1. and Types of Audit Tests
Chapter Five
Audit Planning
and Types of Audit Tests

2. The Phases of an Audit That Relate to Audit Planning
Client acceptance
and continuance
Establish the terms
of the engagement
Preplanning
Assess risks and establish materiality
Plan the audit

3. Prospective Client Acceptance
Obtain and review financial information.
Inquire of third parties.
Communicate with the predecessor auditor.
Consider unusual business or audit risks.
Determine if the firm is independent.
Determine if the firm has the necessary skills and knowledge.
Determine if acceptance violates any applicable regulatory agency requirements or the Code of Professional Conduct.

4. Continuing Client Retention
Evaluate client retention periodically
Near audit completion or after a significant event
Conflicts over accounting & auditing issues
Dispute over fees

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.
In establishing the terms of the engagement, three topics must be discussed:
The engagement letter
The internal auditors
The audit committee.

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 5-1 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.

7. Internal Auditors
(continued)

8. Internal Auditors

9. The Audit Committee Subcommittee of the board of directors
Section 301 of Sarbanes-Oxley Act requires the following for audit committee members of publicly held companies:
Member of board of directors & 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

10. Determine the Audit Engagement Team Requirements
Preplanning
Determine the Audit Engagement Team Requirements
Assess Independence

11. Assess Risks and Establish Materiality
Use audit risk model
Restrict risk at account balance level
Achieve acceptable 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.

12. Let’s look at each of these steps.
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 a preliminary level of control risk by account and assertion.
Assess the possibility of illegal acts.
Identify related parties.
Conduct preliminary analytical procedures.
Develop an overall audit strategy and prepare audit programs.
Consider additional value-added services.
Let’s look at each of these steps.

13. Assess a Preliminary Level for Control Risk by Account and Assertion
Control risk is the risk that material misstatements will not be prevented or detected by internal controls.
The presence of complex information technology may require the use of an IT specialist.
A preliminary assessment of control risk is necessary for the auditor to plan the nature, timing, and extent of testing.

14. Assess the Possibility of Illegal Acts
Direct & Material
Consider laws & regulations as part of audit
Material & Indirect
Be aware may have occurred; investigate if brought to attention

15. Assess the Possibility of Illegal Acts

16. Identify Related Parties
Some 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.

17. Conduct 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.

18. Develop an Overall Audit Strategy
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.
Nature
Timing
Extent

19. Consider Additional Value-Added Services
Tax Planning
System Design and Integration
Internal Reporting
Risk Assessment
Benchmarking
Electronic Commerce

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

21. Tests of Controls Inquiry Inspection Observation Walk Through
Reperformance

22. Tests of Controls

23. Substantive Procedures
Tests of Details
Tests for errors or fraud in individual transactions
Analytical Procedures
Obtains evidential matter about particular assertions related to account balances or classes of transactions

24. Dual Purpose Tests Tests of Controls Substantive Tests

25. 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 evidential matter 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.

26. Purposes of Analytical Procedures
Trend Analysis
Ratio Analysis
Reasonableness Analysis

27. Substantive Analytical Procedures Decision Process

29. 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, and
the precision of the expectation.

30. The Investigation of Differences for Planning and Final Analytical Procedures
Preliminary Analytical Procedures Differences
Final Analytical Procedures Differences
Corroborating evidence not required
Corroborating evidence is required

31. Audit Testing Hierarchy

32. Filling the Assurance Bucket

33. Accounts Payable Example of Filling the Assurance Buckets for Each Assertion

34. Short-Term Liquidity Ratios
Current Ratio
Quick Ratio
Operating Cash Flow Ratio

35. Days Outstanding in Accounts Receivable Days of Inventory on Hand
Activity Ratios
Receivables Turnover
Days Outstanding in Accounts Receivable
Inventory Turnover
Days of Inventory on Hand

36. Gross Profit Percentage
Profitability Ratios
Gross Profit Percentage
Profit Margin
Return on Assets
Return on Equity

37. Coverage Ratios
Debt to Equity
Times Interest Earned

38. End of Chapter 5