Chapter 06

Audit Planning, Understanding the Client, Assessing Risks, and Responding

McGraw-Hill/Irwin
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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Submit a proposal
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Contact the audit committee Make fee arrangements 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

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Communicate with the predecessor auditor

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Overall procedure is important for evaluation of management integrity

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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.

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!!Establish
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an understanding with the client

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Name of the entity Management responsibilities

"! "! "! "! "!

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
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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 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
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Auditor responsibilities
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!! Arrangements
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regarding

!!Develop

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
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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
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!! 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.

!! Competitive

position structure !! Accounting policies and procedures !! Ownership !! Capital structure !! Product and service lines !! Critical business processes !! Internal control
!! Organizational
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Competitive environment Supplier and customer relationships !! Technology developments !! Major laws and regulations !! Economic conditions !! Attractiveness of the industry
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!!ObjectivesOverall !!Operating

Barriers to entry Strength of competitors Bargaining power of suppliers of raw materials and labor Bargaining power of customers
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plans and financial strategies Operational actions to achieve objectives !!Business risksThreats to achieving objectives

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!!Budgets !!Key

!!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

performance indicators analysis !!Segment performance reports !!Balanced scorecard !!External parties
!!Variance

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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
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"!

!!Use

professional judgment and based on reasonable person !!Considers both

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Quantitative and qualitative factors

!!Materiality
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used in

Planning the audit

! At the overall financial statement level ! Allocate to individual accounts

Ex. www.fasb.org, web pages for company

Tour of plant and offices !! Analytical procedures !! The statement of cash flows and obtaining an understanding of the client
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Evaluating audit findings

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!! 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. 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.

!!Overall
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approach

What could go wrong? "! How likely is it that it will go wrong? "! What are the likely amounts involved?
!!Particularly
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!! PCAOB

consider

Inherent risks "! Risks of material misstatement due to fraud (fraud risks)
!!Design
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further audit procedures

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!! Two
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types
!!Considerations
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Fraudulent financial reporting (management fraud) Misappropriation of assets (defalcations)

in identifying fraud risks

!! Procedures
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to assess fraud risks

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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
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Type "! Significance "! Likelihood that it will result in a material misstatement "! Pervasiveness

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Overall response
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Professional skepticism and audit evidence Assigning personnel and supervision Accounting principles Predictability of auditing procedures More reliable evidence Shifting timing to year end Increasing sample sizes Examining journal entries Review accounting estimates for biases Evaluating the business rationale for significant unusual transactions

!!Evaluating !!Discovery
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the results of audit tests of fraud

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Alterations in audit procedures

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Response to the possibility of management override

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Communication to appropriate level of management "! If fraud involves senior management or material misstatement communicate to audit committee

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!! Types
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Further audit procedures should include

"! "!

Tests of controls Analytical procedures Tests of details of transactions and balances

Substantive procedures for all relevant assertions Tests of controls when the auditors risk assessment includes an expectation that controls are operating effectively, or when substantive procedures alone are not sufficient

!! Audit
"! "! "! "! "! "!

procedures

Inspection Observation Inquiry Confirmation Recalculation Reperformance

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Procedures should be linked with the assessed risks of material misstatement at the relevant assertion level !! Overall responses when assessed risks of material misstatement are high
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Heightened professional skepticism Assigning more experienced staff Assigning staff with specialized skills Providing more supervision
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!! Audit
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Documentation

Risk assessment
! Discussion of the audit team, elements of understanding, assessment of risk of material misstatement and risks identified

!!A trail

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Procedure results
! Overall responses, nature, timing and extent of further audit procedures, linkage of procedures with assessed risks, results of audit procedures, conclusions reached about operating effectiveness of controls, significant risk identified, circumstances in which substantive procedures alone will not provide sufficient evidence

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Consideration of fraud
! Similar to risk assessment as document discussion, procedures used to identify fraud risks, fraud risk and response, any other conditions that caused fraud-related procedures and communications with management or audit committee.

of evidence that links source documents, journal entries and ledger entries !!Auditor may follow the audit trail in either of two directions related to the direction of testing
"! "!

Test for existence or occurrence Test for completeness

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Direction of Audit Testing

!!Auditors

consideration of internal control is often organized around clients major transaction cycles (examples)
Revenue cycle Acquisition cycle "! Conversion cycle "! Payroll cycle "! Investing cycle "! Financing cycle
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Transactions Affecting Accounts Receivable

!!Systems
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portion

Deals with clients internal control "! Evidence of test of controls and assessing control risk
!!Substantive
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test portion

Deals with financial statement account balances "! Indirect and direct verification of income statement accounts
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Establish the existence of assets Establish that the company has rights to the assets !! Establish the completeness of recorded assets !! Verify the cutoff of transactions !! Determine the appropriate valuation of the assets and accuracy of related transactions !! Determine the appropriate financial statement presentation and disclosure of the assets
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