CHAPTER 03
Engagement Planning
"Vision without action is a daydream.
Action without vision is a nightmare.”
Japanese Proverb
3-1
LEARNING OBJECTIVES
1.
2.
3.
4.
5.
6.
List and describe the required pre-engagement activities that
auditors undertake before beginning an audit engagement.
Understand the importance of planning the audit engagement
so that it is conducted in accordance with professional
standards.
Define materiality and explain its importance in the audit
planning process.
List and describe the eight general types of audit procedures
for gathering evidence.
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.
Define what is meant by the proper form and content of audit
documentation.
3-2
Engagement Overview and Principles
OBTAIN
(OR RETAIN)
CLIENT
Responsibilities:
Competence
and capabilities,
Independence
ENGAGEMENT
PLANNING
RISK
ASSESSMENT
AUDIT
EVIDENCE
REPORTING
Responsibilities: Professional skepticism, Professional
judgment, Due care
Performance
Reporting
2-3
WHAT NEEDS TO BE CONSIDERED WHEN A
FIRM IS DECIDING TO ACCEPT OR RETAIN A
CLIENT?

Independence & Objectivity

Competence & Expertise

Available Resources

Acceptable Level of Engagement Risk
Background checks of Senior Management
 Inherent risks of the industry
 Communication w/Predecessor Auditor



Obtain & review financial information
Inquire of key parties – Legal Counsel, Bankers,
Analysts
PRE-ENGAGEMENT ACTIVITIES
 Client Acceptance
or Continuance
 Communication
between predecessor and
prospective auditors
 Compliance
with Independence and Ethical
Requirements
 Engagement
Letters
 Termination
Letter
3-5
COMMUNICATION BETWEEN
PREDECESSOR AND PROSPECTIVE
AUDITORS
 Attempt
 If
–
to communicate is required
client permits, issues to discuss
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).
–
Client management integrity issues.
3-6
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
 Public accounting firms must have a process in place
to ensure that they are independent of the company
being audited

3-7
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

3-8
SEE EXHIBIT
3.1
FOR
EXAMPLE
TERMINATION LETTERS
 Reduces
the risk of misunderstandings with the client
in order to avoid legal liability
 Termination
letters are NOT required, but, may be a
good idea to reduce misunderstandings with clients
LIST THREE SPECIFIC INQUIRIES A SUCCESSOR
AUDITOR SHOULD MAKE OF A PREDECESSOR
AUDITOR IN REGARDS TO THE CLIENT:
1. Disagreements about accounting principles or audit
procedures.
2. Communications the predecessor auditors gave the former
client about fraud, illegal acts, and internal control
recommendations.
3. The predecessor auditors’ understanding about the reasons for
the change of auditors (particularly about the predecessor
auditors’ termination).
4. Client management integrity issues.
TRUE OR FALSE? AN AUDITORS
ENGAGEMENT LETTER SHOULD
INCLUDE AN ACKNOWLEDGMENT OF
MANAGEMENT’S RESPONSIBILITY FOR
MAINTAINING EFFECTIVE INTERNAL
CONTROL.
A) TRUE
B) FALSE
WHICH OF THE FOLLOWING MATTERS IS
GENERALLY INCLUDED IN AN AUDITOR’S
ENGAGEMENT LETTER?
A.
B.
C.
D.
Management’s responsibility for the fair
presentation of the financial statements.
The factors to be considered in setting preliminary
judgments about materiality.
Management’s vicarious liability for violations of
laws and regulations committed by its employees.
The auditor’s responsibility to search for significant
internal control deficiencies.
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 their opinion on the
financial statements
 When
planning the engagement, the auditor needs to
develop and document a plan the 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
3-14
EXAMPLE OF AN AUDIT PLAN
Risk
Vendor Management
ALCS does not have authorized
contracts and project agreements in
place to document scope of services to
be provided by ADP, Inc.
ADP, Inc. performance on services
provided is not in accordance with
contractual requirements.
ALCS Corporate Audit Department
Audit: Review of ADP Payroll Processes
Scope: January 2010 to Exit Date
Audit Team: A. R. Thompson; E. J. Lynch; and, M. Moore
Key Control
Test Plan
Assigned To
The contracts included the standard
Obtain and review a copy of the
Altria terms and conditions (e.g., right master agreement and related project
to audit, insurance, confidentiality,
agreements for ADP, Inc.
etc.) and related attachments (e.g.,
1. Ensure the contract includes all
background screening procedures,
required standard terms and
contractor expense guidelines and
conditions.
code of conduct, IT security policy,
2. Ensure the contract has all the
etc.).
required attachments.
3. Verify the required deliverables
are provided in accordance with
contractual terms.
ALCS measures ADP, Inc. performance Obtain and review service level
against the service level agreement
agreement attached to the Master
pursuant to the Master Agreement.
Agreement.
E. Lynch
E. Lynch
Required Documents
1. ADP, Inc Master Services
Agreement
2. Insurance Certification
3. Contract Approval
4. RFP and Bid Documentation /
Waiver
E. Lynch
E. Lynch
M. Moore
1. Gain an understanding of ALCS
M. Moore
process for monitoring ADP, Inc.
performance against service level
requirements.
2. Obtain copies of quarterly service M. Moore
level reports. Determine whether or
not service levels not achieved have
been properly analyzed and
corrected.
3. For service levels not achieved,
M. Moore
review and recalculate credits due
ALCS. Ensure all credit have been
properly received by ALCS.
1. Service Level Agreements (Annex
B)
2. Quarterly Performance Reports
3. SLA Credits Issued
4. Credit Supporting Documentation
STAFFING THE AUDIT ENGAGEMENT
 Teams






usually consist of the:
Audit engagement partner
Audit manager
IT audit specialist
Tax partner
Quality assurance partner
Audit staff
 For
new clients, companies with complex
transactions and public companies, more experienced
staff members are typically assigned.
3-16
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 using the work of internal auditors, external
auditors should consider internal auditors’
objectivity and competence
Who do they report to?
 What education, experience, certifications?

 Internal
auditors should not be delegated tasks that
require extensive professional judgment
3-17
USE OF SPECIALISTS
 Specialists
are persons skilled in fields other than
accounting and auditing 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
3-18
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
3-19
THE PRIMARY PURPOSE FOR OBTAINING AN
UNDERSTANDING OF THE ENTITY’S
ENVIRONMENT (INCLUDING ITS INTERNAL
CONTROL) IN A FINANCIAL STATEMENT AUDIT IS:
A) to determine the nature, timing, and extent of
substantive procedures to be performed.
B) to make consulting suggestions to the entity’s
management.
C) to obtain indirect sufficient appropriate audit
evidence to afford a reasonable basis for an opinion
on the financial statements.
D) to determine whether the entity has changed
any accounting principles.
DURING THE INITIAL PLANNING PHASE OF
AN AUDIT, THE AUDITOR MOST LIKELY
WOULD:
A.
B.
C.
D.
Identify specific internal control activities that
are likely to prevent fraud.
Evaluate the reasonableness of the client’s
accounting estimates.
Discuss the timing of the audit procedures with
the client’s management.
Inquire of the client’s attorney as to whether
any unrecorded claims are probable of assertion.
IN DEVELOPING AN OVERALL AUDIT
STRATEGY, AN AUDITOR SHOULD CONSIDER:
A.
B.
C.
D.
Whether the allowance for sampling risk exceeds the
achieved upper precision limit.
Findings from substantive tests performed at interim
dates.
Whether the inquiry of client’s attorney identifies any
litigation, claims, or assessments not disclosed in the
financial statements.
Preliminary evaluations of materiality, audit risk,
and internal control.
TIME BUDGET
 Used
to maintain control of the audit by identifying
problem areas early in the engagement, thereby
ensuring that the engagement in 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
3-23
TIME REPORTS
 Everyone
who works on the audit engagement is
required to report the time taken to perform
procedures for the audit
 Helps
in evaluating the efficiency of the audit team
members
 Compiling
a record for billing the client
 Compiling
a record for planning the next audit
 Eating
Time?
 Interim
versus Year-end audit work
3-24
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.
• Materiality Criteria:
Quantitative Criteria:
 Absolute size
 Relative size
 Cumulative effects
Qualitative Criteria
 Nature of the item or
issue
 Circumstances
 Uncertainty
• Ultimately, materiality is a matter of professional judgment.
3-25
MATERIALITY


Material information = Important information

Misstatements are not immaterial simply because they
fall beneath a numerical threshold (e.g., fraud)

Material = an amount (or transaction) that would influence
the decisions of users
It is a professional judgment calculated by staff auditors
but MUST be signed-off by the Partner



Rule of Thumb <5% is likely not material, but >10% probably
is material
Low Materiality = More Audit Work
High Materiality = Less Audit Work
USING MATERIALITY ON THE
AUDIT
 Use
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.
3-27
USE OF AUDIT PROCEDURES
 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)
3-28
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
Auditor must develop an independent expectation of the balance
 More efficient


Tests of details
Generally requires sampling
 More effective

3-29
CONTROLS VS SUBSTANTIVE TESTS SUMMARY

Tests of controls - test segregation of duties (authorization,
recording, custody, and comparison) by reperformance,
inquiry, inspection, and observation.

Substantive tests - deal with management assertions (e.g.,
classification, presentation & disclosure, existence/occurrence,
rights & obligations, completeness & cutoff, and
valuation/allocation) and testing them by using the audit
procedures of inquiry, confirmation, observation,
recalculation/reperformance, inspection of assets, inspection of
records and analytical procedures.

Test of controls = internal controls

Substantive testing = test of details & analytical procedures
3-31
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
3-32
TYPES OF AUDIT EVIDENCE
F ooting and Crossfooting
I nquiry
V ouching
E xamination, Inspecting, and Reviewing
C onfirmation
A nalytical Procedures
R eperformance
R ecalculation
O bservation
T racing
S ubsequent Events

Footing and Crossfooting- verifying the
mathematical accuracy of columns of numbers by
adding down and across

Inquiry- written or oral information in response
to questions from the auditor
Requires corroboration to be conclusive
 An exception exists for negative statements
regarding fraud, theft, accounting irregularities, etc.


Vouching- Directional testing from accounting
records back to the supporting documents
Supports the existence and occurrence assertion
 Gathers evidence supporting overstatement errors


Examination, Inspecting, and Reviewing

Physical examination is the examination or inspecting of
tangible assets:
-Direct test of existence
-One of the most reliable types of AE
-Does not provide AE regarding rights & obligations

Inspection of documentation is the auditor’s inspection of
the clients documents and records to substantiate the
information that is, or should be, included in the financial
statements
1. Internal document
2. External document
3. Internal Control
4. Original Documents

Confirmations - describes the receipt of a direct
response from a 3rd party verifying the accuracy of
information that was requested by the auditor
 Highly regarded and often-used types of AE

May be costly and inconvenient

When practical and reasonable, A/R confirms
are required

To be reliable must be controlled

Positive vs. Negative


Positive (good) = Must respond
Negative (sloppy/bad) = Optional response (only if
amount differs)
CONFIRMATIONS CONTINUED
Auditing Standards
Requirements
United States
Auditor must confirm
accounts receivable
Auditors control the mailing
and receipt of replies
Electronic confirmations
are permitted
International
Confirmations are not required
CONFIRMATIONS CONTINUED

Analytical Procedures - Use comparisons and
relationships to assess whether account balances
appear reasonable given expectations, required
during planning and completion phases

Help understand the entity and environment

Assess Going Concern

“Attention Directing”

Reduce other substantive tests
ANALYTICAL PROCEDURES
3-40
Reperformance- Auditor’s independent tests of client
accounting procedures or controls
Recalculation- Involves rechecking a sample of calculations
made by the client
Observation- Use of the senses to assess client activities.
-Requires corroboration
Tracing-Directional testing from source documents to
accounting records
-Supports the completeness assertion
-Gathers evidence supporting understatement errors
Subsequent Events- The auditor is required to perform
procedures for the period after the balance sheet date up to the
date of the auditor’s report
Tracing vs. Vouching
Trace = Forward (source documents to
accounting records)
Vouch = Backward (accounting records to source
documents)
“Vouch back, Trace forward”
Vouching = occurrence
Tracing = completeness
VOUCH VS. TRACING EXAMPLE (CHAP. 8):
AN AUDIT PLAN CONTAINS…
A)
Specifications of audit standards relevant to the
financial statements being audited.
B)
Specifications of the procedures the auditors
believe appropriate for the financial statements
under audit.
C)
Documentation of the assertions under audit, the
evidence obtained, and the conclusions reached.
D)
Reconciliation of the account balances in the
financial statements with the account balances in
the client’s general ledger.
WHICH OF THE FOLLOWING AUDIT
PROCEDURES, AS DISCUSSED IN CLASS, ARE
NOT SPECIFICALLY REQUIRED DURING AN
AUDIT?
a)
b)
c)
d)
e)
Confirmation of accounts receivable
Evidence regarding subsequent events
Analytical procedures during fieldwork
Only a and c
None of the above, all of the above (a-c) are required
during a financial statement audit
PLANNING IN A COMPUTERIZED
ENVIRONMENT
Auditor must evaluate the client’s computerized
environment (i.e. potential for errors or fraud, use of
cloud computing applications)
 Auditor must consider:

Extent to which computers are used
 Complexity of computer operations
 Availability of data
 Need for specialized IT auditors


CAATs (Computer Assisted Audit Techniques)

Used for recalculation, confirmation, document
examination, scanning, analytical procedures, fraud
investigation
3-46
EFFECT OF CLIENT’S COMPUTER
PROCESSING ON AUDIT PLANNING
 Complexity
of computer operations
 Organizational
 Availability
 Use
structure of computer processing
of data
of CAAT’s
 Need
for specialized skills
3-47
COMPUTER ASSISTED AUDIT
TOOLS AND TECHNIQUES (CAATS)
E.g., IDEA, ACL
 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

3-48
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
3-49
PURPOSES OF AUDIT DOCUMENTATION
 Integral
part of audit quality
 Documents
the nature, timing and extent of work
performed
 Evidence
 Basis
of due care
for conclusion
 Facilitates
planning, performance and
supervision
 Provides
basis for review/Assessment of audit
quality
3-50
AUDIT DOCUMENTATION
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
3-51

Permanent Files - Contain data of a historic or
continuing nature pertinent to the current audit

Documents of continuing importance
-articles of incorporation
-bylaws
-stock option contracts

Previous analyses of continuing importance
long-term debt
 fixed assets

Internal control documentation
 Previous analytical procedures


Current files- Include all audit documentation
applicable to the year under audit. Set for each year’s
audit.

Audit Program

General Information

Working Trial Balance
Listing of general ledger accounts at YE
 supported by a lead schedule which shows how each balance is
calculated


Adjusting and Reclassification Entries
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.
3-54
DOCUMENTATION RETENTION
 Documentation
must be retained seven years from
report release date.

If no report—from 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
3-55
EXHIBIT 3.5 CURRENT AUDIT DOCUMENTATION
FILE
3-56
HOW TO CREATE WORKPAPERS – “PSSPC”

Name/Date

P
S
S
P
C




-
Purpose
Source
Scope
Procedures
Conclusion
*Walkthrough Example
*For those of you going into auditing this slide should help you.
Otherwise this wont be on the test.
3-57
EXHIBIT 3.6
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
3-58
HOW TO CREATE WORKPAPERS – “PSSPC”

Name/Date
P
S
S
P
C

-
Purpose
Source
Scope
Procedures
Conclusion
*Walkthrough Example
3-59
IN-CLASS EXAMPLE – AUDIT EVIDENCE
 What
are some risks to consider?
 What
kinds of evidence might you gather?
3-60
IN CLOSING…. SOME LIFE/CAREER ADVICE
 Communication
Don’t assume people know
what you’re saying
 Join Toastmasters
