planning the audit; designing audit programs · pdf file6-3 the audit process--steps after...

Audit Planning,
Understanding the
Client, Assessing
Risks, and
Responding
Chapter 06
McGraw-Hill/Irwin Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

6-2
Obtaining Clients
Submit a proposal Contact the audit committee
Make fee arrangements
Communicate with the predecessor auditor Topics
Integrity of management
Disagreements over accounting principles
Communications to those charged with governance regarding fraud and noncompliance with laws
Communication to management and those charged with governance concerning internal control significant deficiencies and material weaknesses.
Predecessors understanding of reason for change of auditors
Other
Overall procedure is important for evaluation of management integrity

6-3
The Audit Process--
Steps
After obtaining a client, the audit process includes:
1. Plan the audit
2. Obtain an understanding of the client and its environment, including internal control
3. Assess the risks of material misstatement and design further audit procedures
4. Perform further audit procedures
5. Complete the audit
6. Form an opinion and issue the audit report
This chapter emphasizes obtaining a client and steps 1-3.

6-4
Stages of an
Audit--Diagram

6-5
1. Plan the Audit
Establish an understanding with the client
This is ordinarily accomplished through use of
an engagement letter
Related, determine that
The firm meets professional independence
requirements
There are no issues relating to management
integrity
The client understands the terms of the
engagement

6-6
Items Included 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 recorded to the financials are not material
Auditor responsibilities Conducting an audit in accordance with GAAS
Obtaining an understanding of internal control to plan audit and to determine the nature, timing and extent of procedures
Making communications required by GAAS

6-7
Engagement Letters--Optional Items
Arrangements regarding Conduct of the audit (e.g., timing, client assistance)
Use of specialists or internal auditors
Obtaining information from predecessor auditors
Fees and billing
Other services to be provided, such as examination of internal control over financial reporting
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

6-8
Audit PlanningOverall
Develop an overall audit strategy and an audit plan
Plan use of clients staff
Plan involvement of other CPAs
Arrange for specialists
On first year audits:
Communicate with predecessor auditors
Establish opening balances on the financial statements

6-9
2. Obtain an Understanding of the
Client and its Environment
Perform risk assessment procedures, including
Inquiries of management and others within the entity
Analytical procedures
Observation and inspection relating to client activities,
operations, documents, reports and premises.
Other procedures, such as inquiries of others outside the
company (e.g., legal counsel, valuation experts) and
reviewing information from external sources such as
analysts, banks, rating organizations, journals.

6-10
Understanding the Clients
BusinessNature of the Client
Competitive position
Organizational structure
Accounting policies and procedures
Ownership
Capital structure
Product and service lines
Critical business processes
Internal control

6-11
Understanding the Clients Business,
Industry, Regulatory, and Other Factors
Competitive environment
Supplier and customer relationships
Technology developments
Major laws and regulations
Economic conditions
Attractiveness of the industry
Barriers to entry
Strength of competitors
Bargaining power of suppliers of raw materials and labor
Bargaining power of customers

6-12
Understanding the Clients Business
Objectives, Strategies & Business Risks
ObjectivesOverall plans
Operating and financial strategies
Operational actions to achieve
objectives
Business risksThreats to achieving
objectives

6-13
Measuring and Reviewing Performance
Budgets
Key performance indicators
Variance analysis
Segment performance reports
Balanced scorecard
External parties

6-14
Internal Control
Need knowledge and understanding of
how a clients internal control works:
What controls exists
Who performs them
How various types of transactions are
processed and recorded
What accounting records and supporting
documentation exist

6-15
Understanding the Clients
BusinessSources of Information
Inquiries of management
Industry Accounting and Auditing Guides
Industry Risk Alerts
Trade journals and news stories
Government publications
Prior company annual reports and SEC filings
Prior tax returns
Electronic sources Ex. www.fasb.org, web pages for company
Tour of plant and offices
The statement of cash flows and obtaining an understanding of the client
http://www.fasb.org/

6-16
Determining Materiality
Use professional judgment and based on
reasonable person
Considers both
Quantitative and qualitative factors
Materiality used in
Planning the audit
At the overall financial statement level
Allocate to individual accounts
Evaluating audit findings

6-17
Materiality Definitions
FASB (included in SASs)The magnitude of an omission or misstatement of financial information that, in the light of surrounding circumstances, makes it probable that he judgment of a reasonable person relying on the information could have been changed or influenced by the omission or misstatement.
PCAOB interpretation of federal securities lawsA fact is material if there is a substantial likelihood that the fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available.

6-18
3. Assess the Risks of Material Misstatement and
Design Further Audit Procedures
Overall approach
What could go wrong?
How likely is it that it will go wrong?
What are the likely amounts involved?
Particularly consider
Inherent risks
Risks of material misstatement due to fraud (fraud risks)
Design further audit procedures

6-19
Assessing Fraud Risks
Two types Fraudulent financial reporting (management fraud)
Misappropriation of assets (defalcations)
Procedures to assess fraud risks Discussion among engagement team
Inquiries of management and other personnel
Risk assessment analytical procedures (to aid in planning the audit)
Considering fraud risk factors
Incentives
Opportunity
Attitude

6-20
Assessing Fraud Risks
Identifying Fraud Risks
Considerations in identifying fraud risks
Type
Significance
Likelihood that it will result in a material
misstatement
Pervasiveness

6-21
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
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 the business rationale for significant unusual transactions

6-22
Consideration of Fraud
Throughout the Audit
Evaluating the results of audit tests
Discovery of fraud
Communication to appropriate level of
management
If fraud involves senior management or
material misstatement communicate to
audit committee

6-23
(1/2) Types
Tests of controls
Tests of details of transactions and balances
Audit procedures Inspection
Observation
Inquiry
Confirmation
Recalculation
Reperformance

6-24

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