Chapter 6 Audit Planning "Vision without action is a daydream. Action without vision is a nightmare.” - - Japanese Proverb

Why Plan 4-2 Obtain/update an understanding of Important Events which affected the client Identify areas of engagement that represent Special Risks to public accounting firm Ensure that engagement can be completed in a Timely fashion

Continuing Client Retention Evaluate Client Retention Periodically Near Audit Completion or after a Significant Event Conflicts over Accounting & Auditing Issues Dispute over Fees 3

New Client Submit a proposal Communicate with the predecessor auditor Contact the audit committee Make fee arrangements Communicate with the predecessor auditor Topics Integrity of management Disagreements over accounting principles Communications to those charged with governance regarding fraud and noncompliance with laws Communication to management and those charged with governance concerning internal control significant deficiencies and material weaknesses. Predecessor’s understanding of reason for change of auditors Other Overall procedure is important for evaluation of management integrity

Audit Process---Steps After obtaining a client, the audit process includes: 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 9

1. Plan the Audit Establish an understanding with the client ordinarily accomplished through use of an engagement letter Determine: Firm meets professional independence requirements No issues relating to management integrity Client understands the terms of the engagement

Items Included in Engagement Letters Name of the Entity Management Responsibilities Financial statements Establishing effective internal control over financial reporting Compliance with laws and regulations Making records available to the auditors Providing written representations at end of the audit, including that adjustments discovered by the auditors and not recorded to the financials are not material Auditor Responsibilities Conducting an audit in accordance with GAAS Obtaining an understanding of internal control to plan audit and to determine the nature, timing and extent of procedures Making communications required by GAAS 2 2

Engagement Letters--Optional Items Arrangements regarding Conduct of the audit (e.g., timing, client assistance) Use of specialists or internal auditors Obtaining information from predecessor auditors Fees and billing Other 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 3

Audit Planning—Overall Develop an overall audit strategy and an audit plan Plan use of client’s staff Plan involvement of other CPAs Arrange for specialists On first year audits: Communicate with predecessor auditors Establish opening balances on the financial statements

Planning the Audit Overall Audit Strategy for conducting the audit to help to determine what resources are needed to perform the engagement Audit Plan is more detailed than audit strategy and should consider how to conduct the engagement in an effective and efficient manner. 10

Let’s look at each of these steps. Planning the Audit Auditor should be guided by the results of the risk assessment procedures performed to gain an understanding of the entity. Additional steps: Assess the need for specialist. Assess the possibility of illegal acts. Identify related parties. Conduct preliminary analytical procedures. Consider additional value-added services. Document Audit Strategy and Plan and Prepare Audit Programs Let’s look at each of these steps. 11

Specialists A major consideration is planning the audit is the need for specialist (AU 336) The presence of complex information technology may require the use of an IT specialist. The use of an IT specialist is a significant aspect of most audit engagements. 12

Illegal Acts Direct & Material Material & Indirect Consider laws & regulations as part of audit Material & Indirect Be aware this may have occurred; investigate if brought to attention 13

Related Parties Examples from FASB No. 57, “Related Party Disclosure” 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 & 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. 14

System Design and Integration Value-Added Services Tax Planning System Design and Integration Internal Reporting Risk Assessment Benchmarking Electronic Commerce Auditors who audit public companies are limited in the types of consulting services that they can offer their audit clients. 15

Document Audit Strategy and Plan 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 Nature 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. Timing Extent 16

Preliminary Engagement Activities --- Audit Firm Use Audit Risk Model Assess Risks Establish Materiality Restrict risk at Account Balance Level Achieve acceptable level of audit risk 17

2. Obtain an Understanding of the Client and its Environment Perform risk assessment procedures, including Inquiries of management and others within the entity Analytical procedures Observation 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.

Understanding the Client’s Business—Nature of the Client Competitive Position Organizational Structure Accounting Policies and Procedures Ownership Capital Structure Product and Service Lines Critical Business Processes Internal Control

Understanding the Client’s Business—Sources of Information Inquiries of Management Industry Accounting and Auditing Guides Industry Risk Alerts Trade Journals and News Stories Government Publications Prior Company Annual Reports and SEC Filings Prior Tax Returns Electronic Sources Tour of Plant and Offices Analytical Procedures

Understanding Key Business Processes Each organization has key processes that give it a competitive advantage (or disadvantage) Auditor s should identify: Key processes Industry factors affecting key processes How management monitors key processes Potential operational and financial effects associated with key processes

Enterprise Risk Management Framework 4-22 Monitoring Internal Environment Objective Setting Event Identification Information and Communication Risk Assessment Risk Response Control Procedures

Understanding Client's Risk Management Process Understand processes used to evaluate risks Review risk-based approach used by internal auditing Interview management Review regulatory agency reports Review company polices and procedures for addressing risk Review company compensation policies Review prior years' work to determine consistently with current practices Review risk management documents

Understanding the Client’s Business, Industry, Regulatory, and Other Factors Competitive Environment Supplier and Customer Relationships Technology Developments Major Laws and Regulations Economic Conditions Attractiveness of the Industry Barriers to entry Strength of competitors Bargaining power of suppliers of raw materials and labor Bargaining power of customers

Client’s Business—Attractiveness of the Industry Barriers to Entry Strength of Competitors Bargaining Power of Suppliers of Raw Materials and Labor Bargaining Power of Customers 5

Objectives—Overall Plans Understanding the Client’s Business—Objectives, Strategies & Business Risks Objectives—Overall Plans Operating and Financial Strategies—Operational actions to achieve objectives Business Risks—Threats to Achieving Objectives

Key Performance Indicators Variance Analysis Understanding the Client’s Business—Measuring and Reviewing Performance Budgets Key Performance Indicators Variance Analysis Segment Performance Reports Balanced Scorecard External Parties

Understanding the Client’s Business – Internal Control Need knowledge and understanding of how a client’s internal control works: What controls exists Who performs them How various types of transactions are processed and recorded What accounting records and supporting documentation exist

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.

Determining Materiality Use professional judgment and based on reasonable person Considers both --- Quantitative and qualitative factors Materiality used in Planning the audit At the overall financial statement level Allocate to individual accounts Evaluating audit findings

Steps in Applying Materiality Planning extent of tests Step 1 Set preliminary judgment about materiality. Step 2 Allocate preliminary judgment about materiality to segments.

Steps in Applying Materiality 3 Estimate total misstatement in segment. Evaluating Results Step 4 Estimate the combined misstatement. Compare combined estimate with judgment about materiality. Step 5

Set Preliminary Judgment of Materiality Ideally, auditors decide early in the audit the combined amount of misstatements of the financial statements that would be considered material. This preliminary judgment is the maximum amount by which the auditor believes the statements could be misstated and still not affect the decisions of reasonable users.

Factors Affecting Judgment Materiality is a relative rather than an absolute concept. Bases are needed for evaluating materiality. Qualitative factors also affect materiality.

Materiality Guidelines Accounting and auditing standards do not provide specific materiality guidelines Professional judgment is to be used at all times in setting and applying materiality guidelines.

Total Revenues or Total Assets is … Materiality Table Larger of Client Total Revenues or Total Assets is …   Over But not Over Planning Materiality + Factor X Excess Over $0 $30 thousand .0593 30 thousand 100 thousand 1,780 .0312 300 thousand 3,960 .0215 1 million 8,260 .0145 3 million 18,400 .00995 10 million 38,300 .00674 30 million 85,500 .00461 100 million 178,000 .00312 300 million 396,000 .00215 1 billion 826,000 .00145 3 billion 1,840,000 .000995 10 billion 3,830,000 .000674 30 billion 8,550,000 .000461 100 billion 17,800,000 .000312 300 billion 89,600,000 .000215 . . . 82,600,000 .000148 Source: AICPA Audit Sampling Guide, AICPA (New York, New York), 2001.

Allocate Preliminary Judgment About Materiality to Segments Evidence is accumulated by segments Most practitioners allocate materiality to balance sheet accounts. SAS 39 (AU 350)

Estimated Total Misstatement and Preliminary Judgment Cash Accounts receivable Inventory Total estimated misstatement amount Preliminary judgment about materiality $ 4,000 20,000 36,000 $50,000 $ 0 12,000 31,500 $43,500 $ N/A 6,000 15,750 $16,800 18,000 47,250 $60,300 Tolerable misstatement Direct projection Sampling error* Total Account Estimated misstatement amount *estimate for sampling error is 50%

Estimated Total Misstatement and Preliminary Judgment Net misstatements in the sample ÷ Total sampled X Total recorded population value = Direct projection estimate of misstatement $3,500 ÷ $50,000 X $450,000 = $31,500

Particularly Consider Assess the Risks of Material Misstatement and Design Further Audit Procedures Overall approach What could go wrong? How likely is it that it will go wrong? What are the likely amounts involved? Particularly Consider Inherent risks Risks of material misstatement due to fraud (fraud risks) Design Further Audit Procedures

Assessing Fraud Risks Two Types Procedures to Assess Fraud Risks Fraudulent Financial Reporting (Management Fraud) Misappropriation of Assets (Defalcations) Procedures to Assess Fraud Risks Discussion among engagement team Inquiries of management and other personnel Planning analytical procedures Considering fraud risk factors Incentives Opportunity Attitude

Responding to Fraud Risks Overall Response Professional skepticism and audit evidence Assigning personnel and supervision Accounting principles Predictability of auditing procedures Alterations in Audit Procedures More reliable evidence Shifting timing to year end Increasing sample sizes Response to the Possibility of Management Override Examining journal entries Review accounting estimates for biases Evaluating the business rationale for significant unusual transactions

Consideration of Fraud Throughout the Audit Evaluating the results of audit tests Discovery of Fraud Communication to appropriate level of management If fraud involves senior management or material misstatement communicate to audit committee

Design Further Audit Procedures Types Tests of Controls Analytical Procedures Tests of Details of Transactions and Balances Audit Procedures Inspection Observation Inquiry Confirmation Recalculation Reperformance

Design Further Audit Procedures Should include: Substantive procedures for all relevant assertions Tests of controls when the auditors’ risk assessment includes an expectation that controls are operating effectively, or when substantive procedures alone are not sufficient Procedures should be linked with the assessed risks of material misstatement at the relevant assertion level Overall responses when assessed risks of material misstatement are high Heightened professional skepticism Assigning more experienced staff Assigning staff with specialized skills Providing more supervision

Audit Trail Trail of evidence that links source documents, journal entries and ledger entries Auditor may follow the audit trail in either of two directions related to the direction of testing

Direction of Audit Testing

Transaction Cycles Revenue Cycle Acquisition Cycle Conversion Cycle Payroll Cycle Investing Cycle Financing Cycle

Audit Program Systems Portion Substantive Test Portion Deals with client’s internal control Evidence of test of controls and assessing control risk Substantive Test Portion Deals with financial statement account balances Indirect and direct verification of income statement accounts

Dual Purpose Tests Tests of Controls Substantive Tests 50

Planning Memorandum 1. Investigation or review of the prospective or continuing client relationship. 2. Provision of special services or reports and needs for special technical or industry expertise. 3. Staff assignment and timing schedules. 4. Assessed level of control risk. 5. Significant industry or company risks. 6. Computer system control environment. 7. Utilization of the company’s internal auditors. 8. Identification of unusual accounting principles problems. 9. Schedules of work periods, meeting dates with client personnel, and completion dates.

Audit Programs Specify the audit objectives and procedures used to gather, document, and evaluate evidence Guide to the conduct of the audit Effective means for: Organizing and distributing work Monitoring progress Recording work performed Reviewing procedures performed and evidence gathered

Filling the Assurance Bucket 53

Example of Filling the Assurance Buckets for Each Assertion (Accounts Payable) 54

End of Chapter 6 55