Chapter 3 Audit Planning, Types of Audit Tests, and Materiality McGraw-Hill/IrwinCopyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

The Phases of an Audit That Relate to Audit Planning LO# 1 3-2

Prospective Client Acceptance 1.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. 6.Determine if the firm has the necessary skills and knowledge. 7.Determine if acceptance violates any applicable regulatory agency requirements or the Code of Professional Conduct. LO# 1 3-3

Continuing Client Retention Evaluate client retention periodically Near audit completion or after a significant event Conflicts over accounting and auditing issues Dispute over fees LO# 1 3-4

Preliminary Engagement Activities Determine the Audit Engagement Team Requirements Assess Compliance with Ethical Requirements, Including Independence LO# 2 3-5

Establish Terms of the Engagement The terms of the engagement, which are documented in the engagement letter, 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 3-6

The Engagement Letter The engagement letter formalizes the arrangement reached between the auditor and the client. In addition to the items mentioned 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 or client. Additional services to be provided. Arrangements regarding other services. LO# 4 3-7

Internal Auditors LO# 5 3-8

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 3-9

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. An audit plan is more detailed than the audit strategy. Basically, the audit plan should consider how to conduct the engagement in an effective and efficient manner. LO#

Planning the Audit When preparing the audit plan, the auditor should be guided by the results of the client acceptance/continuance process, procedures performed to gain an understanding of the entity, and preliminary engagement activities. Additional steps: Assess business risks. Establish materiality. Consider multilocations. Assess the need for specialists. Assess the possibility of illegal acts. Identify related parties. Consider additional value-added services. Let’s look at each of these steps. LO#

Assess Business Risks To understand the client’s business and transactions To identify financial statement accounts likely to contain errors By understanding the client’s business and identifying where errors are likely to occur, the auditor can allocate more resources to investigate necessary accounts. LO#

Establish planning (overall) materiality (more on this later!) Establish tolerable misstatement for specific accounts Establish tolerable misstatement for classes of transactions LO# 7 Establish Materiality 3-13

Consolidated Financial Statements High Risk Moderate Risk LO# 7 Consider Multilocations or Business Units Low Risk The auditor correlates the amount of audit attention devoted to the location or business unit with the level of risk present. 3-14

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? 3-15

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#

Illegal Acts LO#

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 large, unusual, or nonrecurring transactions especially at year end. Review loan agreements for guarantees. LO#

Additional Value-Added Services Tax Planning System Design and Integration Internal Reporting Risk Assessment Benchmarking Electronic Commerce LO# 7 Auditors who audit public companies are limited in the types of consulting services that they can offer their audit clients. 3-19

Document Audit Strategy and Plan Nature Timing Extent Auditors ensure they have addressed the risks they identified by documenting the linkage from the client’s business, objectives, and strategy to the audit plan. The auditor’s preliminary decision concerning control risk determines the level of control testing, which in turn affects the auditor’s substantive tests of the account balances and transactions. 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. A U D I T E S T S 3-20

Document Audit Strategy LO#

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#

Types of Audit Tests Risk Assessment Procedures Used to obtain an understanding of the entity and its environment, including its internal control. Tests of Controls Directed toward the evaluation of the effectiveness of the design and operation of internal controls. Substantive Procedures Detect material misstatements in a transaction class, account balance, and disclosure component of the financial statements. LO#

Tests of Controls InquiryInspection Walkthrough Reperformance Observation LO#

Tests of Controls LO#

Substantive Procedures Analytical Procedures Obtains evidential matter about particular assertions related to account balances or classes of transactions Tests of Details Tests for errors or fraud in individual transactions, account balances, and disclosures LO#

Dual-Purpose Tests Substantive Tests of Transactions Tests of Controls Dual- Purpose Tests LO#

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. Materiality is not an absolute and it is not a black or white issue! The determination of materiality requires professional judgment. LO#

Steps in Applying Materiality on an Audit Step 1: Determine a materiality level for the overall financial statements (planning materiality) Step 1: Determine a materiality level for the overall financial statements (planning materiality) Step 2: Determine tolerable misstatement (allocation of materiality at individual account/class of transactions level) Step 2: Determine tolerable misstatement (allocation of materiality at individual account/class of transactions level) Step 3: Evaluate auditing findings (near the end of the audit) Step 3: Evaluate auditing findings (near the end of the audit) LO#

Step 1 – Determine Overall Materiality The quantitative base for materiality is a percentage of: Income before taxes. Income from continuing operations. Three year average income. Total assets. Total revenues. Gross profit. The quantitative base for materiality is a percentage of: Income before taxes. Income from continuing operations. Three year average income. Total assets. Total revenues. Gross profit. The quantitative amounts may be adjusted lower for qualitative 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 amounts may be adjusted lower for qualitative 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#

Step 2 –Determine Tolerable Misstatement Tolerable misstatement is the amount of planning materiality allocated to an account or class of transactions. Combined tolerable misstatement is generally greater than planning materiality because: Not all accounts will be misstated by their full tolerable misstatement allocation. Audits of individual accounts are conducted simultaneously. When errors are identified, additional testing is typically performed in that account and related accounts. Overall materiality serves as a “safety net.” Tolerable misstatement is the amount of planning materiality allocated to an account or class of transactions. Combined tolerable misstatement is generally greater than planning materiality because: Not all accounts will be misstated by their full tolerable misstatement allocation. Audits of individual accounts are conducted simultaneously. When errors are identified, additional testing is typically performed in that account and related accounts. Overall materiality serves as a “safety net.” LO#

Step 3 – Evaluate Audit Findings 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#