MODULE 2: Engagement Planning (11% 17%)

Transcription

1 AU2 Advanced External Auditing MODULE 2: Engagement Planning (11% 17%) Lecturer: Glen B. Carlson, B. Comm.(Honours), C.G.A. Module 2 engagement planning Module 2 covers the planning of an audit engagement, beginning with the decision of whether or not to accept the potential client. Building on concepts from External Auditing (AU1) (or your equivalent course), you will go through the planning process of a typical financial statement audit. You will learn about the steps required to complete the planning section of an audit file and will consider the specific matters that arise on the first audit of a new client. 2 Accepting engagements Before accepting a new audit client, the auditor must consider the following matters: client service needs e.g. audit, review engagement, compilation independence from client ability to perform the work within client reporting deadlines how client fits with the accounting practice (business/industry risk) integrity of management (ethics, governance, financial position) 3 1

2 Communication with the previous auditor Communication with the previous auditor is a professional obligation. The purpose is to determine if there is any professional reason not to accept the appointment. (Professional reasons for not accepting the client relate almost entirely to the client s integrity. They do not include non-payment of the previous auditor s fees.) The previous auditor must have the client s approval to provide information. 4 Engagement letters Engagement letters should be obtained for all engagements, not just audits. An engagement letter for an audit sets out the nature and objectives of the audit, management s responsibility for the financial statements, the risk that an audit may not detect all material misstatements, the fee structure for the engagement, a list of working papers to be prepared by the client and a confirmation of the terms by the client. An engagement letter for a review states that the public accountant is acting as an accountant, not an auditor. It clarifies the lower level of assurance provided and the responsibilities of management for the financial statements. An engagement letter for a compilation engagement includes the wording of the Notice to Reader and the fact that no assurance is provided. 5 How understanding the entity and its environment aids an auditor (form A-131) Determining materiality levels Assessing inherent risks Obtaining a sufficient understanding of internal control Identifying the nature and sources of audit evidence available Designing audit procedures Understanding the substance of transactions Assessing the sufficiency of evidence obtained Assessing the appropriateness of the selection and application of accounting principles Evaluating the overall financial statement presentation 6 2

3 Sources of understanding the entity and its environment (form A-140) prior year s audit working papers; discussions with the audit partner and manager; discussions with client management; a tour of the client s premises; review of the client s organization chart; a review of key agreements for sales, purchases, loans, investments, etc.; a review of trade and industry publications for the client s industry; a review of government regulations pertaining to the client s industry; a review of the minutes of board and management meetings. 7 Understanding the entity s environment The auditor should consider the business environment in which the client operates; this includes: nature of the industry and industry economic conditions; general and local economic conditions; industry regulatory requirements; the financial reporting environment. These will help in the auditor s assessment of the inherent risk of misstatement, the appropriateness of the entity s accounting policies and its compliance with applicable laws and regulations. 8 Understanding the client organization The auditor should also consider the specific characteristics of the client organization; these include : the form of ownership and management; motivation and attitude of management; quality and turnover of staff; size and complexity of the entity. These will help in determining overall audit risk and in the preliminary assessment of materiality, inherent risk and control risk. 9 3

4 Methods of obtaining understanding The principal techniques used to gain an understanding of the entity and its environment include: enquiry; analytical procedures; observation and inspection; review of documents. 10 Planning materiality and audit risk audit risk risk that auditor will issue an unqualified report when the f/s are materially misstated f/s are materially misstated if knowledge of misstatement would affect the decision of a reasonable user determination of materiality based on quantitative and qualitative factors 11 Planning materiality and audit risk quantitative factors materiality assessment ($) is related to a measurement base (A211 Materiality assessment) materiality level should represent largest amount of a misstatement or group of misstatements that would not influence or change a decision based on f/s profit oriented normalized after tax income (%) other considerations - assets, equity, revenues, gross profit, first time audit non profit total expenses or revenues (%) 12 4

5 Planning materiality and audit risk qualitative factors macroeconomic trends (recession) or trends within client type of industry e.g. high tech, banking misstatements that change loss into income e.g. capitalized R & D potential impact on compliance with debt covenants and agreements (sinking funds, dividends) 13 Assessing the risk of material misstatement risk of material misstatement (RMM) is risk that f/s are materially misstated prior to commencement of audit two components inherent risk errors likely to occur in f/s and arise from client activities control risk risk that errors will bypass internal controls created to prevent, detect and correct material misstatements 14 Risk of material misstatement HB 5141 (now CAS 315) requires auditor to identify and assess the RMM at both the f/s and assertion level for classes of transactions, account balances and disclosures HB 5135 (now CAS 240) audit team required to meet at planning stage to explicitly consider the susceptibility of entity to material misstatements in f/s resulting from fraud 15 5

6 Risk of material misstatement steps in assessment of RMM (A420 Inherent risk - Characteristics of accounts, A510 Risk of misstatement due to fraud/error) identifying risks understanding of entity and environment (including controls that relate to risks) considering the classes of transactions, account balances and disclosures in f/s relating identified risks to what can go wrong at the assertion level considering whether risks are of a magnitude and likelihood that may result in material misstatement 16 Fraud in the context of auditing fraud for an audit of f/s means a deliberate material misstatement and may involve employee frauds against entity e.g. misappropriations covered up by fraudulent entries fraudulent financial reporting where management deliberately falsifies f/s to mislead users (management fraud) 17 Fraud in the context of auditing factors associated with fraud motivational factor for fraudulent reporting is generally low earnings can be improved by adopting liberal (income increasing) accounting policies allowed by GAAP (estimates, inventory costing, capitalization) business culture and control environment can have a pervasive effect on the statements good corporate governance (code of ethics, audit committees) can minimize the chances of fraud 18 6

7 Fraud in the context of auditing likelihood of an audit test uncovering fraud depends on skills of perpetrator frequency/extent of manipulation size of amounts manipulated attitude of professional skepticism should be maintained notwithstanding past experience of honesty and integrity with management and board 19 Analysis at the planning stage auditor uses analysis in planning audit to assist in designing nature, extent and timing of other auditing procedures auditor analysis of unaudited f/s account analysis identifying accounts that have unusual changes and may require more extensive auditing (preliminary assessment RMM) identifying f/s relationships that appear to be inconsistent with expectations based on client, industry and general knowledge f/s ratio analysis (liquidity, profitability) formulating an expectation of a ratio comparing calculated ratio with the expectation deciding whether difference warrants investigation 20 Key ratios used by auditors Balance sheet ratios: Current ratio measures liquidity Quick ratio measures liquidity Days sales in receivables measures liquidity Doubtful accounts ratio measures liquidity Days sales in inventory measures activity Debt-to-equity ratio measures flexibility Operating ratios: Accounts receivable turnover measures activity Inventory turnover measures activity Cost of sales percentage measures profitability Gross margin percentage measures profitability 21 7

8 Key ratios used by auditors Equity ratios: Working capital/total assets measures flexibility Retained earnings/total assets measures profitability EBIT/total assets measures profitability Market value of equity/debt measures flexibility Net sales/total assets measures profitability 22 Steps in using analytical procedures 1. Formulate an expectation of the account balance or ratio. 2. Compare the recorded amount or calculated ratio with your expectation. 3. Decide whether the difference warrants investigation. 4. Plan the nature, extent and timing of audit procedures to investigate significant differences. 23 Development of the audit strategy and plan audit strategy (PPM form A-201) sets the scope, timing and selection of an audit approach based on control environment and risk of misstatement due to fraud or error guides development of detailed audit plan decides where to focus audit attention 24 8

9 Development of the audit strategy and plan development of audit strategy involves (HB 5150/CAS 300) determining characteristics of engagement that define scope such as industry specific reporting requirements and location of entity considering factors that will determine focus of audit team materiality levels areas with higher assessed RMM material account balances and disclosures how much reliance can be placed on testing internal controls and whether to use a combined or substantive approach 25 Development of the audit strategy and plan audit plan is based on audit strategy sets out the nature, extent and timing of audit procedures to reduce audit risk to acceptable level details procedures to be used to assess the RMM to obtain evidence through both tests of controls and substantive testing to comply with GAAS updated and changed as necessary throughout audit because the results of assessment of risks impacts the nature, extent and timing of other audit work done 26 First-time time engagements A first time audit (for a firm) could result from any of the following situations: client newly formed; client never audited before; client audited by one previous auditor; client audited by more than one previous auditor; client audited in the past but not for all periods. 27 9

10 First-time time audit considerations If there has been a previous audit, the firm should review the previous auditor s working papers and the work done on the previous year s closing balances. This is a practical matter (not required by the standards) and it is usual for the previous auditor to cooperate. 28 First-time time audit considerations Obtain an understanding of the entity and its environment including its internal controls. If the company has not previously been audited, it will be necessary to audit the opening balances; errors in opening balances will either wash out in the current year (causing misstatements in current income and cash flows) or will still be present at the current year-end. Verify consistency of accounting principles. 29 Reporting considerations on first time audits If the comparative figures were not audited, they must be marked as such. If the previous year s figures were not audited or were audited by another auditor, it is usual to state this in the audit report (although it is acceptable for the client to state it in the notes to the financial statements). If the opening balances cannot be verified, it may be necessary to issue a qualified opinion (or denial of opinion) on the income statement and statement of cash flows. The CICA Handbook does allow a split opinion with an unqualified opinion on the closing balance sheet

11 End of module 2 31 Hints for assignment 1 Question 1: If you tend not to do well on multiple choice questions, you would probably benefit from listening to Part 6 of the on-line lecture for Module 1. Questions 2 and 3: Remember to provide full explanations and respond to all parts of the scenarios or statements. Question 5: Consider the effects of the various possible course of action on all those affected by your decision. Question 6: If you have difficulty with this question, you should reread the notes and readings for Topic 2.5. Question 7: Consider the factors that affect assessed inherent risk. Which accounts require the greatest judgement? 32 11