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Audit Planning. Audit Planning. Make preliminary arrangements with the client. Decide whether or not to accept the prospective client. Obtain knowledge of client’s business and industry. Prepare the audit plan, preliminary program, and time budget. Prepare the

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audit planning2
Audit Planning

Make preliminary

arrangements with

the client

Decide whether or

not to accept the

prospective client

Obtain knowledge

of client’s business

and industry

Prepare the audit

plan, preliminary

program, and time

budget

Prepare the

engagement letter

obtaining clients deciding whether to accept clients
Obtaining ClientsDeciding Whether to Accept Clients
  • Engagement risk – auditors’ overall risk of association with a client.
  • Reduce engagement risk by considering management’s reputation and the financial strength of the prospective client.
  • With client’s permission contact third parties concerning:
    • Financial history and credit rating (banker)
    • Legal environment (attorneys)
obtaining clients communications with predecessor auditor
Obtaining Clients Communications with Predecessor Auditor
  • SAS 84 (AU 315) requires the successor auditor to attempt to communicate with the predecessor auditor before accepting the engagement.
    • Recall Rule 301 pertaining to confidential client information. Must ask client to authorize the communication.
  • SEC Form 8-K for public companies
    • Discourages “opinion shopping”
engagement letters responsibilities of each party
Engagement LettersResponsibilities of Each Party
  • 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 made 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
engagement letters other items
Engagement LettersOther 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
  • 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
understanding the client s business
Understanding the 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
  • Client’s operations
    • Accounting policies
    • Industry and regulatory factors
    • Strategies and related business risks
    • Measurement and review of performance
    • Internal control
understanding the client s business basic strategy
Understanding the Client’s Business Basic Strategy
  • Basic strategies
    • Product differentiation
    • Cost leadership
  • Implications of strategy for assessing reasonableness of financial statements
relationship between strategy and financial statement results
Relationship Between Strategy and Financial Statement Results
  • ROA = NI / TA
  • Dupont Analysis

ROA = (NI / Sales) x (Sales / TA)

= Net Profit Margin x Asset Turnover

  • Assume ROA = 10% for Firms A & B

Profit Margin Asset Turnover

Firm A 10% 1.0

Firm B 2% 5.0

materiality
Materiality
  • Consideration (but not quantification) of materiality is required – most firms do quantify.
  • No universal rules for assessing materiality – only guidelines and professional judgment
  • Some methods for quantifying overall materiality
    • 5 to 10% of net income before taxes
    • ½ to 1% of total assets
    • ½ to 1% of total revenues
    • 1% of total equity
    • AICPA table
materiality allocating overall materiality
MaterialityAllocating Overall Materiality
  • Multiply overall materiality by a factor (usually 1.5 to 2.0) and allocate to the various accounts.
    • Multiplying by a factor before allocating alleviates excessive conservatism
    • Allocation is typically to balance sheet accounts (balance sheet approach)
materiality class example
MaterialityClass Example
  • Relevant base = $4,000,000
  • Overall planning materiality

= $38,300 + (0.0067 x $1,000,000) = $45,000

  • Allocation of planning materiality

Allocated amount = $45,000 x 2.0 = $90,000

Base = $2,000,000

Cash allocation = (500,000 / 2,000,000) x 90,000

= $22,500

Similarly, A/R = $13,500, Inv = $31,500, A/P = $14,625, A/L = $5,625 and T/P = $2,250

Total = $90,000

materiality qualitative considerations
MaterialityQualitative Considerations

Remember materiality depends not only on amount, but also on nature of transaction, for example:

  • Illegal payments
  • Compliance with contractual agreements
  • Reversal of earnings trend
  • Changes a loss into income, or vice versa
  • Items that can be measured with precision versus items that arise from estimates
assessing the risk of material misstatement due to fraud sas 99
Assessing the Risk of Material Misstatement Due to Fraud (SAS 99)

Effective date: December 15, 2002.

Supersedes SAS 82

assessing fraud risks
Assessing Fraud Risks
  • Two types
    • 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
assessing fraud risks identifying fraud risks
Assessing Fraud Risks—Identifying Fraud Risks
  • Considerations in identifying fraud risks
    • Type
    • Significance
    • Likelihood that it will result in a material misstatement
    • Pervasiveness
responding to fraud risks
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
consideration of fraud throughout the audit
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
other planning considerations
Other Planning Considerations
  • First-year Procedures
    • SAS 84 recommends second communication with predecessor CPA
  • Use of Client’s Staff
  • Other CPAs
  • Use of Specialists
audit plans
Audit Plans
  • Provides an overview of the engagement. Typically includes:
    • Description of client company
    • Audit objectives
    • Other services
    • Scheduling of work
    • Role of client’s staff
    • Staffing requirements
    • Target dates
    • Special audit risks
    • Significant risks related to errors and fraud
    • Preliminary judgments about materiality
audit programs
Audit Programs

Organization of the Audit Program

  • Systems (Internal Control)
    • Revenue Cycle
    • Acquisition
    • Production
    • Payroll
    • Investing/Financing
  • Substantive tests
    • Organized by major balance sheet accounts
the audit trail direction of audit testing

Test for Existence

Finish

Start

Source Documents

Journals

Ledgers

The Audit TrailDirection of Audit Testing

Test for Completeness

Start

Finish

timing of audit work
Timing of Audit Work
  • Interim Work
    • Consideration of Internal Controls
    • Substantive work on transactions to date

It should be remembered that interim work should be supplemented with additional work covering the period between the interim date and the end of the year