Chapter 06. Audit Planning, Understanding the Client, Assessing Risks, and Responding. McGraw-Hill/Irwin

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1 Chapter 06 Audit Planning, Understanding the Client, Assessing Risks, and Responding McGraw-Hill/Irwin Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2 Obtaining Clients Submit a proposal 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 6-2

3 The 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 This chapter emphasizes obtaining a client and steps

4 Stages of an Audit--Diagram 6-4

5 1. Plan the Audit Establish an understanding with the client This is ordinarily accomplished through use of an engagement letter Related, determine that The firm meets professional independence requirements There are no issues relating to management integrity The client understands the terms of the engagement 6-5

6 Name of the entity Management responsibilities Financial statements Items Included in Engagement Letters 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 6-6

7 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, such as examination of internal control over financial reporting 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 6-7

8 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 6-8

9 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. 6-9

10 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 6-10

11 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 6-11

12 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 6-12

13 Understanding the Client s Business Measuring and Reviewing Performance Budgets Key performance indicators Variance analysis Segment performance reports Balanced scorecard External parties 6-13

14 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 6-14

15 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 Ex. web pages for company Tour of plant and offices Analytical procedures The statement of cash flows and obtaining an understanding of the client 6-15

16 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 6-16

17 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. 6-17

18 3. 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 6-18

19 Two types Assessing 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 Risk assessment analytical procedures (to aid in planning the audit) Considering fraud risk factors Incentives Opportunity Attitude 6-19

20 Assessing Fraud Risks Identifying Fraud Risks Considerations in identifying fraud risks Type Significance Likelihood that it will result in a material misstatement Pervasiveness 6-20

21 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 6-21

22 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 6-22

23 Design Further Audit Procedures Types Tests of controls Analytical procedures (1/2) Tests of details of transactions and balances Audit procedures Inspection Observation Inquiry Confirmation Recalculation Reperformance 6-23

24 Design Further Audit Procedures (2/2) 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 6-24

25 Audit Documentation Audit Documentation Risk assessment Discussion of the audit team, elements of understanding, assessment of risk of material misstatement and risks identified Procedure results Overall responses, nature, timing and extent of further audit procedures, linkage of procedures with assessed risks, results of audit procedures, conclusions reached about operating effectiveness of controls, significant risk identified, circumstances in which substantive procedures alone will not provide sufficient evidence Consideration of fraud Similar to risk assessment as document discussion, procedures used to identify fraud risks, fraud risk and response, any other conditions that caused fraud-related procedures and communications with management or audit committee. 6-25

26 Audit Trail A 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 Test for existence or occurrence Test for completeness 6-26

27 Direction of Audit Testing 6-27

28 Transaction cycles Auditors consideration of internal control is often organized around client s major transaction cycles (examples) Revenue cycle Acquisition cycle Conversion cycle Payroll cycle Investing cycle Financing cycle 6-28

29 Transactions Affecting Accounts Receivable 6-29

30 Audit Program Systems 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 6-30

31 Indirect Verification of Income Statement Accounts 6-31

32 Objectives of Substantive Programs for Asset Accounts Establish the existence of assets Establish that the company has rights to the assets Establish the completeness of recorded assets Verify the cutoff of transactions Determine the appropriate valuation of the assets and accuracy of related transactions Determine the appropriate financial statement presentation and disclosure of the assets 6-32

33 Relationship of Financial Statement Assertions to the Audit 6-33

34 Relationships among Audit Objectives, Risks of Material Misstatement, and Audit Procedures 6-34