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AUDITING
An International Approach
Eighth Edition
SMIELIAUSKAS, BEWLEY, KWAN,
COGLIANO, BARRETTE
Chapter 5
Preliminary Audit
Planning: Understanding
the Auditee’s Business
© 2019 McGraw-Hill Education Limited
PowerPoint Author:
Alla Volodina, CPA, CA, MBA
Schulich School of Business, York University
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Learning Objectives
•1 Summarize the financial statement audit process.
•2 Explain the main characteristics of an
independent audit engagement.
•3 Describe the activities that auditors undertake to
decide whether to accept a financial statement
audit engagement, and the first tasks performed
once an audit engagement is accepted.
•4 Explain why auditors need to understand the
auditee organization’s business and environment
and its risks and controls.
© 2019 McGraw-Hill Education Limited
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Learning Objectives
•5 Use preliminary analytical procedures on
management’s draft financial statements to
identify areas where misstatements are most
likely.
•6 Explain the materiality levels used for planning
the audit and how these amounts are determined.
•7 List the preliminary planning decisions set out in
the overall audit strategy.
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Appendices
•8 (Appendix 5A) Describe the contents of an audit
engagement letter
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The Essentials of Preliminary Audit Planning
and Understanding the Auditee’s Business
• Before an audit engagement is accepted, whether
it is a new engagement or the continuation of one
that was performed in a previous year, the auditor
has to determine whether professional ethics
codes and requirements of GAAS can be met
– Is the auditor independent of the company, both in fact
and in appearance?
– Does the auditor have the competence and available
resources to comply with GAAS for this company?
– Are those charged with governance willing and able to
accept their responsibilities to fairly present the
financial statements?
© 2019 McGraw-Hill Education Limited
The Essentials of Preliminary Audit Planning and
Understanding the Auditee’s Business
(continued)
• If the engagement is accepted, an audit
engagement letter is prepared
• Includes:
– Nature of the audit
– Management’s responsibilities
– Auditor’s responsibilities
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Risk Assessment
• Risk of material misstatement in the financial
statements is used to describe the possibility that
business or environmental risks have resulted in
the financial statements not being a fair
representation of the company’s economic
realities.
– The auditor’s risk assessments will identify the key risk
areas in the audit.
– The audit team will emphasize those areas
© 2019 McGraw-Hill Education Limited
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Materiality
• Materiality refers to a monetary amount that
auditors believe financial statement users would
find significant, or material, to their decision
making.
– Used for planning how to perform the audit
– Used for concluding whether financial statements are
materially misstated
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Overall audit strategy
• Record all deliberations and decisions in planning
in the document called Overall Audit Strategy
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The Audit Process: An Overview of an
Independent Audit of Financial Statements
Steps:
Elements
Pre-engagement activities
Risk Assessment
Preliminary audit planning: Risk Identification
Risk assessment procedures to plan audit
Internal control documentation and testing
Response to Assessed
Risks
Sampling decisions
Substantive procedures
Concluding & Reporting
Review audit findings
Form opinion and issue report
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The Audit Process: Ongoing Activities
• Communications among audit team members
throughout the process
• Documentation of the audit decisions and findings
• Revisions to risk assessments and planned
responses if appropriate due to knowledge
obtained during audit process
• Communications with those charged with the
auditee’s governance and its management
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Independent Audit Engagement
Characteristics
• A wide variety of organizations, or “entities,” are
required to produce financial statements to meet
their external stakeholders’ information needs,
and to have them independently audited.
• At the outset of an audit engagement, it is
important for the auditors to understand what kind
of entity is being audited, who the people are who
are charged with governance of the entity, the
stakeholders to whom they are accountable, and
the client’s reasons for wanting an audit.
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Acceptance Decision: Pre-engagement
Activities
• Auditors undertake two types of activities before
beginning an audit:
– Risk management:
• Auditors try to reduce the risk (probability of something going
wrong) by carefully managing the engagement.
– Quality management:
• Auditors manage audit in accordance with quality control
standards.
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Audit Engagement Acceptance and
Continuance
• Client selection and retention:
– An important element of an accounting firm’s quality
control policies and procedures is a system for
deciding:
(a) to accept a new client, and
(b) whether to resign from audit engagements.
– Accounting firms are not obligated to accept
undesirable clients, nor retain existing audit clients.
© 2019 McGraw-Hill Education Limited
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Audit Engagement Acceptance and
Continuance
1. Evaluate auditor independence and ability to comply with other
relevant ethical requirements
2. A) Obtain information from the prospective auditee’s management in
order to understand the business and its risks,
2. B) to assess whether the organization’s managers able to accept
responsibility for preparing financial statements in accordance with an
acceptable financial reporting framework and for implementing adequate
controls to reduce risk of error and fraud.
3. Consider whether the firm has the competence and resources to
perform the audit
4. Consider whether the engagement requires special attention or
involves unusual risks
5. For new audits, communicate with the previous auditor
© 2019 McGraw-Hill Education Limited
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Determining Auditability
• The auditor considers:
– Whether the financial statements presented in
accordance with GAAP.
– Whether management understands its responsibility for
preparing the financial statements, and for designing
and implementing adequate internal controls.
– Management’s commitment to providing written
representations or other scope limitations.
© 2019 McGraw-Hill Education Limited
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Auditee Retention
• Decisions to continue auditing an organization
are similar to acceptance decisions.
– The public accounting firm will have more first-hand
experience with the auditee.
– Annual retention reviews take into account changes for
the auditee.
© 2019 McGraw-Hill Education Limited
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Communication Between Predecessor
and Successor Auditors
• When companies change auditors, the former
auditor is the predecessor auditor, and the new
auditor is the successor auditor.
– Rules of professional conduct require the successor
auditor to contact the predecessor auditor.
• Ask if there are issues that should be considered in accepting
the client.
• Obtain information from the predecessor auditor for planning
the audit.
– Predecessor auditor is required by the rules of conduct
to respond to the communication.
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Communication Between Predecessor
and Successor Auditors
• Successor auditor should ask the client to
consent to discussions with the predecessor
auditor.
– Consent is not required, the communication must take
place.
– Consent allows the predecessor auditor to relay more
information.
• Predecessor auditor still has a duty to maintain confidentiality.
• Audit files belong to the auditor, not the client.
– Auditor should be wary of any client who refuses
consent.
© 2019 McGraw-Hill Education Limited
Auditor’s Risk From Accepting An Audit
Engagement
• Key Factors to consider:
– How widely distributed are the audited financial
statements?
– How strong is the financial condition of the auditee?
– How trustworthy is auditee’s management?
– How complex is the financial reporting required?
– How knowledgeable are the people using the financial
statements likely to be?
© 2019 McGraw-Hill Education Limited
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Engagement Letters
• When a new audit client is accepted an
engagement letter must be obtained.
– The engagement letter forms the contract for the audit.
• Standards require the auditor and management to agree on
the terms of the audit engagement.
– A new engagement letter should be obtained every
year of a continuing audit.
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Staff Assignment
• When the new client is obtained, accounting firms
assign a full-service team to the new client.
– The audit team may consist of just one or two people
– For larger auditees and public company audits, a
second review partner might be required.
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Time Budget
• The partner or manager propose a plan for the
timing of the work based on previous experience
and knowledge of the business.
– The time budget allows the audit firm to spread its
workload between interim and year-end periods.
• Interim — weeks or months before the statement date.
• Year-end — shortly before or after the statement date.
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Time Budget
• Everyone on the audit reports the time taken to
perform the audit procedures.
– Time reports are recorded by the time budget
categories to all for:
• evaluation of the efficiency of audit team members,
• billing the client, and
• planning the next audit of the client.
© 2019 McGraw-Hill Education Limited
Understanding the Auditee’s Business,
Environment and Risks
• Understanding the client’s business and
operating environment is very important in an
audit.
– It helps to assess the risk that financial statements
might contain material misstatements.
– Used to establish and overall audit strategy, design the
audit plan and audit programs.
© 2019 McGraw-Hill Education Limited
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Understanding the Client’s Business —
Significant Risks
• What is the underlying economic reality of the
entity’s financial condition and performance?
– This is what the financial statements should capture
and communicate to users
• Business environment risks related to
– Industry, regulatory, economy-related, and other external factors
• Business operational risks related to
– Strategy and related business processes, investments, financing, and
performance measures
© 2019 McGraw-Hill Education Limited
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Understanding the Client’s Business —
Significant Risks (continued)
• What could have gone wrong in preparing the
financial statements?
– This will lead to misstating the financial statements.
• Entity risks related to corporate governance, management
quality, related parties, internal control, accounting policies,
information systems, etc.
© 2019 McGraw-Hill Education Limited
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Understanding the Client’s Business —
Business Environment Risks
• In order to design an effective audit, auditors
must understand the business and the economic
environment of the business including factors
such as:
–
–
–
–
national economic condition and policies,
geographic location,
developments in taxation and regulation, and
specific industry characteristics.
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Analytical Procedures Requirements
• Although particular analytical procedures are not
required by audit standards, the timing of these
procedures is specified:
– at the beginning of the audit when planning is taking
place, and
– at the end of the audit when the partners in charge
review the overall quality of the work and form an
opinion.
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General Analytical Procedures
• Five types of general analytical procedures:
– Compare current-year account balances with one or
more comparable periods.
– Compare current-year account balances and financial
relationships with similar information for the auditee’s
industry.
– Compare current-year account balances with the
company’s anticipated results.
– Evaluate the relationships of current-year balances to
other current-year balances for conformity to
predictable patterns.
– Study the relationships of current-year balances to
relevant nonfinancial information.
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Preliminary Analytical Procedures
• Analytical procedures are most effective when
integrated with other sources of information.
• Many other early information gathering activities
can also be considered analytical procedures:
– Review of accounting misstatements discovered in
prior years
– Conversations with the auditee personnel
– Review of corporate charter and bylaws (or partnership
agreement)
– Review of contracts, agreements, and legal
proceedings
– Reading and study of the minutes of meetings
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Preliminary Analytical Procedures
• Auditors look for relationships in accounts as
indicators of problems and to plan further audit
work.
– Horizontal analysis: examination of numbers and
ratios across two or more years.
– Vertical analysis: examination of amounts expressed
each year as proportions of a base (sales or total
assets).
© 2019 McGraw-Hill Education Limited
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Applying Analytical Procedures to Management’s
Draft Financial Statements (part 1)
• Analysis of the draft statements may show
relationships that do not make sense.
– Indicates problem areas where misstatements may
exist.
– The analysis of the draft statements is attention
directing (i.e. risk assessment at an early stage)
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Applying Analytical Procedures to Management’s
Draft Financial Statements (part 2)
• Preliminary analytical procedures also:
– Provide for an organized approach, they provide
considerable familiarity with the client’s business and
provide a standard starting point,
– describe financial activities by identifying relationships
and changes in data, and
– allow the auditor to ask relevant questions.
© 2019 McGraw-Hill Education Limited
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Applying Analytical Procedures to Management’s
Draft Financial Statements (part 3)
• In addition, the auditor should analyze the cash
flow statement for irregularities, such as cash
deficits from operations.
– The cash flow statement will reveal aspects of the
clients business not evident in the financial statements.
• E.g. cash deficit from operations might signal financial difficulty
© 2019 McGraw-Hill Education Limited
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Materiality Levels for Audit Planning
• Materiality is one of the first important judgments
the auditor must make, since it affects every other
planning, examination, and reporting decision.
– Materiality is the largest amount of uncorrected
misstatement that might exist in financial statements
that still fairly present the company’s financial position
and results of operations.
© 2019 McGraw-Hill Education Limited
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Materiality Levels for Audit Planning
(part 2)
• Financial statement materiality:
– Information is material and should be disclosed if it is
likely to influence the economic decisions of financial
statement users.
• Focus on users of financial statements.
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Materiality Levels for Audit Planning
(part 3)
• Accounting numbers are not perfectly
accurate because of the nature of
accounting.
– Estimates are used, and honest mistakes happen.
– Some inaccuracy is unavoidable.
• Unimportant inaccuracies do not affect users.
• Cost of finding and correcting small errors is too great.
• Time to find all errors would delay statements.
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Materiality Levels for Audit Planning
• To leave room for error and reduce the probability
that the total misstatement exceeds materiality,
auditors will determined an amount of
performance materiality.
– The difference between financial statement materiality
and performance materiality is a cushion for
misstatements that were undiscovered by the auditors.
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Materiality Judgment Criteria
• Materiality is both a quantitative and a qualitative
judgment.
– Auditors cannot rely solely on quantitative benchmarks.
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Materiality Judgment Criteria (part 2)
• Small misstatements may be material in some
cases.
• For example:
– masks a change in earnings or other trends,
– hides a failure to meet analysts’ consensus expectations for the
auditee,
– changes a loss into net income or vice versa,
– concerns a segment of the business that is considered significant,
– affects the auditee’s compliance with regulatory requirements,
– involves concealment of an unlawful transaction or fraud, or
– has the effect of increasing management compensation—for
example, satisfies requirements for the award of bonuses or other
forms of incentive compensation.
© 2019 McGraw-Hill Education Limited
Materiality Judgment Criteria —
Quantitative
• Auditors are generally left without definite,
quantitative guidelines to determine materiality.
– Quantitative guidelines:
•
•
•
•
•
5% of income from continuing operations,
5% of net income before bonus,
½ to 2% of revenues or expenses for non-for profit entities,
½ to 1% of net asset value for the mutual fund industry, or
1% of revenue for the real estate industry.
© 2019 McGraw-Hill Education Limited
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Materiality Judgment Criteria —
Quantitative (part 2)
• In some circumstances, the auditor may also
select alternative financial statement items for
establishing materiality.
• When income measures are used as a basis,
they should be normalized or averaged.
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Materiality Judgment Criteria —
Qualitative
• In addition to quantitative guidelines, the auditor
should consider other factors as well.
–
–
–
–
User related factors
Nature of the item or issue
Other circumstances
Effect on share price
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Cumulative Effects of Errors
• Auditors must consider the sum of known or
potential misstatements.
– Considering five errors of $15,000 each to be
immaterial is inappropriate when materiality is
determined to be $50,000.
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Overall Audit Strategy
• Audit planning is an ongoing, iterative process.
– The preliminary planning activities are the basis for the
overall audit strategy.
– The audit strategy guides development of the detailed
audit plan, which details the nature, extent and timing
of the audit procedures.
• The auditor shall establish an overall audit
strategy that sets the scope, timing, and direction
of the audit, and that guides the development of
the audit plan.
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Overall Audit Strategy (part 2)
• In establishing the overall audit strategy, the auditor shall
– (a) Identify the characteristics of the engagement that define its
scope;
– (b) Ascertain the reporting objectives of the engagement to plan
the timing of the audit and the nature of the communications
required;
– (c) Consider the factors that, in the auditor’
s professional
judgment, are significant in directing the engagement team’
s
efforts;
– (d) Consider the results of preliminary engagement activities and,
where applicable, whether knowledge gained on other
engagements performed by the engagement partner for the entity
is relevant; and
– (e) Ascertain the nature, timing, and extent of resources
necessary to perform the engagement.
© 2019 McGraw-Hill Education Limited