CHAPTER TWO

Audit process and strategies

2. Audit planning Process
2.1 Steps in accepting an audit engagement
In performing a financial statement audit the external auditors attest management assertions to users. To
maintain the public confidence he/she has to discharge this professional responsibility with the highest
degree of objectivity, integrity and independence.
The first standard of fieldwork requires an auditor to adequately plan the audit. An audit is planned after
an engagement is accepted. Thus, the following three steps are involved in accepting an engagement:
1. Evaluating integrity of management
2. Assessing the auditor’s ability to conduct the audit in accordance with GAAS
3. Preparing an engagement letter

2.1.1 Evaluate integrity of management

Before accepting a new engagement, the auditor has to evaluate integrity of management. If
management lacks integrity, it is highly likely that financial statements be intentionally misstated. This in
turn increases the risk of issuing inappropriate opinion (issuing unqualified opinion while the financial
statements are materially misstated). For a new client the auditor may obtain information about the
integrity of management by communicating with predecessor auditor, and making inquiries to other third
parties. For an existing client the auditor should review his previous experience with the client
management.

The successor auditor should communicate with the predecessor auditor to asses and evaluate the
integrity of the management, disagreements with management concerning accounting principles, the
predecessor auditor’s understanding as to why there is a need to assigning another auditor. This helps the
successor auditor to decide to accept or reject the engagement.

The auditor should also gather information from third party like a legal advisor, the prospective client’s
bankers and from newsletters and other written materials to evaluate management integrity,

2.1.2 Assess ability to perform the audit in accordance with GAAS

The general standards require the audit to be performed with due professional care by technically
competent person with an independent mental attitude.

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Hence, the auditor should evaluate if there are factors that may affect the auditor’s independence. Since
the audit work should be performed with a highest level of competence, before deciding to accept the
engagement, the audit firm has to make sure as to the availability of an auditor with technical proficiency.

After gathering preliminary information, the auditor would decide either to accept or reject the
engagement
2.1.3 Prepare engagement letter
Once the engagement is accepted the auditor sends an engagement letter to the client stating the objective
of the audit, work to be performed by the client staff, the basis for determination of audit fee and the start
and completion of the audit work.
2.2 Planning the engagement
After the engagement is accepted the auditor has to plan the audit. An audit plan is an overview of the
engagement describing the characteristics of the client business operations and the overall audit strategy.
An audit plan is a high level description of the audit work to be performed in a certain period of time. It
includes the areas to be audited; the type of work planned the objectives and scope of the work and other
topics like budget, resource allocation schedule dates and other general aspects of the work.
Before beginning an auditing project, the work of the auditor should be planned in a manner appropriate
for meeting the audit objectives. As a part of the planning process auditors should obtain an
understanding of the organization and its processes. Auditors should also establish the scope of the audit
work and perform a preliminary assessment of internal control over the function being reviewed.
The nature of the organization and the level of detail at which the audit work is being performed
determine the knowledge of the organization and its processes required by the auditor.
The auditor may require specialized knowledge when dealing with unusual or complex operations. A
more extensive knowledge of the organization and its processes will ordinarily be required when the
audit objective involves a wide range of information system functions rather than when the objective are
for limited functions.

The auditor should gain an understanding of the types of events transactions and practices that can have a
significant effect on the specific organization function process or data that is the subject of the auditing
project. Knowledge of the organization should include the business, financial and inherent risks facing
the organization

The auditor should use this information in identifying potential problems, formulating the objectives and
scope of the work, performing the work and considering actions of management for which the auditor
should be alert.

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Audit plans differ in form and content among public accounting firms. But the following are included in
any form of audit plan
Description of the client business
a) Objectives of the audit
b) Time and schedule of the specific tasks to be performed by the auditor.
c) Work to be done by the client staff
d) Staff requirement during the engagement
e) Expected dates for completing the audit
An audit plan is drafted before starting the audit work but it may be modified throughout the audit
engagement. The components of audit planning and the sequence in which they are performed are shown
below.

Obtain understanding Obtain understanding

of client’s business of clients internal
and industry. control structure

Assess materiality Assess audit risk Identify audit

objectives

Design audit Schedule Assign professional staff

program the work to the engagement

2.3 Developing an overall audit strategy

After obtaining a thorough understanding of the client’s business, the auditor formulates an overall audit
strategy for the engagement at hand. In planning an audit, auditors should carefully consider the
appropriate levels of materiality and risk.

2.3.1 Materiality
In the planning process, the auditor should ordinarily establish levels of planning materiality such that the
audit work will be sufficient to meet the audit objectives and will use audit resources efficiently. For
example, in the review of an existing system the auditor will evaluate materiality of the various
components of the system in planning the audit program for the work to be performed. The auditor
should consider both qualitative and quantitative aspects in determining materiality.

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The main purpose of an audit is to express an opinion on the truth and fairness of the financial
statements. The concept of materiality affects the nature and size of audit tests. The auditor designs audit
procedures to verify if financial statement items are free of material error and irregularities.

In financial statement audit, due to cost and time only selected transactions are examined. This implies
accepting errors in the financial statements to remain undetected. However even 100% checking does not
guarantee 100% accuracy. Therefore, either the whole transactions or selected transaction checked there
is certain level of risk. Hence, the auditor’s main concern in financial statement audit is to minimize risk
and to ensure that no material error remains undetected.

Materiality and audit risk are related .Both must be considered in the planning stage so as to determine
the extent, timing and nature of the examination.

For planning purposes, materiality is the auditor’s preliminary estimate of the smallest amount of
misstatements that would affect the judgment of a reasonable person relying up on the financial
statements. Assessing the level of materiality of misstatement would help auditors to appropriately
modify their opinions whenever there are material deficiencies in the client’s financial statements.
However, they may issue unqualified report if the deficiencies are immaterial.

Assessing level of materiality of misstatements in financial statement items means evaluating as to

whether the financial statements contain material misstatement or not. The financial statements are
management assertions and they contain the following five management assertions.
1. Existence or occurrence
Assets liabilities and owners’ equity reflected in the financial statement exist: the recorded
transactions have occurred.
2. Completeness
All transactions, assets, liabilities and owners’ equity that should be presented in the financial
statements is included
3. Rights and obligations:
The client has rights to assets and obligations to pay liabilities that are included in the financial
statements.
4. Valuation or allocation:
Assets liabilities owners’ equity revenues and expenses are presented at amounts that are
determined in accordance with GAAP.

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5. Presentation and disclosure
Accounts are described and classified in the financial statements in accordance with GAAP and
all material disclosures are provide
For any particular financial statement item if all of the assertions are accurate the overall assertion that
account is presented in conformity with GAAP
2.3.2 Audit risk
An assessment of risk should be made to provide reasonable assurance that all material items will be
adequately covered during the audit work. This assessment should identify areas with relatively high
risk of existence of material problems.

Audit risk is the risk that the auditor will issue an inappropriate opinion on the accounts, i.e. audit risk is
the risk that the auditor gives unqualified opinion on the financial statements when be should have
qualified opinion.

It is the chance that material misstatements exist in the financial statements and the auditors do not detect
the misstatement with their audit procedures. Audit risk is the chance that
i. A material misstatement in an assertion has occurred and
ii. The auditors do not detect the misstatement
Audit risk has three components. These are inherent risk, control risk, and detection risk
Inherent risk refers to the susceptibility of an account balances to material error assuming the client
does not have any related internal controls
Control risk is the risk that a material misstatement in an account balance will not be prevented or
detected on a timely basis by the company’s internal control
Detection risk is the risk that auditor’s procedures for verifying account balances will not detect a
material error when in fact such error exists. It the risk that the auditor’s procedures will lead them
to conclude that a material misstatement does exist.
Therefore detection risk is directly related to the effectiveness of the auditor’ procedures, while inherent
and control risk are functions and control risk are functions of the client and its environment. In planning
the audit the auditor should assess the extent of inherent and control risk, and then plan relevant audit
procedures to the effectiveness of the auditors’ procedures, while inherent and control risk are functions
of the client and its environment.

In planning the audit the auditor should assess the extent of inherent and control risk, and then plan
relevant audit procedures to reduce detection risk to the level tolerable. This turn helps auditors to reduce
the overall audit risk so as to issue an appropriate opinion.

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2.4 Planning a recurring engagement
Planning a repeated engagement requires the auditor less time and it is easier than planning for a new
engagement. This because
a) The auditor has good understanding of the client entity since he/she has been involved in the
previous year’s audit. And therefore, the auditor only needs to understand if there are major changes
b) In planning a recurring engagement, the auditor obtains useful information from the previous years
working papers.

c) The previous years audit program shows detailed procedures performed and the length of time
required to perform them. This information helps the auditor to come up with an audit program for
the recurring engagement taking into consideration the previous year’s audit

2.5 Audit programs

The result of an audit process is an audit program. An audit program is a detailed list of the audit
procedures to be pertained by the auditor in examining the financial statements. It is a means of attaining
audit objectives.
Before starting the work, the auditor should ordinarily establish a preliminary program for a review. This
audit program should be documented in a manner that will permit the auditor to record completion of the
audit work and identify work that remains to be done. As the work progresses, the auditor should
evaluate the adequacy of the program based on information gathered during the audit. The audit program
may be modified if the auditor believes that the planned procedures are not sufficient.
The objectives of preparing audit programs are
 To assist in planning the audits so that efficient and effective procedures are applied in
accordance with the audit strategy
 To provide clear instruction to staff as to the nature extent, and timing of procedures
 To provide a record of the work done and the conclusions drawn, as a basis for effective quality
control and to meet audit evidence requirements.
An audit program has two major sections.
1. The systems section
This section of the audit program focuses on the procedures used to evaluate the effectiveness of
the internal control structure and it is organized around major transactions cycles of the internal
control structure.
2. The substantive test section

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 This section deals with the procedures for substantive testing of financial statement amounts and
the adequacy of financial statement disclosure. Besides this section of the audit program is
organized in terms of major financial statement items.

Assignment
1. What is the purpose of an incoming auditor communication with predecessor? What should the
incoming auditor do if the predecessor auditor informs him that he did not seek re-appointment due
to the management’s attempts to exercise undue influence on him to modify his report?
2. What is an audit engagement letter? What are its usual contents?
3. What is the main advantage of an audit engagement letter? What are the main advantages of audit
planning?
4. One of the preliminary steps taken by an auditor in a new audit engagement is to obtain knowledge
about the business of the enterprise under audit, how does an auditor gain such knowledge? How is it
useful to the auditor?
5. The first standard of fieldwork requires that “the work is to be adequately planned...” An effective
tool that aids the auditor in adequately planning the work is an audit program. What is an audit
program and what planning does it serve?
6. Financial statements contain five broad assertions regarding the accounts and classes of transactions
included in the statements
a) Who makes the assertions?
b) List and describe each of the assertions
7. Distinguish between the substantive approach and the systems approach to an audit

The end!!

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