Auditing & Assurance

Services 7e

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 Chapter 03

Engagement Planning
"Vision without action is a daydream;
action without vision is a nightmare.”
Japanese Proverb

©McGraw-Hill Education 3-2

• Chapter 3 Learning Objectives
1. List and describe the required pre-engagement activities that auditors
undertake before beginning an audit engagement.
2. Understand the importance of planning the audit engagement so that it is
conducted in accordance with professional standards.
3. Define materiality and explain its importance in the audit planning
process.
4. List and describe the eight general types of audit procedures for gathering
evidence.
5. List and discuss matters of planning that auditors should consider related
to the client’s computer environment and describe how CAATs can be
used to improve the efficiency of the audit process.
6. Define what is meant by the proper form and content of audit
documentation.

©McGraw-Hill Education. 3-3

• Pre-Engagement Activities
• Client Acceptance or Continuance
– Communication between predecessor and prospective auditors
• Compliance with Independence and Ethical Requirements
• Engagement Letters
– Termination Letter

LO 3-1

©McGraw-Hill Education. 3-4

• Communication between Predecessor and
Prospective Auditors
• An attempt to communicate is required by the
prospective auditor. After securing approval from the
audit client, communication should include:
– Basic information regarding issues that reflect directly on
the integrity of management.
– Disagreements about accounting principles or audit
procedures.
– Communications the predecessor auditors gave the former
client about fraud, illegal acts, and internal control
recommendations.
– The predecessor auditors’ understanding about the reasons
for the change of auditors (particularly about the
predecessor auditors’ termination).
©McGraw-Hill Education. 3-5
• Compliance with Independence and Ethical
Requirements
• The responsibilities principle requires auditors to
comply with appropriate ethical requirements for
each audit engagement
• Auditors must maintain independence in mental
attitude and independence in fact
• Independence in appearance relates to perceptions of
auditors’ independence
• A lack of independence can result in disciplinary
action by regulators and/or professional organizations
and litigation by those who relied on the financial
statements
©McGraw-Hill Education. 3-6
• Engagement Letters
• When a new client is accepted or when an audit engagement
continues from year to year, an engagement letter should be
prepared.
• Acts as a contract between auditor and client.
• Serves as a means of reducing the risk of misunderstandings
with the client and as a means of avoiding legal liability for
claims that the auditors did not perform the work promised
• Should include:
– Objectives of the engagement
– Management’s responsibilities
– Auditors’ responsibilities
– Any limitations of the engagement

©McGraw-Hill Education. 3-7

• Illustration of an Engagement Letter

©McGraw-Hill Education. 3-8

• Audit Plan
• A comprehensive list of the specific audit procedures that the
audit team needs to perform to gather sufficient appropriate
evidence on which to base its opinion on the financial statements.
• When planning the engagement, the auditor needs to develop and
document a plan that describes the procedures to be performed to
assess the risk of material misstatement at the financial statement
and assertion level.
• The auditor must then carefully plan the nature, timing and extent
of control tests and substantive tests that are designed to mitigate
these risks to an acceptable level.

LO 3-2
©McGraw-Hill Education. 3-9
• Staffing the Audit Engagement
• Teams usually consist of the:
– Audit engagement partner
– Audit manager
– IT audit specialist
– Tax specialist
– Quality assurance partner
– Audit staff
• For new clients, companies with complex
significant transactions and public companies,
more experienced staff members are typically
assigned.
©McGraw-Hill Education. 3-10
• The Importance of Audit Quality

©McGraw-Hill Education. 3-11

• Considering the Work of Internal Auditors
• Must obtain an understanding of a client’s internal audit
department and its work.
• Audit efficiency can be realized when the two groups work
together.
• Prior to relying on the work of internal auditors, external
auditors should consider internal auditors’ objectivity and
competence.
• External auditors can not delegate responsibility for audit
decisions to the internal auditors.
• Internal auditors should not be delegated tasks that require
extensive professional judgment.

©McGraw-Hill Education. 3-12

• Using the Work of an Audit Specialist
• Audit specialists are persons skilled in fields other
than accounting and auditing—actuaries, appraisers,
attorneys, environmental engineers, and geologists—
who are not members of the audit team.
• Auditors must know about the specialist’s
professional qualifications, experience and reputation.
• Should be unrelated to the company being audited.
• Auditors should obtain an understanding of the
specialist’s methods and assumptions.
• Specialists are not referred to in the audit report
unless the specialists’ findings cause the auditors’
report to be modified.
©McGraw-Hill Education. 3-13
• Use of IT Auditors
• Specialized skills are often needed to evaluate the
effect of computerized processing on the audit, to
understand the flow of transactions, or to design and
perform audit procedures.
• IT auditors are members of the audit team and are
called in when the need for their skills arises.
• Audit managers and partners should possess
sufficient knowledge to know when to call on
specialists and to supervise their work.

©McGraw-Hill Education. 3-14

• Time Budget
• Used to maintain control of the audit by identifying
problem areas early in the engagement, thereby
ensuring that the engagement is completed on a
timely basis.
• Interim audit work refers to procedures performed
several weeks or months before the balance sheet
date.
• Year-end audit work refers to procedures performed
shortly before and after the balance sheet date.

©McGraw-Hill Education. 3-15

• Time Reports
• Everyone who works on the audit engagement is
required to report the time taken to perform
procedures for each phase of the audit. These time
reports are recorded by budget categories for the
purposes of:
– Evaluating the efficiency of the audit team members.
– Compiling a record for billing the client.
– Compiling a record for planning the next audit.

©McGraw-Hill Education. 3-16

• Materiality
• Materiality refers to an amount (or transaction) that would influence the
decisions of users [i.e., an amount (or event) that would make a
difference]. The emphasis is on user, rather than management or the audit
team.
• Auditors must examine both quantitative and qualitative factors when
assessing materiality. Some of the more common factors that auditors use
in making materiality judgments include:
– Quantitative Criteria

• Absolute size
• Relative size
• Cumulative effects
– Qualitative Criteria

• Nature of the item or issue

• Circumstances
• Uncertainty
LO 3-3 Ultimately, materiality is a matter of professional judgment.
©McGraw-Hill Education. 3-17
• Using Materiality on the Audit
• As a guide to planning substantive procedures—
directing attention and audit work to those items or
accounts that are important, uncertain, or susceptible to
errors or frauds.
• As a guide to evaluation of the evidence. Auditors use
performance materiality to make sure that the
aggregate of uncorrected and undetected immaterial
misstatements does not exceed materiality for the
financial statements as a whole.
• As a guide for making decisions about the audit report.

©McGraw-Hill Education. 3-18

• Audit Procedures For Obtaining Audit
Evidence
• Auditors use audit procedures for three purposes
including:
– To gain an understanding of the client and the risks
associated with the client (risk assessment procedures).
– To test the operating effectiveness of client internal control
activities (test of controls).
– To produce evidence about management’s assertions
related to the amounts and disclosures in a client’s financial
statements (substantive procedures).

LO 3-4
©McGraw-Hill Education. 3-19
• Substantive Audit Plan
• Should contain a list of audit procedures for gathering
evidence related to the relevant assertions identified
for the significant financial statement accounts and
disclosures of an audit client.
• Two ways to conduct substantive tests:
– Substantive analytical procedures
– Tests of details

©McGraw-Hill Education. 3-20

• Assertions, Evidence, and Audit Procedures

©McGraw-Hill Education. 3-21

• Types of Audit Procedures
1. Inspection of records and documents
– Vouching
– Tracing
– Scanning
2. Inspection of tangible assets
3. Observation
4. Inquiry
5. Confirmation
6. Recalculation
7. Reperformance
8. Analytical Procedures

©McGraw-Hill Education. 3-22

• Examination of Documents: Vouching and
Tracing

©McGraw-Hill Education. 3-23

• Analytical Procedures
• Auditors can evaluate financial statement accounts by developing
expectations about what an account balance should be based on an
analysis of relevant financial and nonfinancial data.
• When an auditor compares the expectation to a recorded balance,
analytical procedures are being performed. Auditors are required to use
them when planning the audit and when performing the review of the
financial statements near the end of the audit before the audit report is
issued. In addition, auditors use analytical procedures to provide evidence
about management’s financial statement assertions during the testing
phase of the audit.
• Auditors need to be careful to use independent, reliable information for
analyses. The sources of information shown for the analytical procedures
are very important. And auditors must gain comfort over the information
that is used to develop expectations during analytical procedures.
• Analytical procedures take five general forms as summarized on the next
slide.
©McGraw-Hill Education. 3-24
• Analytical Procedures (continued)

©McGraw-Hill Education. 3-25

• Planning in a Computerized Environment
• Temporary transaction trails
• Uniform processing of transactions
• Potential for errors and fraud
• Potential for increased management supervision
• Initiation or subsequent execution of transactions by
computer
• Use of cloud computing applications

LO 3-5
©McGraw-Hill Education. 3-26
• Effect of Client’s Computer Processing on
Audit Planning
• Complexity of computer operations
• Organizational structure of computer processing
• Availability of data
• Use of CAAT’s
• Need for specialized skills

©McGraw-Hill Education. 3-27

• Availability of Data

©McGraw-Hill Education. 3-28

• Computer Assisted Audit Tools and Techniques
(CAATs)
• With CAATS, the auditor is able to access and extract client
information without disrupting data processing.
• Some CAATs Procedures:
– Calculate field statistics (totals, high, low and average
value)
– Perform complex recalculations
– Join and compare different data files
– Perform detailed analysis
• Stratification
• Gap and duplicate detection
• Sample selection

©McGraw-Hill Education. 3-29

• Using CAAT in the Audit

©McGraw-Hill Education. 3-30

• Audit Documentation
• Definition
– The written record of the basis for the auditor’s conclusions that
provides the support for the auditor's representations, whether those
representations are contained in the auditor's report or otherwise.

• Objectives
– Improve audit quality
– Enhance public confidence

LO 3-6
©McGraw-Hill Education. 3-31
• Purposes of Audit Documentation
• Integral part of audit quality
• Documents the nature, timing and extent of work
performed
• Evidence of due care
• Basis for conclusion
• Facilitates planning, performance and supervision
• Provides basis for review

©McGraw-Hill Education. 3-32

• Audit Documentation Requirements
• Audit documentation should be prepared in sufficient detail to enable an
experienced auditor having no previous connection with the engagement
to:
– Understand the nature timing, extent, and results of procedures,
evidence obtained and conclusions reached.
– Determine who performed the work, date of work, reviewer and date
of review.
• Audit documentation should provide a clear link to significant findings or
issues and
– Demonstrate compliance with professional standards.
– Support basis for conclusions for each relevant assertion.
– Document that accounting records agree with financial statements.

©McGraw-Hill Education. 3-33

• Audit Documentation Files
• Permanent files
– Information of continuing audit significance
– For example, key contracts, bylaws, organization chart, royalty and
bond agreements

• Current files
– Includes the entire engagement administration file for the year under
audit
– Includes all documentation that is sufficient to support all
conclusions on the audit

©McGraw-Hill Education. 3-34

• Significant Accounts and Relevant Assertions
The planning documentation must include a listing of each significant account and
disclosure in the client’s financial statements. If there is a chance the account could
contain a material misstatement, it should be identified as significant. The
documentation also must include a listing of each relevant financial statement assertion
related to the significant accounts and disclosures. If the assertion has a reasonable
possibility of containing a misstatement that would cause the statements to be material
misstated, it must be categorized as relevant. Documentation of the significant
accounts and disclosures, along with the relevant assertions, forms the basis of the
current file documentation. Some examples of significant accounts and relevant
assertions are shown below:

©McGraw-Hill Education. 3-35

• Current Audit Documentation File

©McGraw-Hill Education. 3-36

• Illustrative Audit Documentation
• Information on each Workpaper
– Name, date, purpose, page
number
– Procedures performed and
conclusions reached by the
auditor
• Evidence that auditor
followed GAAS
• Audit Tick Mark
Legend
– Preparer’s and Reviewers’
initials

©McGraw-Hill Education. 3-37

• Documentation Retention
• Documentation must be retained seven years from
report release date. If no report is issued,
documentation should be retained from the last day
of fieldwork.
• Documentation to be retained include those
documenting discussion and subsequent resolution of
differences in professional judgments among team
members.
• All documentation must be finalized within 45 days
of the audit report’s release date.

©McGraw-Hill Education. 3-38