4-1 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Chapter 4 Engagement Planning "Vision without action is a daydream. Action without vision is a nightmare.” - - Japanese Proverb

4-2 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Chapter 4 Learning Objectives 1.List and describe the activities auditors undertake before beginning an engagement. 2.Identify the procedures and sources of auditors can use to obtain knowledge of a client’s business and industry. 3.Perform analytical procedures to identify potential problems. 4.List and discuss matters of planning auditors should consider for clients who use computers and describe how a computer can be used as an audit tool. 5.Review audit documentation for proper form and content.

4-3 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Goals of Planning Obtain (or update) an understanding of IMPORTANT EVENTS that have affected the client and its operations Identify areas of the audit engagement that may represent SPECIAL RISKS to the auditor Ensure that the audit is completed in a TIMELY fashion

4-4 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Pre-Engagement Arrangements Client selection and retention Communication between predecessor and successor auditors Engagement letters Staff assignment Time budget

4-5 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Understanding the Client’s Business Methods and sources of information –Inquiry, including prior year working papers –Observation –Study Other aspects of planning –Materiality and planning –First-time audits –Internal auditors –Identification of related parties –Specialists –Analytic procedures

4-6 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Planning Memorandum Summary of planning procedures Considerations –Audit or review –Need for specialists –Staff assignment and timing schedules –Assessed level of control risk –Significant client or industry risks –Utilization of internal auditors –Identification of unusual accounting principle problems Basis for audit program

4-7 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. PRELIMINARY ANALYTIC PROCEDURES RECORDED ACCOUNT BALANCE ESTIMATED ACCOUNT BALANCE Attention directing –Identify potential problem areas An organized approach –A standard starting place to start examining the financial statements Describe the financial activities –Identify unusual changes in relationships in the data Ask relevant questions –What could be wrong? –What legitimate reasons are there for these results? Cash flow analysis

4-8 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Analytic Procedure Steps 1.Develop an expectation. 2.Define a significant difference. 3.Calculate predictions and compare them with the recorded amount. 4.Investigate significant differences. 5.Document each of the above steps.

4-9 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Analytic Procedures: Sources of Information Analytic ProceduresSources of Information Comparison of current-year account balances to those of one or more comparable periods Financial account information for comparable periods. Comparison of the current-year account balances to anticipated results found in the company’s budgets and forecasts. Company budgets and forecasts. Evaluation of the relationships of current- year balances to other current-year balances for conformity with predicable patterns based on the company’s experience. Financial relationships among accounts in the current period (ratios). Comparison of the current-year account balances and ratios with similar industry information. Industry statistics. Study of the relationships of current-year balances with relevant nonfinancial information (e.g., production statistics). Nonfinancial information, such as production statistics.

4-10 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Analytic Procedures: Stages of Use Preliminary -- required Substantive testing -- optional Final Review -- required

4-11 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Effect of Electronic Environment on Audit Engagement The definition of auditing is not changed. The purposes of auditing are not changed. The generally accepted auditing standards are not changed. The assertions of management embodied in financial statements are not changed. The control objectives are not changed. The requirement to gather sufficient competent evidence is not changed. The independent auditor's report on financial statements is not changed.

4-12 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. What has changed? The auditor must evaluate the impact of technology on the client’s operations. The auditor must evaluate computer controls implemented by the client in the auditor’s study and evaluation of the client’s internal controls. The auditor can use the computer’s speed and accuracy to assist in the audit.

4-13 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Effect of Computer Processing on Transactions Transaction trails Uniform processing of transactions Segregation of duties Potential for fraud Potential for increased management supervision Initiation or subsequent execution of transactions by computer

4-14 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Planning considerations Extent to which computers are used Complexity of computer operations Organizational structure of computer processing Availability of data Use of CAATS Need for specialized skills

4-15 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Computer Assisted Audit Tools and Techniques (CAATTs) CAATTs - the use of software to perform audit procedures With CAATTS, the auditor is able to access and extract client information without disrupting data processing Some CAATTs Procedures: –Calculate field statistics (totals, high, low and average value) –Performing complex recalculations –Join, concantenate and compare different files –Perform detailed analysis Stratification Gap and duplicate key detection Sample selection

4-16 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Audit Documentation (PCAOB 3) Definition –The written record of the basis for the auditor’s conclusions that provides the support for the auditor's representations, whether those representations are contained in the auditor's report or otherwise. Objectives –Improve audit quality –Enhance public confidence Contents –Planning and performance of the work –Procedures performed –Evidence obtained –Conclusions reached by the auditor

4-17 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Purposes of Audit Documentation Integral part of audit quality Nature timing and extent of work performed Professional judgments Basis for conclusion Facilitates planning, performance and supervision Provides basis for review

4-18 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Audit Documentation Files Current Permanent Prior Year Working Papers

4-19 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. APOLLO SHOES, INC.C-1 Inventory Lead Schedule APOLLO SHOES, INC.B-1 Accounts Receivable Lead Schedule Exhibit 4-5 Current File APOLLO SHOES, INC.A-3 Bank Confirmation APOLLO SHOES, INC.A-2 First National Bank Reconciliation APOLLO SHOES, INC.A-1 Cash Lead Schedule 12/31/04 Ref Account Unaudited AJE Balance C-1 1rst Natl $484,000 $50,000 $534,000 APOLLO SHOES, INC.TB-1 Working Trial Balance 12/31/04 Ref Account Unaudited AJE Balance A-1 Cash $484,000 $50,000 $534,000 B-1 A/R C-1 Inventory APOLLO SHOES, INC.TB-2 Adjusting Entries dr cr Cash $50,000 Expenses $50,000 Other Lead Schedules Supporting Schedules

4-20 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Audit Documentation Requirement Audit documentation should be prepared in sufficient detail to provide a clear understanding of its purpose, source, and the conclusions reached. Clear link to significant findings or issues. Demonstrate –Compliance with PCAOB standards –Support basis for conclusions on every relevant assertion –Accounting records agreed with financial statements

4-21 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Significant Findings or Issues Selection, application and consistency of accounting principles, including disclosures, Results of procedures that indicate need for significant modification of procedures, existence of material misstatements, significant deficiencies in controls Audit adjustments Disagreements Circumstances that cause significant difficulty Significant changes In assessed audit risk Matters that could result in report modification

4-22 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Exhibit 4-6 Audit Documentation Information on Workpaper –Name, date, purpose, page number –Procedures performed and conclusions reached by the auditor Evidence that auditor followed general standards and standards of field work Audit Mark Legend –Reviewers’ initials

4-23 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Documentation Requirement Sufficient to enable an experienced auditor, having no previous connection with the engagement, to: –Understand the nature timing, extent and results of procedures, evidence and conclusions –Determine who performed the work, date of work, reviewer and date of review

4-24 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Specific Audit Documentation Matters Should include identification of items inspected, confirmed or tested. –Satisfied by indicating source and selection criteria. Documentation of inspected agreements should include abstracts or copies. Should include contradictory information found –Information the auditor has identified relating to significant findings or issues that is inconsistent with or contradicts the auditor’s final conclusions. Procedures performed in response. Records documenting consultation on or resolutions of differences among team and with others consulted.

4-25 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Engagement Completion Document (PCAOB 3) Include all significant findings or issues. Include items identified during interim review. Must have completed all necessary procedures and obtained sufficient evidence before report release date. Documentation should be complete (documentation completion date) no more than 45 days after report release date.

4-26 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Documentation Retention (PCAOB 3) Seven years from report release date. –If no report—from last day of fieldwork Additions/Amendments –Documentation may not be deleted or discarded after report release date. –Additions must indicate date the information was added, Name of preparer Reason

4-27 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Specific Documentation Retention Requirements (PCAOB 3) Issuing office must retain prior to report release date –Engagement completion document –List of significant fraud risk factors, responses and results of related procedures –Inconsistent or contradictory information –Finding affecting consolidating or combining of accounts –Information to reconcile amounts audited by other auditors to consolidated financial statements –Schedule of audit adjustments –All significant control deficiencies and material weakness and clear distinction between categories –Representation letters –Matters to be communicated to audit committee

4-28 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Audit Documentation Review Hierarchical review process Reviewers include –New auditors –Supervisory personnel –Engagement supervisors and quality reviewers –Successor auditor –Inspection teams –Others including advisors engaged by the audit committee or parties to an acquisition

4-29 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Other Issues Related to Audit Documentation Ownership –Auditors maintain ownership, even after auditor-client relationship is over. Confidentiality –Only can be made public with permission, or if subpoenaed, or as part of a peer review of firm practices, or as part of an ethics investigation of firm personnel.