentation exist
15 Understanding the Client’s Business—Sources of Information Inquiries of managementIndustry Accounting and Auditing GuidesIndustry Risk AlertsTrade journals and news storiesGovernment publicationsPrior company annual reports and SEC filingsPrior tax returnsElectronic sourcesEx. web pages for companyTour of plant and officesAnalytical proceduresThe statement of cash flows and obtaining an understanding of the client
16 Determining Materiality Use professional judgment and based on reasonable personConsiders bothQuantitative and qualitative factorsMateriality used inPlanning the auditAt the overall financial statement levelAllocate to individual accountsEvaluating audit findings
17 Materiality Definitions FASB (included in SASs)—The magnitude of an omission or misstatement of financial information that, in the light of surrounding circumstances, makes it probable that he judgment of a reasonable person relying on the information could have been changed or influenced by the omission or misstatement.PCAOB 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.
18 Particularly consider 3. Assess the Risks of Material Misstatement and Design Further Audit ProceduresOverall approachWhat could go wrong?How likely is it that it will go wrong?What are the likely amounts involved?Particularly considerInherent risksRisks of material misstatement due to fraud (fraud risks)Design further audit procedures
19 Assessing Fraud Risks Two types Procedures to assess fraud risks Fraudulent financial reporting (management fraud)Misappropriation of assets (defalcations)Procedures to assess fraud risksDiscussion among engagement teamInquiries of management and other personnelRisk assessment analytical procedures (to aid in planning the audit)Considering fraud risk factorsIncentivesOpportunityAttitude
20 Assessing Fraud Risks – Identifying Fraud Risks Considerations in identifying fraud risksTypeSignificanceLikelihood that it will result in a material misstatementPervasiveness
21 Responding to Fraud Risks Overall responseProfessional skepticism and audit evidenceAssigning personnel and supervisionAccounting principlesPredictability of auditing proceduresAlterations in audit proceduresMore reliable evidenceShifting timing to year endIncreasing sample sizesResponse to the possibility of management overrideExamining journal entriesReview accounting estimates for biasesEvaluating the business rationale for significant unusual transactions
22 Consideration of Fraud Throughout the Audit Evaluating the results of audit testsDiscovery of fraudCommunication to appropriate level of managementIf fraud involves senior management or material misstatement communicate to audit committee
23 Design Further Audit Procedures (1/2) TypesTests of controlsAnalytical proceduresTests of details of transactions and balancesAudit proceduresInspectionObservationInquiryConfirmationRecalculationReperformance
24 Design Further Audit Procedures (2/2) Further audit procedures should includeSubstantive procedures for all relevant assertionsTests of controls when the auditors’ risk assessment includes an expectation that controls are operating effectively, or when substantive procedures alone are not sufficientProcedures should be linked with the assessed risks of material misstatement at the relevant assertion levelOverall responses when assessed risks of material misstatement are highHeightened professional skepticismAssigning more experienced staffAssigning staff with specialized skillsProviding more supervision
25 Audit Documentation Audit Documentation Risk assessment Discussion of the audit team, elements of understanding, assessment of risk of material misstatement and risks identifiedProcedure resultsOverall responses, nature, timing and extent of further audit procedures, linkage of procedures with assessed risks, results of audit procedures, conclusions reached about operating effectiveness of controls, significant risk identified, circumstances in which substantive procedures alone will not provide sufficient evidenceConsideration of fraudSimilar to risk assessment as document discussion, procedures used to identify fraud risks, fraud risk and response, any other conditions that caused fraud-related procedures and communications with management or audit committee.
26 Audit TrailA trail of evidence that links source documents, journal entries and ledger entriesAuditor may follow the audit trail in either of two directions related to the direction of testingTest for existence or occurrenceTest for completeness
28 Transaction cyclesAuditors’ consideration of internal control is often organized around client’s major transaction cycles (examples)Revenue cycleAcquisition cycleConversion cyclePayroll cycleInvesting cycleFinancing cycle
30 Audit Program Systems portion Substantive test portion Deals with client’s internal controlEvidence of test of controls and assessing control riskSubstantive test portionDeals with financial statement account balancesIndirect and direct verification of income statement accounts
31 Indirect Verification of Income Statement Accounts
32 Objectives of Substantive Programs for Asset Accounts Establish the existence of assetsEstablish that the company has rights to the assetsEstablish the completeness of recorded assetsVerify the cutoff of transactionsDetermine the appropriate valuation of the assets and accuracy of related transactionsDetermine the appropriate financial statement presentation and disclosure of the assets47
33 Relationship of Financial Statement Assertions to the Audit
34 Relationships among Audit Objectives, Risks of Material Misstatement, and Audit Procedures
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