Chapter 3
Audit Planning,
Types of Audit
Tests, and
Materiality
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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.
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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.
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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.
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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
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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.
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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
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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
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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?
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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.
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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.
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Establish an Understanding with the Entity
2- Internal Audit Function
LO# 5
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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.
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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.
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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.
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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.
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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
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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.
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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?
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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
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LO# 7
Consider Violations of Laws and
Regulations
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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
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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.
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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.
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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
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LO# 7
Document Audit Strategy,
Audit Plan, and Audit Programs
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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
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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.
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LO# 9
Tests of Controls
Inquiry
Inspection
Observatio
n
Walkthrough
Reperform
ance
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LO# 9
Tests of Controls
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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
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LO# 9
Dual-Purpose Tests
Substantive
Tests of
Transactions
Tests of
Controls
DualPurpose
Tests
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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.
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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)
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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.
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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.”
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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.
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End of Chapter 3
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