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Chapter 3Chapter 3Audit Planning, Audit Planning, Types of Audit Types of Audit
Tests, and Tests, and MaterialityMateriality
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
The Phases of an Audit That Relate to The Phases of an Audit That Relate to Audit PlanningAudit Planning
LO# 1
3-2
Prospective Client AcceptanceProspective Client Acceptance1. 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.
LO# 1
3-3
ContinuingContinuing ClientClient RetentionRetention
Evaluate client retention periodically
Near audit completion or after a significant
event
Conflicts over accounting and auditing issues
Dispute over fees
LO# 1
3-4
Preliminary Engagement ActivitiesPreliminary Engagement Activities
Determine the Audit Engagement Team
Requirements
Assess Compliance with Ethical Requirements,
Including Independence
LO# 2
3-5
EstablishEstablish Terms of the Terms of the EngagementEngagement
The terms of the engagement, which are documented in the engagement letter, should include the objectives of
the engagement, management’s responsibilities, the auditor’s responsibilities, and the limitations of the
engagement.
Who signs the engagement letter?
In establishing the terms of the engagement, three topics must be discussed:
1.The engagement letter;
2.Using the work of the internal auditors; and
3.The role of the audit committee.
LO# 3
3-6
The Engagement LetterThe Engagement LetterThe engagement letter formalizes the arrangement reached
between the auditor and the client.
In addition to the items mentioned in the sample engagement letter in Exhibit 3-1 in the textbook, the engagement letter may
include:
• Arrangements for use of specialists or internal auditors.
• Any limitations of liability of the auditor or client.
• Additional services to be provided.
•Arrangements regarding other services.
LO# 4
3-7
Internal AuditorsInternal AuditorsLO# 5
3-8
The Audit CommitteeThe Audit Committee
Subcommittee of the board of
directors
No specific requirements for privately
held companies
Section 301 of Sarbanes-Oxley Act requires the following for audit committee members of
publicly held companies:
•Member of board of directors and independent.
•Directly responsible for overseeing work of any registered public accounting firm employed by the company.
•Must preapprove all audit and nonaudit services provided by its auditors.
•Must establish procedures to follow for complaints.
•Must have authority to engage independent counsel.
LO# 6
3-9
Planning the AuditPlanning the Audit• The auditor will develop an overall audit strategy for
conducting the audit. This will help the auditor to determine what resources are needed to perform the engagement.
• An audit plan is more detailed than the audit strategy.
• Basically, the audit plan should consider how to conduct the engagement in an effective and efficient manner.
LO# 7
3-10
Planning the AuditPlanning the AuditWhen preparing the audit plan, the auditor should be guided by the results of the client acceptance/continuance process, procedures performed to gain an understanding of the entity,
and preliminary engagement activities.
Additional steps:
•Assess business risks.
•Establish materiality.
•Consider multilocations.
•Assess the need for specialists.
•Assess the possibility of illegal acts.
•Identify related parties.
•Consider additional value-added services.
Let’s look at eachof these steps.
LO# 7
3-11
Assess Business RisksAssess Business Risks
To understand the client’s business and transactions
To identify financial statement accounts likely to
contain errors
By understanding the client’s business and identifying where errors are likely to occur, the auditor can allocate
more resources to investigate necessary accounts.
LO# 7
3-12
Establish planning (overall) materiality
Establish tolerable misstatement for specific accounts
Establish tolerable misstatement for
classes of transactions
LO# 7
Establish MaterialityEstablish Materiality
3-13
Consolidated Financial
Statements
High RiskModerate
Risk
LO# 7
Consider Multilocations or Business Consider Multilocations or Business UnitsUnits
Low Risk
The auditor correlates the amount of audit attention devoted to the location or business unit with the level of risk present.
3-14
Use of SpecialistsUse of Specialists
A major consideration in planning the audit is the need for a specialist.
The use of an IT specialist is a significant aspect of most audit engagements.
The presence of complex information technology
may require the use of an IT specialist.
LO# 7
What other types of specialists might be
needed?
3-15
Illegal ActsIllegal Acts
Illegal Acts
Direct and Material
Consider laws and regulations as part of audit
Material and Indirect
Be aware may have occurred;
investigate if brought to attention
LO# 7
3-16
Illegal ActsIllegal ActsLO# 7
3-17
Related PartiesRelated Parties
Some examples from FASB ASC Topic 850, “Related Party Disclosures”
•Affiliates of the enterprise.
•Entities using equity method to account for investments.
•Trusts for benefit of employees.
•Principal owners of enterprise.
•Management.
•Immediate families of the principal owners and management.
•Other parties that can have significant influence.
How to Identify Related Parties
•Review board minutes.
•Review conflict-of-interest statements.
•Review transactions with major customers, suppliers, borrowers,
and lenders.
•Review large, unusual, or nonrecurring transactions especially at year end.
•Review loan agreements for guarantees.
LO# 7
3-18
Additional Value-Added ServicesAdditional Value-Added Services
Tax PlanningSystem
Design and Integration
Internal Reporting
Risk Assessment
BenchmarkingElectronic Commerce
LO# 7
Auditors who audit public companies are limited in the types of consulting services that they can offer
their audit clients. 3-19
Document AuditDocument AuditStrategy and PlanStrategy and Plan
Nature
Timing
Extent
Auditors ensure they have addressed the risks they identified by documenting the linkage from the
client’s business, objectives, and strategy to the audit plan.
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.
LO# 7
Document overall audit strategy and audit plan, which involves documenting
the decisions about
The auditor 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.
A
U
D
I
T
T
E
S
T
S 3-20
Document Audit Strategy Document Audit Strategy LO# 7
3-21
Supervision of the AuditSupervision of the Audit• Engagement partner and other supervisory
members of the team:
• Inform engagement team members of their responsibilities
• Direct engagement team members to identify and communicate audit issues
• Review the work of the engagement team members
LO# 8
3-22
Types of Audit TestsTypes of Audit Tests
Risk Assessment Procedures
Used to obtain an understanding of the entity and its environment, including its internal control.
Tests of ControlsDirected toward the evaluation of the
effectiveness of the design and operation of internal controls.
Substantive Procedures
Detect material misstatements in a transaction class, account balance,
and disclosure component of the financial statements.
LO# 9
3-23
Tests of ControlsTests of Controls
Inquiry Inspection
Walkthrough Reperformance
Observation
LO# 9
3-24
Tests of ControlsTests of Controls
LO# 9
3-25
Substantive ProceduresSubstantive Procedures
Analytical Procedures
Obtains evidential matter about
particular assertions related to account
balances or classes of transactions
Tests of Details
Tests for errors or fraud in individual
transactions, account balances, and disclosures
LO# 9
3-26
Dual-Purpose TestsDual-Purpose Tests
Substantive Tests of
Transactions
Tests of Controls
Dual-Purpose
Tests
LO# 9
3-27
MaterialityMateriality
The magnitude of an omission or misstatement of accounting information that makes it probable that
the judgment of a reasonable person relying on the information would be changed or influenced
by the omission or misstatement.
The magnitude of an omission or misstatement of accounting information that makes it probable that
the judgment 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 a black or white issue!
The determination of materiality requires professional judgment.
LO# 10
3-28
Steps in Applying MaterialitySteps in Applying Materialityon an Auditon an Audit
Step 1: Determine a materiality level for the overall financial statements
(planning materiality)
Step 1: Determine a materiality level for the overall financial statements
(planning materiality)
Step 2: Determine tolerable misstatement
(allocation of materiality at individual account/class of transactions level)
Step 2: Determine tolerable misstatement
(allocation of materiality at individual account/class of transactions level)
Step 3:Evaluate auditing findings(near the end of the audit)
Step 3:Evaluate auditing findings(near the end of the audit)
LO# 11
3-29
Step 1 – Determine Overall Step 1 – Determine Overall MaterialityMateriality
The quantitative base formateriality is a percentage of:
• Income before taxes.
•Income from continuing operations.
•Three year average income.
•Total assets.
•Total revenues.
• Gross profit.
The quantitative base formateriality is a percentage of:
• Income before taxes.
•Income from continuing operations.
•Three year average income.
•Total assets.
•Total revenues.
• Gross profit.
The quantitative amountsmay be adjusted lower forqualitative factors such as:
• Material misstatements in prior years.
• Potential for fraud or illegal acts.
• Potential loan covenant violations.
• High market pressures.
• High fraud risk.
• Higher than normal risk of bankruptcy.
The quantitative amountsmay be adjusted lower forqualitative factors such as:
• Material misstatements in prior years.
• Potential for fraud or illegal acts.
• Potential loan covenant violations.
• High market pressures.
• High fraud risk.
• Higher than normal risk of bankruptcy.
LO# 11
3-30
Step 2 –Determine Tolerable Step 2 –Determine Tolerable MisstatementMisstatement
Tolerable misstatement is the amount of planning materiality allocated to an account or class of transactions. Combined tolerable misstatement is generally greater than planning materiality because: Not all accounts will be misstated by their full tolerable
misstatement allocation. Audits of individual accounts are conducted
simultaneously. When errors are identified, additional testing is typically
performed in that account and related accounts. Overall materiality serves as a “safety net.”
Tolerable misstatement is the amount of planning materiality allocated to an account or class of transactions. Combined tolerable misstatement is generally greater than planning materiality because: Not all accounts will be misstated by their full tolerable
misstatement allocation. Audits of individual accounts are conducted
simultaneously. When errors are identified, additional testing is typically
performed in that account and related accounts. Overall materiality serves as a “safety net.”
LO# 11
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Step 3 – Evaluate Audit Step 3 – Evaluate Audit FindingsFindings
When the audit evidence is gathered, the auditor: Aggregates misstatements from each account or class of
transactions (including known and likely misstatements). Considers the effect of misstatements not adjusted in the
prior period. Compares the aggregate misstatement to planning
materiality. 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.
When the audit evidence is gathered, the auditor: Aggregates misstatements from each account or class of
transactions (including known and likely misstatements). Considers the effect of misstatements not adjusted in the
prior period. Compares the aggregate misstatement to planning
materiality. 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.
LO# 11
3-32
End of Chapter 3End of Chapter 3
3-33
