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Chapter 6

Chapter 6. Audit Planning, Understanding the Client, Assessing Risks, and Responding. PACBO 2 nd Standard of Field Work.

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Chapter 6

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  1. Chapter 6 Audit Planning, Understanding the Client, Assessing Risks, and Responding

  2. 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.

  3. Overall Audit Planning Process Decide whether or not to accept a prospective client; keep existing client

  4. 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

  5. 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

  6. 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)

  7. 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

  8. Engagement Letter Items (con’t) • 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.

  9. 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

  10. 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

  11. 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

  12. 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

  13. 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)

  14. 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)

  15. 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

  16. 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

  17. 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(Don’t 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

  18. 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)

  19. 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

  20. 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

  21. 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)

  22. Audit Documentation-Planning • Discussion of the Audit Teamconcerning the risk of material misstatements due to the error or fraud, • Key Elements of Understanding of the Entity & its Environment, • Assessment of Risk of Material Misstatementat both the financial statement level and at the relevant assertion level, and • Risks Identified.

  23. Documenting Planning – Fraud Risks • Discussion among engagement team personnel about fraud risks, • Procedures performed to identify fraud risks, • Fraud risks identified and the auditor’s 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.

  24. Documenting Planning’s 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.

  25. 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.

  26. Material Tolerable Misstatement Individually Significant Item – At the F.S. /Account Level – At the Assertion Level – At the Transaction Level Materiality Terminology

  27. 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.

  28. 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.

  29. Timing of the Audit Work Interim Final Consider & Substantive SubstantivePlanning Test ICS Tests Tests I__________________________I_________I Beg of End of Last FY FY Audit I ---------------------Interim Period---------------I Field Work

  30. Category of Audit Steps • Planning: • Initial Planning of the Audit • Obtain an Understanding of the Client, its Environment and the Client’s 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)

  31. Test for Existence Finish Start Source Documents Journals Ledgers Direction of Audit Testing Test for Completeness Start Finish

  32. Directional Testing • Relates to testingexistence/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.)

  33. Tests for Existence(Validity)(to detect F.S. overstatements) Source DocumentsRecording To Detect Overstated or False Sales Go To Sample From Sales Invoice Sales Journal Sales Order Bill of Lading To Detect Nonexistent PP&E Go To Sample From Invoice PP&E Sub Ledger Observations

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

  35. Tests for Completeness(to detect F.S. understatements) Source DocumentsRecording To Detect Understated Sales Sample From Go To Sales Invoices Sales Journal Sales Orders Bills of Lading To Detect Unrecorded Liabilities Sample FromGo To Receiving Reports Purchases Journal Vendor Invoices

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