Audit Planning, Types of Audit Tests, and Materiality Chapter 3 Audit Planning, Types of Audit Tests, and Materiality

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

Prospective Client Acceptance LO# 1 Prospective Client Acceptance Obtain and review financial information. Inquire of third parties regarding client integrity. Communicate with the predecessor auditor. Consider unusual business or audit risks. Determine if the firm is independent (the determination is more stringent if it is a public company seeking an audit) Determine if the firm has or can obtain the necessary skills and knowledge. 3-3

Continuing Client Retention LO# 1 Continuing Client Retention Evaluate client retention periodically Typically evaluation is done right after completion of audit, before starting on the next year’s audit Conflicts over accounting and auditing issues (serious issues) Dispute over fees, need for a larger CPA firm due to growth of the company, or other issues 3-4

On February 5, 2001, Arthur Andersen partners met to discuss continuance of Enron as an audit client. Meeting minutes are hyperlinked in the course schedule

Preliminary Engagement Activities LO# 2 Preliminary Engagement Activities Determine the Audit Engagement Team Requirements Assess Compliance with Ethics and Independence Requirements 3-6

Establish Terms of the Engagement LO# 3 Establish Terms of the Engagement In establishing the terms of the engagement, three topics must be discussed: The engagement letter; Using the work of the internal auditors; and The role of the audit committee. The terms of the engagement, which are documented in the engagement letter (an example is shown on p. 73-74), 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? 3-7

LO# 4 The Engagement Letter The engagement letter formalizes the arrangement reached between the auditor and the client. In addition to the items 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 (however, the SEC, federal banking regulators and many state insurance departments prohibit this) Additional services to be provided. 3-8

LO# 5 Internal Auditors 3-9

The Audit Committee Subcommittee of the board of directors LO# 6 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. Subcommittee of the board of directors No specific requirements for privately held companies 3-10

Audit Committee Members’ Knowledge In the past, audit committees were often weak not only because of lack of independence – there also often was a lack of knowledge. Thus all audit committee members must at least be "financially literate” or able to read and understand fundamental financial statements. 1 member must be a "financial expert“ i.e. Understand GAAP and financials Understand GAAP re estimates, accruals & reserves Be experienced in preparing, auditing or analysis Understand internal controls re financial reporting Understand audit committee functions

LO# 7 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. Then an audit plan - more detailed than the audit strategy – is developed. The audit plan should consider how to conduct the engagement effectively and efficiently. 3-12

LO# 7 Assess Business Risks To understand the client’s business and transactions To identify financial statement accounts more likely to contain errors By understanding the client’s business and identifying the areas where errors are more likely to occur, the auditor can disproportionately allocate more resources to investigate those areas. 3-13

Establish Materiality LO# 7 Establish overall materiality (more on this later!) Establish tolerable misstatement for specific accounts Establish tolerable misstatement for classes of transactions 3-14

What other types of specialists might be needed? LO# 7 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. What other types of specialists might be needed? 3-15

Illegal Acts Illegal Acts Direct and Material Material and Indirect LO# 7 Illegal Acts 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 3-16

LO# 7 Illegal Acts When auditing a public company, Section 10A of the Securities Act of 1934 requires the auditor to notify the SEC if a direct and material illegal act is discovered, if the company itself does not quickly notify the SEC. Note that Section 10A applies even if the illegality just makes the quarters misstated (this is not intuitive since after all the auditor is there to audit the annual financial statements). 3-17

Related Parties How to Identify Related Parties LO# 7 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 agreements with major customers, vendors, and management. Review loan agreements for guarantees. 3-18

Additional Value-Added Services LO# 7 Additional Value-Added Services Tax Planning System Design and Integration Internal Reporting Risk Assessment Benchmarking Electronic Commerce Auditors who audit public companies are more limited re consulting services that they can provide to their audit client. More about this in Chapter 19. 3-19

Document Audit Strategy and Plan LO# 7 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 The strategy and plan are based in part on the auditor’s evaluation of the auditor’s risk and materiality evaluations. The documentation of the plan helps communicate to the staff auditors what exactly they need to do. Timing Extent 3-20

Supervision of the Audit LO# 8 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 3-21

Risk Assessment Procedures Substantive Procedures LO# 9 Types of Audit Tests Risk Assessment Procedures To understand the entity and its environment, including its internal control. Tests of Controls To evaluate the design and operating effectiveness of internal controls. Substantive Procedures Tests of details of transactions and balances (more in Ch. 9) and substantive analytical procedures (more in Ch. 5) 3-22

Dual-Purpose Tests: Using one sample for 2 purposes LO# 9 Dual-Purpose Tests: Using one sample for 2 purposes Tests of Controls Substantive Tests of Transactions Dual-Purpose Tests 3-23

LO# 10 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 a concept. Auditors, like accountants, transform this into numbers and percentages. But then we override the numbers and percentages sometimes, because we cannot the numbers and percentages are only for the purpose of implementing the concept. 3-24

Steps in Applying Materiality on an Audit LO# 11 Steps in Applying Materiality on an Audit Step 1: Determine overall financial statements materiality Step 2: Determine tolerable misstatement (allocation of materiality at individual account level) Step 3: Evaluate auditing findings (near the end of the audit) 3-25

LO# 11 Step 1a – Calculate Overall Materiality (aka Planning Materiality aka Global Materiality aka financial statement materiality) Different “bases “can be used to calculate overall materiality , e.g.: Income before taxes. (3% to 5%) Income from continuing (5% typically) operations. Three year average income. (5% typically) Total assets. (1/3 of 1% typically) Total revenues.(1/2 of 1% typically) Note that not all auditors agree on what base to use or what % 3-26

LO# 11 Step 1b – Consider qualitative factors. You may need to adjust lower (be more cautious and conservative) the Overall Materiality 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. 3-27

Step 2 –Determine Tolerable Misstatement LO# 11 Step 2 –Determine Tolerable Misstatement Tolerable misstatement (50%-75% of overall materiality) is the amount of overall materiality allocated to one account or class of transactions. The various tolerable misstatements total more than planning materiality. 3-28 28

LO# 11 Step 3 – Evaluate Audit Findings, first one account at a time (Ch. 9); later in the aggregate (Ch. 17) 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. 3-29 29

End of Chapter 3 3-30