Chapter 3

Audit Planning, Types of Audit Tests, and Materiality

McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

The Phases of an Audit That Relate to Audit Planning

LO# 1

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LO# 1

Prospective Client Acceptance

1. Obtain and review financial information. 2. Inquire of third parties regarding client integrity. 3. Communicate with the predecessor auditor. 4. Consider unusual business or audit risks. 5. Determine if the firm is independent. 6. Determine if the firm has the necessary skills and knowledge.

7. Determine if acceptance violates any applicable regulatory agency requirements or the Code of Professional Conduct.
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LO# 1

Continuing Client Retention

Evaluate client retention periodically

Near audit completion or after a significant event

Conflicts over accounting and auditing issues

Dispute over fees

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LO# 2

Preliminary Engagement Activities

Determine the Audit Engagement Team Requirements

Assess Compliance with Ethical Requirements, Including Independence

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Establish Terms of the Engagement

In establishing the terms of the engagement, three topics must be discussed: 1.The engagement letter; 2.Using the work of the internal auditors; and 3.The role of the audit committee.

LO# 3

The terms of the engagement, which are documented in the engagement letter, should include the objectives of the engagement, managements responsibilities, the auditors responsibilities, and the limitations of the engagement. Who signs the engagement letter?
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LO# 4

The Engagement Letter

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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LO# 5

Internal Auditors

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LO# 6

The Audit Committee

Subcommittee of the board of directors
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.

No specific requirements for privately held companies

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 an understanding of the entity, and preliminary engagement activities. Additional steps:

Assess business risks. Establish materiality. Consider multilocations. Assess the need for specialists. Assess the possibility of illegal acts. Identify related parties. Consider additional value-added services.

Lets look at each of these steps.

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LO# 7

Assess Business Risks

To understand the clients business and transactions To identify financial statement accounts likely to contain errors

By understanding the clients business and identifying where errors are likely to occur, the auditor can allocate more resources to investigate necessary accounts.
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LO# 7

Establish Materiality
Establish planning (overall) materiality
(more on this later!)

Establish tolerable misstatement for specific accounts

Establish tolerable misstatement for classes of transactions

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Consider Multilocations or Business Units

Consolidated Financial Statements

LO# 7

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

Use of 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

Illegal Acts
Illegal Acts
Direct and Material
Consider laws and regulations as part of audit

Material and Indirect

Be aware may have occurred; investigate if brought to attention
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LO# 7

Illegal Acts

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LO# 7

Related Parties
Some examples from FASB ASC Topic 850, Related Party Disclosures

How to Identify Related Parties

Affiliates of the enterprise. Entities using equity method to

account for investments.

Review board minutes. Review conflict-of-interest

statements.

Trusts for benefit of employees. Review transactions with major customers, suppliers, borrowers, Principal owners of enterprise. and lenders. Management. Review large, unusual, or Immediate families of the principal nonrecurring transactions
owners and management. especially at year end.

Other parties that can have

significant influence.

Review loan agreements for

guarantees.
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LO# 7

Additional Value-Added Services

Tax Planning System Design and Integration

Internal Reporting

Risk Assessment

Benchmarking

Electronic Commerce

Auditors who audit public companies are limited in the types of consulting services that they can offer their audit clients.
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LO# 7

Document Audit Strategy and Plan

Document overall audit strategy and audit plan, which involves documenting the decisions about
A U

Nature

The auditor documents how the client is managing its risk (via internal control processes) and the effects of the risks and controls on the planned audit procedures.

D
I T

Timing
T
E S T S

Auditors ensure they have addressed the risks they identified by documenting the linkage from the clients business, objectives, and strategy to the audit plan.

Extent

The auditors preliminary decision concerning control risk determines the level of control testing, which in turn affects the auditors substantive tests of the account balances and transactions.
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LO# 7

Document Audit Strategy

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LO# 8

Supervision of the Audit

Engagement partner and other supervisory members of the team: 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. Detect material misstatements in a transaction class, account balance, and disclosure component of the financial statements.
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Substantive Procedures

LO# 9

Tests of Controls

Inquiry

Inspection

Observation Reperformance

Walkthrough

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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

Obtains evidential matter about particular assertions related to account balances or classes of transactions
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LO# 9

Dual-Purpose Tests
Tests of Controls Substantive Tests of Transactions

DualPurpose Tests

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LO# 10

Materiality
The magnitude of an omission or misstatement of accounting information that makes it probable that the judgment of a reasonable person relying on the information would be changed or influenced by the omission or misstatement. 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 a materiality level for the overall financial statements (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 before taxes. Income from continuing operations. Three year average income. Total assets. Total revenues. The quantitative amounts may be adjusted lower for qualitative factors such as:

LO# 11

Material misstatements in prior years.

Potential for fraud or illegal acts.

Potential loan covenant violations. High market pressures. High fraud risk.

Gross profit.

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. 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 planning materiality. If the aggregate misstatement is less than planning 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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