OVERVIEW OF RISK-BASED

1
AUDIT PROCESS

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2 Information a CPA firm seek in its
investigation of prospective client
In their investigation of a prospective client:

 The CPAs should assess the backgrounds and reputations of the

prospect and its major shareholders, directors, and officers. Thus,
inquiries are made of underwriters, bankers, and attorneys that
conduct business with the prospective client.

 The CPAs are required to make inquiries of the prospect's

predecessor auditors to obtain information that might enter into the
acceptance decision, such as information regarding the integrity of
management. The prospect's financial reports, SEC filings, credit
reports, and tax returns are used as sources of financial background
information.
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3 Purpose and nature of an
engagement letter
 An engagement letter is sent to the client by the auditors to make
clear the nature of the engagement, any limitations on the scope
of the audit, work to be performed by the client's staff, and the basis
for computing the auditors' fee.

 The engagement letter represents the written contract for the

engagement, and its primary objective is to prevent possible
misunderstandings between the client and the auditors.

 It constitutes an executory contract between the auditors and the

client.

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4 Phrase “Shopping for accounting
principles”.
 “Shopping for accounting principles” is a practice whereby
management changes auditors to a CPA firm that is more likely to
allow an accounting principle that has been the subject of dispute
with the company’s prior auditors.

 A number of mechanisms serve to discourage the practice,

including:
1) the requirements under PAS No. 84 for the successor auditors to inquire
of the predecessors about the reasons for the change in auditors,

2) the SEC 8-K requirements for management to report the reasons for a
change in auditors which also require the auditors to express their
agreement with the details,
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5 Phrase “Shopping for accounting
principles”.
3) the requirements under PAS No. 97 that require accountants who are
being asked to provide a report on the accounting treatment of an
prospective or completed transaction to consult with the client’s
auditors to ensure that they have a complete understanding of the
form and substance of the transaction.

4) In addition, the Sarbanes-Oxley Act of 2002 requires the audit

committee to assume responsibility for engaging, compensating, and
overseeing the auditors.

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6 Criticize the following statement.
“Throughout this audit, for all purpose we
will define a “material amount” as
“P500,000”.
 The approach described in the statement is not appropriate.
Materiality depends on both the dollar amount and the nature of
the item. For example, auditors apply a more rigorous standard of
materiality in evaluating transactions between related parties and
potentially illegal acts than they apply to misstatements in
accounts.

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7 Two types of misstatement due to
fraud.
 The two types of misstatements due to fraud are:

1) Misstatements arising from fraudulent financial reporting

(Management Fraud)

2) Misstatements arising from misappropriation of assets (sometimes

referred to as defalcation)
(Employee Fraud)

Fraudulent financial reporting is of more concern to the auditors

because it typically results in effects that are much more material
to the financial statements.

Defalcations often are not material to the financial statements.

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8 What is business risk?

 A business risk is a treat to achieving management’s objectives.

 Examples:
Business Risk Risk of Material Misstatement
Rapidly changing technology in Inventory may be overvalued
the client’s industry may threaten because it is not valued at net
to cause the client’s products to realizable value.
become obsolete.
Economic conditions in the Accounts receivable may be
industry may result in significant overvalued because the
uncollectible accounts receivable. allowance for uncollectible
accounts is not adequate.

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9 Should a separate audit program prepared for
each audit engagement or can a standard
program be used for most engagements?
 The audit procedures to be followed in a given engagement
depend upon such factors as:
a) The risks of material misstatement of the financial statements,
b) The assumption about the effectiveness of internal control,
c) The auditors' estimates of materiality,
d) The nature of the accounting records,
e) The caliber of accounting personnel, and
f) Any special objectives of the engagement.

Consequently, a separate, tailor-made audit program should be

prepared for each audit engagement.

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10 “An audit program is desirable when new staff
members are assigned to an engagement, but an
experienced auditor should be able to conduct
an audit without reference to an audit program”.
 The quotation is misleading because it implies that an audit
program is no more than a checklist of instructions for
inexperienced auditors.

 Audit programs are essential to assessing that all work is performed

and are used on virtually all audit engagements regardless of the
amount of experience of the auditor.

 Also, a written audit program is required for all audits.

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11 Risk of material misstatement of an
assertion
 The risk of material misstatement is the probability that an account,
class of transactions, or disclosure is materially misstated.

 Risk of material misstatement is consists of:

• Inherent risk – the risk of material misstatement without

considering internal control

• Control risk – the risk that internal control will fail to prevent or
detect and correct the material misstatement

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12 Significant risks

 Significant risks often relate to non-routine transactions and

estimation transactions. Such transactions typically involve more
subjective judgment than routine transactions and, therefore, they
often have a higher risk of material misstatement. Significant risks
may also be fraud risks.

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13 Factors that might cause audit
engagement to exceed original time
estimate
 Factors which may cause an audit engagement to exceed the
original time estimate include the following:
1) Accounting records may not be up to date and complete.
2) Inadequacies in internal control may be discovered necessitating a
more detailed audit than anticipated.
3) A significant risk, such as a fraud risk, may be discovered requiring an
extension of audit procedures.
4) Fraud may be discovered, and an extended investigation may be
authorized by the client to clarify the situation.
5) Inadequate supervision of audit staff may permit unnecessary or mis-
directed work to be performed.
6) Findings during the course of the audit may cause the client to request
extension of the scope of the work.
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14 Factors that might cause audit
engagement to exceed original time
estimate
 In some engagements, clients are charged at agreed daily or hourly rates
for the time used to perform the audit.
 The difficulty of forecasting time requirements is a principal reason for the
use of per diem rates rather than quoting a fee for the entire engagement.
 For many engagements, a maximum fee is agreed upon; this plan may, of
course, force the auditing firm to absorb part of the cost of unexpected
amounts of work.
 A decision as to charging the client for unusual amounts of time will involve
consideration of all aspects of the engagement and prior relations with the
client.
 Generally, however, the client should not be billed for excessive time
attributed to audit inefficiencies (e.g. item (5) above).
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15 What problems are created for a CPA firm when
audit staff members underreport the amount of
time spent in performing the specific audit
procedures?
 Underreporting of time results in the CPA firm not billing the client for
all of the time actually involved in rendering the professional
services.
 Thus, the firm's revenue is being restricted. In addition, the
underreporting will cause the firm to underestimate the amount of
time required for future engagements.
 Thus, auditors on future engagements will be expected to perform
audit procedures in an unrealistically short period of time.
 This interferes with the performance of an effective audit as well as
the realistic evaluation of firm personnel.

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16
Cases

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  The audit committee of the BOD of Violet Corp. asked Argante & Tan,
17 CPAs, to audit Violet’s financial statements for the year ended December
31, 2013. Argante & Tan explained the need to make an inquiry with
predecessor auditor and requested permission to do so. Violet’s
management agreed and authorized the predecessor auditor to respond
fully to Argante & Tan’s inquiries.
 After a satisfactory communication with the predecessor auditor, Argante
& Tan drafted an engagement letter that was mailed to the audit
committee of th BOD of Violet Corp. The engagement letter clearly set
forth arrangements concerning the involvement of the predecessor auditor
and other matters.
 Required:
a) What information should Argante & Tan have obtained during their inquiry of the
predecessor auditor prior to acceptance of the engagement?
b) Describe what other matters Argante & Tan would generally have included in
the engagement letter.

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