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Chapter 6Audit 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 statementsEstablishing effective internal control over financial reportingCompliance with laws and regulationsMaking records available to the auditorsProviding 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 ResponsibilitiesConducting an audit in accordance with GAAS or PCAOB StdsObtaining an understanding of internal control to plan audit and
to determine the nature, timing and extent of proceduresMaking communications required by GAAS or PCAOB Stds
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Engagement Letter Items (con’t)
Arrangements RegardingConduct of the audit (e.g., timing, client assistance)Use of specialists or internal auditorsObtaining information from predecessor auditors (if not done)Fees and billingOther 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
Initial Overall Audit Planning
Obtain Understanding of the Client, its Environment, including Internal Controls
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 Client’s Business - Nature of the Client
Client’s 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 Client’s Business - Nature of the Client (con’t)
Product differentiation
Cost leadership
Objectives—Overall plans
Operating and financial strategies - Operational actions to achieve objectives
Business risks - Threats to achieving objectives
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Understanding the Client’s 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
Initial Overall Audit Planning
Obtain Understanding of the Client, its Environment, including Internal Controls
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 ParticularlyInherent risksControl RisksRisks of material misstatement due to
fraud (fraud risks)
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Assessing Fraud Risks
Two TypesFraudulent Financial Reporting Misappropriation of Assets (Defalcations)
Procedures to Assess Fraud RisksDiscussion among engagement team Inquiries of management and other personnelPlanning analytical proceduresConsidering existence of fraud risk factors
1. Incentives2. Opportunity3. Attitude
Chapter Appendix 6B
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Assessing Fraud Risks (con’t)
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 ResponseProfessional skepticism and audit evidenceAssigning personnel and supervisionAccounting principlesPredictability of auditing procedures
Alterations in Audit Procedures (Don’t be predictable)More reliable evidenceShifting timing to year endIncreasing sample sizes
Response to the Possibility of Management OverrideExamining journal entriesReview accounting estimates for biasesEvaluating 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
Initial Overall Audit Planning
Obtain Understanding of the Client, its Environment, including Internal Controls
Assess Misstatement Risks (IR & CR)
(including fraud risks)
Develop Further Audit Procedures (Tests of Controls
& Substantive Tests)
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Designing Further Audit Procedures
Types of TestsTests 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 skepticismAssigning more experienced staffAssigning staff with specialized skillsProviding more supervision
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Overall Audit Planning Process
Decide whether or not to accept a
prospective client;keep existing client
Initial Overall Audit Planning
Obtain Understanding of the Client, its Environment, including Internal Controls
Assess Misstatement
Risks (IR & CR)
Develop Further Audit Procedures (Tests of Controls & Substantive
Tests)
Tweaking the Audit Plan During Further Audit Procedures
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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
1. Discussion among engagement team personnel about fraud risks,
2. Procedures performed to identify fraud risks,
3. Fraud risks identified and the auditor’s response to those risks,
4. Any other conditions that caused the auditors to perform additional fraud-related procedures
and
5. Nature of any communications made to mgmt, audit committee, or others about fraud.
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Documenting Planning’s Effect
After the audit procedures have been performed, the auditors should document:1. The auditors’ overall responses to address the assessed
risk of misstatement at the financial statement level.
2. The nature, timing, and extent of further audit procedures performed.
3. The linkage of those procedures with the assessed risks at the relevant assertion level.
4. The results of the audit procedures.
5. 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: FASB’s 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)
Management’s 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
1. Planning: Initial Planning of the Audit
Obtain an Understanding of the Client, its Environment and the Client’s Internal Controls
2. Assess Risks of Material Misstatements & Design Further Audit Procedures (Tests of Controls and Substantive Tests)
3. Perform Test of Controls, if appropriate (chapter 7)
4. Perform Substantive Tests of Balances, Transactions & Disclosures
5. Complete the Audit (Final Tests after Yearend) (chapter 16)
6. Form an Opinion & Issue the Audit Report (chapter 17)
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Direction of Audit Testing
Finish StartTest for Existence
Source Source DocumentsDocuments
JournalsJournals LedgersLedgers
Start FinishTest for Completeness
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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 RecordingTo Detect Overstated or False Sales
Go To Sample FromSales Invoice Sales JournalSales Order
Bill of Lading
To Detect Nonexistent PP&E Go To Sample From Invoice PP&E Sub LedgerObservations
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Tests for Existence (Validity)
(to detect F.S. overstatements)
Source Documents RecordingTo Detect Overstated Purchases
Go To Sample FromReceiving Reports Purchases Journal
To Detect Nonexistent Employees/Salaries Go To Sample From
HR Records Payroll RegisterObservations
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Tests for Completeness
(to detect F.S. understatements)
Source Documents RecordingTo Detect Understated Sales
Sample From Go ToSales Invoices Sales JournalSales OrdersBills of Lading
To Detect Unrecorded Liabilities Sample From Go To Receiving Reports Purchases JournalVendor Invoices