1. BA 427 – Assurance and Attestation Services
Lecture 20
The Audit: Phase I

2. Lecture 20 – Phase I Client acceptance and continuation
Initial planning
Assess client business risk
Preliminary analytical procedures
Set materiality and overall audit risk
Assess inherent risk
Assess control risk
Assess fraud risk
Audit evidence and the audit program

3. Client acceptance and continuation
New clients
Evaluate management’s integrity, reputation, and financial stability.
Evaluate client business risk.
Evaluate industry risk.
Communicate with predecessor auditor.
Understand the services desired by the client, and evaluate the accounting firm’s desire and ability to deliver those services.

4. Client acceptance and continuation
Communications with predecessor auditor
Initiated by the successor auditor.
Required, under GAAS (SAS 84), prior to accepting the engagement.
Requires permission of the client.
Old working papers are normally made available.

5. Client acceptance and continuation
Existing clients
Ongoing evaluation of management integrity and the working relationship between the auditors and client management.
Evaluation of trends with regard to client business risk and industry risk.
Ongoing evaluation of the services desired by the client, and the accounting firm’s desire and ability to deliver those services.

6. Lecture 20 – Phase I Client acceptance and continuation
Initial planning
Assess client business risk
Preliminary analytical procedures
Set materiality and overall audit risk
Assess inherent risk
Assess control risk
Assess fraud risk
Audit evidence and the audit program

7. Initial Planning Prepare an engagement letter. Select the audit team.
Evaluate the client’s internal audit function, if any.
Evaluate the need for outside specialists.

8. Initial Planning
Prepare an engagement letter and obtain a signed copy from the client.
The engagement letter should specify:
Nature of services to be rendered
Deadlines for completing the audit
Assistance to be provided by client personnel
Fees
Limitations on the auditor’s responsibilities

9. Initial Planning Select the audit team
According to the first General Standard of GAAS: “The audit is to be performed by a person or persons having adequate technical training and proficiency as an auditor.”
According to the first Standard of Field Work of GAAS: “The work is to be adequately planned and assistants, if any, are to be properly supervised.”

10. Initial Planning Evaluate the internal audit function
This evaluation affects the nature, timing and extent of external audit procedures.
The external auditor assesses the competence and objectivity of the internal audit function.

11. Initial Planning Using the work of a specialist
Examples include actuaries and appraisers.
Auditor must be satisfied with the qualifications and reputation of the specialist. (The specialist need not be independent of the client.)
The auditor should understand the specialist’s methods and assumptions, consider whether the specialist’s findings support the assertions, and test the data provided by the client.

12. Initial Planning Using the work of a specialist
The client, auditor and specialist should document their understanding of the nature of the work to be performed.
The audit report normally does not refer to the work of the specialist.

13. Lecture 20 – Phase I Client acceptance and continuation
Initial planning
Assess client business risk
Preliminary analytical procedures
Set materiality and overall audit risk
Assess inherent risk
Assess control risk
Assess fraud risk
Audit evidence and the audit program

14. Assess client business risk
Client business risk is the risk that the client will fail to achieve its objectives.
Sources of client business risk:
Industry and external environment
Business operations and processes
Management and governance, objectives and strategies, measurement and performance

15. Assess client business risk
Industry and external environment
Industry-wide risks (regulation, deregulation, economic trends, competition).
Inherent risks typical for companies in the industry (e.g., inventory obsolescence, regulatory approval).
Accounting issues relevant to the industry.

16. Assess client business risk
Business operations and processes
Key products and associated risks.
Key customers and associated risks.
Key suppliers and associated risks.
Tour the plant and offices.
Identify related parties and related party transactions.

17. Assess client business risk
Management and governance, objectives and strategies, measurement and performance
Review corporate charter and bylaws.
Review the company’s code of ethics.
Review minutes of meetings.
Identify terms of key contracts and legal obligations.
Identify the client’s key performance measures.

18. Lecture 20 – Phase I Client acceptance and continuation
Initial planning
Assess client business risk
Preliminary analytical procedures
Set materiality and overall audit risk
Assess inherent risk
Assess control risk
Assess fraud risk
Audit evidence and the audit program

19. Preliminary analytical procedures
Analytical procedures conducted in the planning phase of the audit serve the following objectives:
Understand the client’s industry and business
Assess going concern
Indicate possible misstatements
Reduce detailed tests

20. Preliminary analytical procedures
Analytical procedures are defined by SAS no. 56:
“Evaluations of financial information made by a study of plausible relationships among financial and nonfinancial data … involving comparisons of recorded amounts to expectations developed by the auditor.”

21. Preliminary analytical procedures
Types of analytical procedures:
Compare client data to industry data.
Compare current period to prior periods.
Compare current period to budget.
Compare financial data for internal consistency between accounts.
Compare financial data to expected results based on operational data.

22. Preliminary analytical procedures
Ratios used in analytical procedures:
Cash ratio, quick ratio and current ratio.
A/R turnover and A/R days to collect.
Inventory turnover and inventory days to sell.
Debt to equity
EPS
Gross profit percentage
ROA and ROE

23. Lecture 20 – Phase I Client acceptance and continuation
Initial planning
Assess client business risk
Preliminary analytical procedures
Set materiality and overall audit risk
Assess inherent risk
Assess control risk
Assess fraud risk
Audit evidence and the audit program

24. Set materiality and overall audit risk
Materiality as defined by the FASB:
The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.

25. Set materiality and overall audit risk
Five steps in applying materiality
Step 1: Set preliminary judgment about materiality.
Step 2: Allocate preliminary judgment about materiality to segments.
Step 3: Estimate misstatement in segment.
Step 4: Estimate combined misstatement.
Step 5: Compare combined estimate with preliminary or revised judgment about materiality.

26. Set materiality and overall audit risk
The first two steps are the only steps that occur in the planning phase of the audit.
Step 1: Set preliminary judgment about materiality.
Step 2: Allocate preliminary judgment about materiality to segments.

27. Set materiality and overall audit risk
Step 1: Set preliminary judgment about materiality.
The maximum amount by which the statements could be misstated and still not affect the decisions of reasonable users.
One of the most important decisions the auditor makes.
Requires considerable professional judgment.
Professional standards do not say 5% or 10!

28. Set materiality and overall audit risk
Step 1: Quantitative factors in setting materiality.
Materiality is a relative concept.
Hence, the auditor must identify one or more bases by which to set materiality.
Net income before taxes is a common base.
Other bases include: net sales, gross profit, total assets, current assets, owners’ equity.

29. Set materiality and overall audit risk
Step 1: Qualitative factors in setting materiality.
Misstatements that affect contractual obligations.
Misstatements that affect a trend in earnings.
Misstatements that turn a loss into a profit (or vice versa).
Misstatements arising from irregularities.

30. Set materiality and overall audit risk
Step 2: Allocate preliminary judgment about materiality to individual accounts.
This allocation facilitates planning the audit of individual balance sheet line-items.
This allocation identifies the tolerable misstatement in each account.
The sum of tolerable misstatements can exceed overall materiality.
The allocation must consider the possibility that a significant misstatement in an individual account might affect F/S users.

31. Set materiality and overall audit risk
The Audit Risk Model:
AR = IR x CR x DR
Where
AR = Audit Risk
IR = Inherent Risk
CR = Control Risk
DR = Detection Risk
Each of these items ranges from 0 to 1.

32. Set materiality and overall audit risk
The Audit Risk Model (A.R.M.):
AR = IR x CR x DR
Audit Risk: This is the likelihood that the F/S are materially misstated. It is a probability, and a choice variable by the auditor. 5%, 1%, or 1/10 of 1% are common objectives.
The A.R.M. can be applied separately for each balance sheet account. (Even so, the auditor might choose the same level of Audit Risk for each account).

33. Set materiality and overall audit risk
Engagement risk is the risk the audit firm will suffer a loss arising from the client relationship.
Engagement risk is closely related to, but not synonymous with, client business risk.
Auditors disagree about whether engagement risk should be considered in planning the audit.
In other words, should some audits provide more assurance than others?

34. Set materiality and overall audit risk
If Engagement Risk Affects Acceptable Audit Risk, then consider:
The degree to which external users will rely on the financial statements. Related factors are client size, distribution of ownership, and nature and amount of liabilities.
The likelihood that the client will experience financial difficulties.
Management integrity.

35. Lecture 20 – Phase I Client acceptance and continuation
Initial planning
Assess client business risk
Preliminary analytical procedures
Set materiality and overall audit risk
Assess inherent risk
Assess control risk
Assess fraud risk
Audit evidence and the audit program

36. Assess Inherent Risk Inherent risk (IR):
The auditor’s assessment of the likelihood that there are material misstatements before considering the effectiveness of controls.
In assessing inherent risk, the auditor considers such factors as:
Nature of the client’s business
Initial versus repeat engagement
Nature of accounting judgments and estimates
Non-routine transactions

37. Lecture 20 – Phase I Client acceptance and continuation
Initial planning
Assess client business risk
Preliminary analytical procedures
Set materiality and overall audit risk
Assess inherent risk
Assess control risk
Assess fraud risk
Audit evidence and the audit program

38. Assess control risk Control Risk (CR):
The auditor’s assessment of the likelihood that material misstatements are not prevented or detected by the client’s internal controls.
Hence: CR x IR is the likelihood that the account is materially misstated as presented to the auditors.
To set CR below 1, the auditor will have to understand controls and test controls.

39. Assess control risk Control Risk (CR):
Therefore, if the auditor does not want to test internal controls, CR must be set at 1, regardless of the actual effectiveness of internal controls.

40. Lecture 20 – Phase I Client acceptance and continuation
Initial planning
Assess client business risk
Preliminary analytical procedures
Set materiality and overall audit risk
Assess inherent risk
Assess control risk
Assess fraud risk
Audit evidence and the audit program

41. Assess fraud risk
We discussed this topic in connection with SAS No. 99.

42. Lecture 20 – Phase I Client acceptance and continuation
Initial planning
Assess client business risk
Preliminary analytical procedures
Set materiality and overall audit risk
Assess inherent risk
Assess control risk
Assess fraud risk
Audit evidence and the audit program

43. Audit evidence and the audit program
Third standard of field work:
Sufficient competent evidential matter is to be obtained through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit.

44. Audit evidence and the audit program
Competence of evidential matter
Sufficiency of evidential matter

45. Audit evidence and the audit program
Competence of evidential matter: Evidence should be
Valid (objective and reliable)
Independent sources are better than sources internal to the organization.
Direct evidence (from physical examination, observation, computation and inspection) is more persuasive than indirect evidence.
Relevant (including timely)

46. Audit evidence and the audit program
Sufficiency of evidential matter
Five ways to accumulate evidential matter:
Procedures to obtain an understanding of controls
Tests of controls
Substantive tests of transactions
Analytical procedures
Tests of details of balances

47. Audit evidence and the audit program
Financial statement assertions:
Completeness
Rights and Obligations
Valuation or Allocation
Existence or Occurrence
Presentation and Disclosure

48. Audit evidence and the audit program
Financial statement assertions:
Completeness
Whether all transactions and accounts that should be presented in the financial statements are included.
Rights and Obligations
Valuation or Allocation
Existence or Occurrence
Presentation and Disclosure

49. Audit evidence and the audit program
Financial statement assertions:
Completeness
Rights and Obligations
Whether, at a given date, all assets are the rights of the entity and all liabilities are the obligations of the entity.
Valuation or Allocation
Existence or Occurrence
Presentation and Disclosure

50. Audit evidence and the audit program
Financial statement assertions:
Completeness
Rights and Obligations
Valuation or Allocation
Whether the assets, liabilities, revenues and expenses of an entity have been included in the financial statements at the appropriate amounts, in conformity with GAAP.
Existence or Occurrence
Presentation and Disclosure

51. Audit evidence and the audit program
Financial statement assertions:
Completeness
Rights and Obligations
Valuation or Allocation
Existence or Occurrence
Whether assets and liabilities exist at a given date and whether recorded transactions have occurred during a given period.
Presentation and Disclosure

52. Audit evidence and the audit program
Financial statement assertions:
Completeness
Rights and Obligations
Valuation or Allocation
Existence or Occurrence
Presentation and Disclosure
Whether financial statement components have been properly classified, described, and disclosed.

53. Audit evidence and the audit program
Existence
F/S
Completeness
Underlying Accounting Data
Corroborating Information
Economic Transactions

54. Audit evidence and the audit program
Types of Evidence
Physical evidence of tangible assets
Confirmation by a third party
Documentation, internal and external
Observation to assess certain activities
Client inquiry, can be written or oral
Reperformance
Analytical procedures

55. Audit evidence and the audit program
Audit workpapers
Permanent files (used every year)
Articles of incorporation and bylaws
Contracts and debt agreements
Organization chart
Internal control analyses

56. Audit evidence and the audit program
Audit workpapers
Current files (annual)
The Audit Program
Working Trial Balance
Lead Schedules
Tests of controls
Substantive tests

57. Audit evidence and the audit program
Assets
Liabilities & Equity
Cash
Accounts receivable
Inventory
Prepaid assets
Property, plant and equipment
Other assets
Total
Accounts payable
Other current liabilities
Long-term debt
Shareholders’ equity
Common stock
Retained earnings
Total liabilities and equity

58. Audit evidence and the audit program
Assets
Liabilities & Equity
Cash
Accounts receivable
Inventory
Prepaid assets
Property, plant and equipment
Other assets
Total
Accounts payable
Other current liabilities
Long-term debt
Shareholders’ equity
Common stock
Retained earnings
Total liabilities and equity

59. Audit evidence and the audit program
Working Trial Balance
Prior year
Trial balance
Adjusting entries
Reclassifications
Final balance
Account
Cash
Accounts receivable
Inventory
Prepaid assets
Property, plant and equipment
Other assets
Total

60. Audit evidence and the audit program
Lead Schedule: Cash
Prior year
Trial balance
Adjusting entries
Reclassifications
Final balance
Account
Sunwest Bank – general account
Sunwest Bank – Payroll account
First Federal Savings and Loan
Petty cash
Total cash