McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Audit Planning and Types of Audit Tests Chapter Five

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 The Phases of an Audit That Relate to Audit Planning

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Prospective Client Acceptance 1.Obtain and review financial information. 2.Inquire of third parties. 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 or ethical requirements.

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Continuing Client Retention Evaluate client retention periodically Near audit completion or after a significant event Conflicts over accounting & auditing issues Dispute over fees

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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. In establishing the terms of the engagement, three topics must be discussed: 1.The engagement letter. 2.The internal auditors. 3.Those charged with governance.

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 The Engagement Letter The engagement letter formalises the arrangement reached between the auditor and the client. In addition to the items mentioned in the sample engagement letter in Exhibit 5-1 in the textbook, the engagement letter may include: Arrangements for use of experts or internal auditors. Any limitations of liability of the auditor or client. Additional services to be provided. Arrangements regarding other services.

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Internal Auditors

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Those Charged with Governance Board of Directors Audit Committee

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Preliminary Engagement Activities Determine the Audit Engagement Team Requirements Assess Compliance with Ethical Requirements, including Independence

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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.

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Planning the Audit When preparing the audit plan, the auditor should be guided by the results of the risk assessment procedures performed to gain an understanding of the entity. Additional steps: Assess business risks and establish materiality. Assess the need for experts. Consider the possibility of non- compliance (illegal) acts. Identify related parties. Conduct preliminary analytical procedures. Consider additional value-added services. Let’s look at each of these steps.

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Assess Risks and Establish Materiality Use audit risk model Restrict risk at account balance level Achieve acceptable low level of audit risk You may want to review the detailed discussion in Chapter 3 of the process used to assess the client’s business risks and to establish materiality. Assess Risks Establish Materiality

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Experts A major consideration in planning the audit is the need for an auditor’s expert (ISA 620). The use of an IT expert is a significant aspect of most audit engagements. The presence of complex information technology may require the use of an IT expert.

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Non-Compliance (Illegal) Acts Non-Compliance Acts Direct & Material Consider laws and regulations as part of audit Material & Indirect Be aware may have occurred; investigate if brought to attention

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Non-Compliance Acts

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Related Parties Some examples from IAS 24 Related Party Disclosure Parents and subsidiaries. Significant influence. Joint control. Associate entity. Joint venture. Management. Close family of the principal owners & management. Other parties that can have significant influence. How to Identify Related Parties Review minutes of meetings of boards and management. Review conflict of interest statements. Review records of the entity’s investments. Review contracts and agreements with key management or those charged with governance. Review significant contracts and agreements not in the entity’s ordinary course of business.

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Preliminary Analytical Procedures 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.

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Additional Value-Added Services Tax Planning Transaction Support IT- consultancy Internal reporting Benchmarking Risk Assessment Auditors are limited in the types of consulting services that they can offer their audit clients.

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Document Overall Audit Strategy and Audit Plan 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. 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. AUDITTESTSAUDITTESTS Nature Timing Extent

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Document Overall Audit Strategy and Audit Plan

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Types of Audit Tests Risk Assessment Procedures Used to obtain an understanding of the entity and its environment, including internal control. Tests of Controls Performed to obtain audit evidence about the operating effectiveness of controls in preventing, detecting and correcting material misstatements. Substantive Procedures Detect material misstatements in a transaction class, account balance, and disclosure element of the financial statements.

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Tests of Controls InquiryInspection Walk Through Reperformance Observation

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Tests of Controls

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Substantive Procedures Analytical Procedures Obtains evidence 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

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Dual Purpose Tests Substantive Tests Tests of Controls Dual Purpose Test

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Purposes of Analytical Procedures Preliminary Analytical Procedures Used to assist the auditor to better understand the business and to plan the nature, timing, and extent of audit procedures. Substantive Analytical Procedures Used to obtain evidence about particular assertions related to account balances or classes of transactions. Final Analytical Procedures Used as an overall review of the financial information in the final review stage of the audit.

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Purposes of Analytical Procedures (See Table 5-5) Trend Analysis Ratio Analysis Reasonableness Analysis

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Substantive Analytical Procedures Decision Process

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Develop an Expectation Auditing standards require the auditor to have an expectation whenever analytical procedures are used. An expectation can be developed using a variety of information sources such as: Financial and operating data. Budgets and forecasts. Industry publications. Competitor information. Management’s analyses. Analyst’s reports.

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Define a Tolerable Difference The size of the tolerable difference depends on: The significance of the account. The desired degree of reliance on the substantive analytical procedures. The level of disaggregation in the amount being tested. The precision of the expectation. But the amount is always less than materiality!

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Compare and Investigate Compare the expectation to the recorded amount and investigate any differences greater than the tolerable difference.

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 The Investigation of Differences for Planning and Final Analytical Procedures Preliminary Analytical Procedures Differences Corroborating evidence is not required Final Analytical Procedures Differences Corroboratin g evidence is required

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Audit Testing Hierarchy

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Filling the Assurance Bucket

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Example of Filling the Assurance Buckets for Each Assertion (Accounts Payable)

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Short-Term Liquidity Ratios Current Ratio Quick Ratio Operating Cash Flow Ratio

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Activity Ratios Receivables Turnover Days Outstanding in Accounts Receivable Inventory Turnover Days of Inventory on Hand

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Profitability Ratios Gross Profit Percentage Profit Margin Return on Assets Return on Equity

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Coverage Ratios Debt to Equity Times Interest Earned

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Audit of Group Financial Statements Component of a Group Entity or business activity in which financial information is included in the group financial statements. Component Auditor An auditor who, at the request of the group engagement team, performs work on financial information related to a component for the group audit. Auditing standards require the group engagement team to identify components that are likely to be significant components.

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Audit of Group Financial Statements

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 End of Chapter 5