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Chapter 3: Audit Planning, Types of Audit Tests, and Materiality

The three phases of an Audit that Relate to Audit Planning
1). Client acceptance and continuance
2). Preliminary engagement activities
3). Plan the audit
Prospective Client Acceptance
1). Obtain and review financial information
2). Inquire of third parties regarding client integrity
3). Communicate with the predecessor auditor
4). Consider unusual business or audit risks.
5). Determine if the firm is independent
6). Determine if the firm has the necessary skills and knowledge
7). Determine if acceptance violates any applicable regulatory agency requirements or the Code of Professional Conduct
Continuing Client Retention
1) evaluate periodically near the completion of an audit or when some significant event occurs
2). Conflicts over accounting and auditing issues or disputes over fees may lead to disassociation
Preliminary Engagement Activities
1). Determine the audit engagement team requirements
2). Ensure the audit team and audit firm are in compliance with ethical requirements, including independence
3). establishing an understanding with the client
The engagement letter
The engagement letter formalizes the arrangement reached between the auditor and the client. it may include:
1) specialists or internal auditor
2) limitation of liabilities
3) additional services to be provided
4) arrangements regarding other services
Internal Auditors
Competence: relates to professional experience, policies, performance
Objectivity: responsible for the internal audit function; policies to maintain internal auditor objectivity about the area audited.
The Audit Committee
1) it is the subcommittee of the board of directors
2) No specific requirements for privately held companies
3) Section 301 of Sarbanes--Oxley Act requirements relates to public held companies:
a. member of board of director and independent
b. directly responsible for overseeing work of any registered public accounting firm employed by the company
c. must preapprove all audit and nonaudit services provided by its auditors
d. must establish procedures to follow for complaints
e. must have authority to engage independent counsel
Planning the Audit
1) develop an overall audit strategy--help the auditor to determine what resources are needed to perform the engagement
2) audit plan is more detailed than strategy--nature, timing, and extent of planned audit procedures performed; should be conduced in effective and efficient manner
3) auditor gain an understanding of the entity, and preliminary engagement activities. additional steps:
business risks/materiality/multilocations/need for specialists/ possibility of illegal acts/ related parties/ additional value-added services
Asses Business Risks
1) to understand the client's business and transactions
2) to identify financial statement accounts likely to contain errors
by doing the two things above, the auditor can allocate more resources to investigate necessary accounts
Establish Materiality
establish planning (overall) materiality:
1) establish tolerable misstatement for specific accounts
2) establish tolerable misstatement for classes of transactions
Consider Multilocations or Business Units
Consolidated financial statements:
1) high risk 2)moderate risk 3)low risk
the auditor correlates the amount of audit attention devoted to the location or business unit with the level of risk present
Assess the Need tof Specialists
A major consideration in planning the audit is the need for a specialist:
1) expertise for finance, tax, valuation, pension, and IT
2) auditor is still ultimately responsible for work performed by the specialist--competence and objectivity
Assess the possibility of illegal Acts
1) direct and material effect: consider laws and regulations as part of audit
2) indirect and material effect: be aware may have occurred; investigate if brought to attention
Illegal Acts
1) unauthorized transactions
2) unusual fines/penalties
3) violations of laws/regulations
4) large payments
5)unexplained payments
6)failure to file tax returns or pay government duties
Identify Related Parties
1) review board minutes
2) review conflict-of-interest statements
3) review transactions wit major customers, suppliers, borrowers and lenders
4) review large, unusual, or nonrecurring transactions especially at year end
5) review loan agreements for guarantees
Additional Value-Added Services
1) tax planning
2) system design and integration
3) internal reporting
4) risk assessment
5) benchmarking
6) electronic commerce
Auditors who audit public companies are limited in the types of consulting services that they can offer their audit clients
Document Audit Strategy and Plan
1) document overall audit strategy and audit plan, which involves documenting the decision about natur, timing, extent
2) audit documents how the client is managing its risk (via internal control processes) and the effects of the risks and controls on the planned audit procedures
3) auditors ensure they have addressed the risks they identified by documenting the linkage from client's business, objectives, and strategy to the audit plan
4) the auditor's preliminary decision concerning control risk determines the level of control testing, which in turn affects the auditor's substantive tests of the account balances and transactions
Supervision of the Audit
engagement partner and other supervisory members of the team:
1) inform engagement team members of their responsibilities
2) direct engagement team members to identify and communicate audit issues
3) review the work of the engagement team members
Types of Audit Tests
1) Risk assessment procedures--used to obtain an understanding of the entity and its environment, including its internal control
2) Tests of Controls--directed toward the evaluation of the effectiveness of the design and operation of internal controls
3) Substantive procedures--detect material misstatements in a transaction class, account balance, and disclosure component of the financial statement
Tests of controls
1) inquiry
2) inspection
3) observation
4) walkthrough-transactions
5) reperformance
Substantive Procedures
1) tests of details-tests for errors or fraud in individual transactions, account balances, and disclosures
2) analytical procedures-obtains evidential matter about particular assertions related to account balances or classes of transactions
Dual-purposes tests
both tests of controls and substantive tests of transactions
The magnitude of an omission or misstatement of accounting information that makes it probable that the judgement of a reasonable person relying on the information would be changed or influenced by the omission or misstatement
materiality is not an absolute and it is not black/white issue. the determination of materiality requires professional judgement
Steps in Applying Materiality on an Audit
1. determine a materiality level of the overall financial statements (planning materiality)
2. determine tolerable misstatement (allocation of materiality at individual account/class of transactions level)
3. evaluate auditing findings (near the end of audit)
Step 1: Determine overall materiality
quantitative based for materiality is a % of :income; total assets; total revenues; GP
the quantitative amounts may be adjusted lower for qualitative factors:
1) material misstatements in prior years
2) potential for fraud or illegal acts
3) potential loan covenant violations
4) high market pressures
5) high fraud risk
6) higher than normal risk of bankruptcy
Step 2: Determine Tolerable Misstatement
The amount of planning materiality allocated to an account or class of transactions. combined tolerable misstatement is generally greater than planning materiality because
1) not all accounts will be misstated by their full tolerable misstatement allocation
2) audits of individual accounts are conducted simultaneously
3) when errors are identified, additional testing is typically performed in that account and related accounts
4) overall materiality serves as a "safety net"
Evaluate Audit Findings
1) aggregate misstatements from each account or class of transactions (including known and likely misstatements)
2) considers the effect of misstatements not adjusted in the prior period
3) compares the aggregate misstatement to planning materiality
4) if the aggregate misstatement is less than planning materiality, the auditor can conclude that the financial statements are fairly presented, if not, an adjustment should be made