Audit Planning, Understanding the Client, Assessing Risks, and Responding

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Chapter 6

• Audit Planning, Understanding the Client,
  Assessing Risks, and Responding

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PACBO 2nd Standard of Field Work

• The auditor must obtain a sufficient
  understanding of the entity and its environment,
  including its internal control, to assess the
  risk of material misstatement of the financial
  statements whether due to error or fraud, and to
  design the nature, timing, and extent of further
  audit procedures.

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Overall Audit Planning Process
Decide whether or not to accept a prospective
client keep existing client
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Keys to Client Screening

• Research Client and its Reputation, including Key
  Executives
• Visit Client Facilities
• Assess CPA Firm Competence Independence
• Always Contact Prior CPA (w/ Client OK)
• Assess Riskiness of the Client and Consider
  Avoiding the Riskiest Clients

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Risky Clients

• Key executives appear uncooperative or reputation
  for questionable integrity
• Financial problems
• Growing much faster than others in the industry
• Shopping for lowest price
• Refuse to sign engagement letter or management
  representation letter
• High IR and CR factors for fraud

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Overall Audit Planning Process
Decide whether or not to accept a prospective
client keep existing client
Initial Overall Audit Planning

• Establish an understanding with the client as to
  the nature of the engagement. (Engagement Letter)
• Develop an initial
• Audit strategy, plan or approach
• (Reliance on internal controls?)
• Audit Program
• (testing procedures nature, timing extent)

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Items 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 made to books and financial
  statements are not material)
• Auditor Responsibilities
• Conducting an audit in accordance with GAAS or
  PCAOB Stds
• Obtaining an understanding of internal control to
  plan audit and to determine the nature, timing
  and extent of procedures
• Making communications required by GAAS or PCAOB
  Stds

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Engagement Letter Items (cont)

• Arrangements Regarding
• Conduct of the audit (e.g., timing, client
  assistance)
• Use of specialists or internal auditors
• Obtaining information from predecessor auditors
  (if not done)
• 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.
• SAS 89 Management confirms immateriality of
  unrecorded misstatements.
• SAS 99 Management to share knowledge on fraud.

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Overall Audit Planning Process
Decide whether or not to accept a prospective
client keep existing client
Obtain Understanding of the Client, its
Environment, including Internal Controls
Initial Overall Audit Planning

• Primary Sources
• Inquiries of Mgmt and Client Policies
  Procedures
• Tour client facilities
• AICPA Audit Accounting Guides
• Internet several text problems(6-36)
• Library
• Industry Associations
• Prior F.S. and Annual Reports
• Analytical Procedures

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Understanding the Clients Business - Nature of
the Client

• Clients competitive position
• Organizational structure
• Accounting policies and procedures
• Ownership Capital structure
• Product and service lines
• Critical business processes
• Overall internal control structure

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Understanding the Clients Business - Nature of
the Client (cont)

• Product differentiation
• Cost leadership
• ObjectivesOverall plans
• Operating and financial strategies - Operational
  actions to achieve objectives
• Business risks - Threats to achieving objectives

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Understanding the Clients BusinessIndustry,
Regulatory, and Other Factors

• Industry competitive environment
• Supplier and customer relationships
• Technology developments
• Major laws and regulations
• Industry economic conditions

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Overall Audit Planning Process
Decide whether or not to accept a prospective
client keep existing client
Obtain Understanding of the Client, its
Environment, including Internal Controls
Initial Overall Audit Planning
Assess Misstatement Risks (IR CR) (including
fraud risks)
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Assess the Risks ofMaterial Misstatement (IR
CR)

• Overall Approach
• What could go wrong?
• How likely will it go wrong?
• What are the likely amounts involved?
• Consider Particularly
• Inherent risks
• Control Risks
• Risks of material misstatement due to fraud
  (fraud risks)

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Assessing Fraud Risks

• Two Types
• Fraudulent Financial Reporting
• Misappropriation of Assets (Defalcations)
• Procedures to Assess Fraud Risks
• Discussion among engagement team
• Inquiries of management and other personnel
• Planning analytical procedures
• Considering existence of fraud risk factors
• Incentives
• Opportunity
• Attitude

Chapter Appendix 6B
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Assessing Fraud Risks (cont)

• Assessing Extent of Fraud Risks
• Type of risk
• Significance of accounts impacted
• Likelihood that it could result in a material
  misstatement
• Pervasiveness

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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 (Dont be
  predictable)
• 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 business rationale for significant
  unusual transactions

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Overall Audit Planning Process
Decide whether or not to accept a prospective
client keep existing client
Obtain Understanding of the Client, its
Environment, including Internal Controls
Initial Overall Audit Planning
Develop Further Audit Procedures (Tests of
Controls Substantive Tests)
Assess Misstatement Risks (IR CR) (including
fraud risks)
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Designing Further Audit Procedures

• Types of Tests
• Tests of Controls for Placed in Operations
  Operating Effectiveness IF Reliance is Desired
• Substantive Tests
• Analytical Procedures to Assess Balance as to
  Reasonableness/Fairness
• Tests of Details of Balances or Transactions
• Audit Procedures (chapter 5)
• Inspection, Observation, Inquiry, Confirmation,
  Recalculation Reperformance

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Further Audit Procedures

• Procedures should be linked with the assessed
  risks of material misstatement at the relevant
  assertion level.
• When assessed risks of material misstatement are
  high, include
• Heightened professional skepticism
• Assigning more experienced staff
• Assigning staff with specialized skills
• Providing more supervision

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Overall Audit Planning Process
Decide whether or not to accept a prospective
client keep existing client
Obtain Understanding of the Client, its
Environment, including Internal Controls
Initial Overall Audit Planning
Develop Further Audit Procedures (Tests of
Controls Substantive Tests)
Tweaking the Audit Plan During Further Audit
Procedures
Assess Misstatement Risks (IR CR)
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Audit Documentation-Planning

1. Discussion of the Audit Team concerning the risk
   of material misstatements due to the error or
   fraud,
2. Key Elements of Understanding of the Entity its
   Environment,
3. Assessment of Risk of Material Misstatement at
   both the financial statement level and at the
   relevant assertion level, and
4. Risks Identified.

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Documenting Planning Fraud Risks

• Discussion among engagement team personnel about
  fraud risks,
• Procedures performed to identify fraud risks,
• Fraud risks identified and the auditors response
  to those risks,
• Any other conditions that caused the auditors to
  perform additional fraud-related procedures
• and
• Nature of any communications made to mgmt, audit
  committee, or others about fraud.

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Documenting Plannings Effect

• After the audit procedures have been performed,
  the auditors should document
• The auditors overall responses to address the
  assessed risk of misstatement at the financial
  statement level.
• The nature, timing, and extent of further audit
  procedures performed.
• The linkage of those procedures with the assessed
  risks at the relevant assertion level.
• The results of the audit procedures.
• The conclusions reached with regard to the use of
  audit evidence about the operating effectiveness
  of controls that was obtained in a prior audit.

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Materiality

• 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.
• Source FASBs Statement of Financial
  Accounting Concepts No. 2.

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Materiality Terminology

• Material
• Tolerable Misstatement
• Individually
• Significant Item

• At the F.S. /Account Level
• At the Assertion Level
• At the Transaction Level

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Materiality and F.S. Users

• Users are assumed to
• Have an appropriate knowledge of business,
  economic activities accounting and a
  willingness to study the information in the F.S.
  with an appropriate diligence,
• Understand that F.S. are prepared and audited to
  levels of materiality,
• Recognize the uncertainties inherent in the
  measurement of amounts based on the use of
  estimates, judgment, and the consideration of
  future events and
• Make appropriate economic decisions on the basis
  of the information in the financial statements.

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What is a Misstatement?

• Inaccuracy in gathering or processing data from
  which F.S. are prepared. (in maintaining
  accounting records or preparing F.S.)
• Difference between the amount, classification, or
  presentation of a reported F.S. element, account,
  or item and that would have been reported under
  GAAP. (Violation of GAAP)
• Omission of a F.S. element, account, or item or
  F.S. disclosure.
• F.S. Disclosure that is not presented in
  conformity with GAAP.
• Incorrect accounting estimate. (errors in
  computing)
• Managements Judgments concerning an accounting
  estimate or the selection or application of
  accounting policies that the auditor considers
  unreasonable or inappropriate.

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Timing of the Audit Work

• Interim Final
• Consider Substantive
  Substantive Planning Test ICS
  Tests Tests I____________________
  ______I_________I
• Beg of
  End of Last
• FY
  FY Audit
• I ---------------------Interim
  Period---------------I Field Work
  

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Category of Audit Steps

• Planning
• Initial Planning of the Audit
• Obtain an Understanding of the Client, its
  Environment and the Clients Internal Controls
• Assess Risks of Material Misstatements Design
  Further Audit Procedures
• (Tests of Controls and Substantive Tests)
• Perform Test of Controls, if appropriate (chapter
  7)
• Perform Substantive Tests of Balances,
  Transactions Disclosures
• Complete the Audit (Final Tests after Yearend)
  (chapter 16)
• Form an Opinion Issue the Audit Report (chapter
  17)

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Direction of Audit Testing
Test for Completeness
Start
Finish
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Directional Testing

• Relates to testing existence/occurrence and
  completeness assertions.
• Audit conclusions relate only to the universe
  from which sample is taken.
• To test completeness, we go in direction of the
  normal accounting transaction recording.
• (e.g., From source documents to the recording
  in journals and ledgers.)
• To test existence, we go in opposite direction.
• (e.g., From the recording in journals and
  ledgers to source documents.)

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Tests for Existence (Validity)(to detect F.S.
overstatements)

• Source Documents Recording
• To Detect Overstated or False Sales
• Go To Sample From
• Sales Invoice Sales Journal
• Sales Order
• Bill of Lading
• To Detect Nonexistent PPE
• Go To Sample From Invoice PPE Sub
  Ledger
• Observations

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Tests for Existence (Validity)(to detect F.S.
overstatements)

• Source Documents Recording
• To Detect Overstated Purchases
• Go To Sample From
• Receiving Reports Purchases Journal
• To Detect Nonexistent Employees/Salaries
• Go To Sample From
• HR Records Payroll Register
• Observations

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Tests for Completeness(to detect F.S.
understatements)

• Source Documents Recording
• To Detect Understated Sales
• Sample From Go To
• Sales Invoices Sales Journal
• Sales Orders
• Bills of Lading
• To Detect Unrecorded Liabilities
• Sample From Go To
• Receiving Reports Purchases Journal
• Vendor Invoices