Chapter 3 Audit Planning, Types of Audit Tests, and Materiality Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter Overview This chapter covers the following phases of the audit Another phases will be discussed in he following chapters It then covers the major types of audit tests and the concept of materiality. 1-2 3-2 Client acceptance or continuance LO# 1 Prospective Client Acceptance A public accounting firm should investigate a prospective client prior to accepting an engagement using the following procedures: 1. Obtain and review financial information. 2. Inquire of third parties regarding client integrity. 3. Consider unusual business or audit risks. Procedures for Evaluating a Prospective Client 4. Determine if the firm is independent. 5. Determine if the firm has the necessary technical skills and knowledge. 6. Determine if acceptance violates any applicable regulatory agency requirements or the Code of Professional Conduct. 1-3 3-3 Client acceptance or continuance LO# 1 Continuing Client Retention Public accounting firms should evaluate periodically whether to continue their relationship with current clients. This evaluation may take place at or near the completion of an audit or when some significant event occurs. Conflicts over accounting and auditing issues or disputes over fees may lead a public accounting firm to disassociate itself from the entity. 1-4 3-4 LO# 2 Preliminary Engagement Activities There are generally three preliminary engagement activities: (1) determining the audit engagement team requirements, (2) ensuring that the audit team and audit firm are in compliance with ethical and independence requirements, and (3) establishing an understanding with the entity. Closer Look 1-5 3-5 LO# 2 Preliminary Engagement Activities There are generally three preliminary engagement activities: (1) determining the audit engagement team requirements, (2) ensuring that the audit team and audit firm are in compliance with ethical and independence requirements, and (3) establishing an understanding with the entity. Public accounting firms need to ensure that their engagements are completed by auditors having the proper degree of technical training and proficiency given the circumstances of the entity. engagement size and complexity, level of risk, any special expertise, personnel availability, and timing of the work to be performed. 1-6 3-6 LO# 2 Preliminary Engagement Activities There are generally three preliminary engagement activities: (1) determining the audit engagement team requirements, (2) ensuring that the audit team and audit firm are in compliance with ethical and independence requirements, and (3) establishing an understanding with the entity. A public accounting firm should establish policies and procedures to ensure that persons at all organizational levels within the firm meet the profession’s ethical requirements 1-7 3-7 LO# 2 Preliminary Engagement Activities There are generally three preliminary engagement activities: (1) determining the audit engagement team requirements, (2) ensuring that the audit team and audit firm are in compliance with ethical and independence requirements, and (3) establishing an understanding with the entity. This understanding reduces the risk that either party may mis-interpret what is expected or required of the other party. Closer Look 1-8 3-8 LO# 3 Establish an Understanding with the Entity In establishing an understanding with the client, three topics must be discussed: 1.The engagement letter; 2.Using Using the work of the internal audit function; and 3.The role of the audit committee. The terms of the engagement, which are documented in the engagement letter, should include the objectives of the engagement, management’s responsibilities, the auditor’s responsibilities, and the limitations of the engagement. Who signs the engagement letter? 1-9 3-9 Establish an Understanding with the Entity 1- The Engagement Letter LO# 4 The engagement letter formalizes the arrangement reached between the auditor and the client. In addition to the items mentioned in the sample engagement letter in Exhibit 3-1 in the textbook, the engagement letter may include: • Arrangements for use of specialists or internal auditors. • Any limitations of liability of the auditor or client. • Additional services to be provided. •Arrangements regarding other services. 1-10 3-10 Establish an Understanding with the Entity 2- Internal Audit Function LO# 5 When the entity has an internal audit function (IAF), the auditor may use the work of the IAF as evidence and request IAF assistance in conducting the audit. The auditor first needs to obtain an understanding of the IAF. Table 3–2 presents factors that the auditor should consider when assessing the IAF. 1-11 3-11 Establish an Understanding with the Entity 2- Internal Audit Function LO# 5 1-12 3-12 Establish an Understanding with the Entity 3- The Audit Committee Subcommittee of the board of directors No specific requirements for privately held companies LO# 6 Section 301 of Sarbanes-Oxley Act requires the following for audit committee members of publicly held companies: • • • • • Member of board of directors and independent. Directly responsible for overseeing work of any registered public accounting firm employed by the company. Must preapprove all audit and nonaudit services provided by its auditors. Must establish procedures to follow for complaints. Must have authority to engage independent counsel. 1-13 3-13 LO# 7 Planning the Audit • The auditor will develop an overall audit strategy for conducting the audit. This will help the auditor to determine what resources are needed to perform the engagement. • An audit plan is more detailed than the audit strategy. • Basically, the audit plan should consider how to conduct the engagement in an effective and efficient manner. 1-14 3-14 LO# 7 Planning the Audit When preparing the audit plan, the auditor should be guided by the results of the client acceptance/continuance process, procedures performed to gain the understanding of the entity, and preliminary engagement activities. Additional steps: • Assess business risks. • Establish materiality. • Consider multilocations. • Assess the need for specialists. • Consider violations of laws and regulations. • Identify related parties. • Consider additional value-added services. • Document the overall audit strategy, audit plan, and prepare audit programs. Let’s look at each of these steps. 1-15 3-15 LO# 7 Assess Business Risks To understand the entity’s business and transactions To identify financial statement accounts likely to contain errors By understanding the entity’s business and identifying where errors are likely to occur, the auditor can allocate more resources to investigate more risky accounts. 1-16 3-16 LO# 7 Establish Materiality it is too costly for auditors to audit all transactions that occur within the entity. Thus, auditors consider materiality from a reasonable user perspective Establish overall materiality (more on this later!) Establish tolerable misstatement for accounts Establish tolerable misstatement for disclosures 1-17 3-17 LO# 7 Consider Multi-locations or Business Units Consolidated Financial Statements High Risk Moderate Risk Low Risk The auditor correlates the amount of audit attention devoted to the location or business unit with the level of risk present. 1-18 3-18 LO# 7 Assess the Need for Specialists A major consideration in planning the audit is the need for a specialist. The use of an IT specialist is a significant aspect of most audit engagements. The presence of complex information technology may require the use of an IT specialist. What other types of specialists might be needed? 1-19 3-19 LO# 7 Consider Violations of Laws and Regulations Illegal Acts Direct and Material Consider laws and regulations as part of audit Two Types of Illegal Acts That affect on financial Statements Material and Indirect Be aware of what may have occurred; investigate if brought to attention 1-20 3-20 LO# 7 Consider Violations of Laws and Regulations 1-21 3-21 LO# 7 Related Parties It is important to identify related party transactions because the transaction may not be “at arm’s length.” For example, the entity may buy or sell goods or services at prices that differ significantly from prevailing market prices 1-22 3-22 LO# 7 Related Parties Some examples from FASB ASC Topic 850, “Related Party Disclosures” • • • • • • • Affiliates of the enterprise. Entities using equity method to account for investments. Trusts for benefit of employees. Principal owners of enterprise. Management. How to Identify Related Parties • Review board minutes. • Review conflict-of-interest statements. • Financial and reporting information provided to creditors, investors, and regulators. Immediate families of the principal owners and management. • Contracts or other agreements Other parties that can have significant influence. • Review significant unusual with major customers, vendors, and management. transactions. 1-23 3-23 LO# 7 Additional Value-Added Services As part of the planning process, the auditor should look for opportunities to recommend additional value-added services. Tax Planning Risk Assessment System Design and Integration Benchmarking Internal Reporting Electronic Commerce Auditors who audit public companies are limited in the types of consulting services that they can offer their auditees. 1-24 3-24 LO# 7 Document Audit Strategy, Audit Plan, and Audit Programs Document overall audit strategy and audit plan, which involves documenting the decisions about Nature The auditor documents how the entity is managing its risk (via internal control processes) and the effects of the risks and controls on the planned audit procedures. Timing Auditors ensure they have addressed the risks they identified by documenting the linkage from the entity’s business, objectives, and strategy to the audit plan. Extent The auditor’s preliminary decision concerning control risk determines the level of control testing, which in turn affects the auditor’s substantive tests of the account balances and transactions. A U D I T T E S T S 1-25 3-25 LO# 7 Document Audit Strategy, Audit Plan, and Audit Programs 1-26 3-26 LO# 8 Supervision of the Audit An important part of the planning and conduct of the audit is appropriate supervision of audit personnel (AS13). The engagement partner has the overall responsibility for the engagement and its performance and should supervise the audit engagement team so that the work is performed as directed and supports the conclusions reached. • Engagement partner and other supervisory members of the team should: • Inform engagement team members of their responsibilities • Direct engagement team members to identify and communicate audit issues • Review the work of the engagement team members 1-27 3-27 LO# 9 Types of Audit Tests Risk Assessment Procedures Used to obtain an understanding of the entity and its environment, including its internal control. Tests of Controls Directed toward the evaluation of the effectiveness of the design and operation of internal controls. Substantive Procedures Detect material misstatements in a transaction class, account balance, and disclosure component of the financial statements. 1-28 3-28 LO# 9 Tests of Controls Inquiry Inspection Observatio n Walkthrough Reperform ance 1-29 3-29 LO# 9 Tests of Controls 1-30 3-30 LO# 9 Substantive Procedures Tests of Details Analytical Procedures Tests for errors or fraud in individual transactions, account balances, and disclosures Evaluations of financial information through analysis of plausible relationships among financial and nonfinancial data 1-31 3-31 LO# 9 Dual-Purpose Tests Substantive Tests of Transactions Tests of Controls DualPurpose Tests 1-32 3-32 LO# 10 Materiality The United States Supreme Court interpretation of materiality is that a 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.” Materiality is not an absolute and it is not a black or white issue! The determination of materiality requires professional judgment. 1-33 3-33 Steps in Applying Materiality on an Audit LO# 11 Step 1: Determine overall materiality (planning materiality) Step 2: Determine tolerable misstatement (allocation of materiality at individual account/class of transactions level) Step 3: Evaluate auditing findings (near the end of the audit) 1-34 3-34 Step 1 – Determine Overall Materiality The quantitative base for materiality is a percentage of: • Income (loss) before taxes. •Income from continuing operations. •Three year average income. •Total assets. • Net assets. •Total revenues. • Gross profit. •Total equity LO# 11 The quantitative amounts may be adjusted lower for qualitative factors such as: • Material misstatements in prior years. • High risk of fraud. • Potential loan covenant violations. • High market pressures. • Volatile business environment. • Higher than normal risk of bankruptcy. 1-35 3-35 Step 2 –Determine Tolerable Misstatement LO# 11 Tolerable misstatement is the amount of planning materiality allocated to an account or class of transactions. Combined tolerable misstatement is generally greater than planning materiality because: ● Not all accounts will be misstated by their full tolerable misstatement allocation. ● Audits of individual accounts are conducted simultaneously. ● Materiality is often a small fraction of the account being audited and planned procedures will be sufficiently precise to identify significant misstatements. ● When errors are identified, additional testing is typically performed in that account and related accounts. ● Overall materiality serves as a “safety net.” 1-36 3-36 Step 3 – Evaluate Audit Findings LO# 11 When the audit evidence is gathered, the auditor: ● ● ● ● Aggregates misstatements from each account or class of transactions (including known and likely misstatements). Considers the effect of misstatements not adjusted in the prior period. Compares the aggregate misstatement to overall materiality. If the aggregate misstatement is less than overall materiality, the auditor can conclude that the financial statements are fairly presented, if not, an adjustment should be made. 1-37 3-37 End of Chapter 3 1-38 3-38