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

2. 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

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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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.

19. 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

20. 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

21. 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

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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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.

30. 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

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

32. Steps in Applying Materiality3
Estimate total
misstatement in segment.
Evaluating
Results
Step 4
Estimate the
combined misstatement.
Compare combined
estimate with judgment
about materiality.
Step 5

33. 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.

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

35. 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.

36. 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
10 billion
3,830,000
30 billion
8,550,000
100 billion
17,800,000
300 billion
89,600,000
. . .
82,600,000
Source: AICPA Audit Sampling Guide, AICPA (New York, New York), 2001.

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

38. 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 $
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%

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. 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

47. Direction of Audit Testing

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

49. 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

50. Dual Purpose Tests Tests of Controls Substantive Tests50

51. 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.

52. 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

53. Filling the Assurance Bucket53

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

55. End of Chapter 6 55