Auditing: An International

Approach
Week 3: Preliminary Audit Planning
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Week 3: Preliminary Audit Planning

The company accountant is
shy and retiring. Hes shy a
million dollars. Thats why
hes retiring.

Milton Berle
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Week 3: Learning Objectives
1. Summarize the financial statement audit process,
and the main characteristics of an independent
audit engagement.
2. Describe the activities auditors undertake to decide
whether to accept an audit engagement and why
they need to understand the auditee organizations
business and environment and its risks and
controls.
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Week 3: Learning Objectives
3. Identify the principal assertions in managements
financial statements and the related risks of
material misstatement.
4. Explain the materiality levels used for planning the
audit and how these amounts are determined.
5. Show how preliminary analytical procedures help
identify areas where misstatements are most likely
to occur.
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Objective of an Audit of Financial
Statements
The purpose of a financial statement audit is
explained in CAS 200:
Expression of an opinion that the financial statements
fairly presented and are in conformity with GAAP.
The audit is conducted by an independent auditor.

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Auditor Responsibilities
Auditor Responsibilities are also described in CAS
200:
Expression of an opinion.
Reasonable assurance that material misstatements are
absent.
Plan and perform the audit in accordance with GAAS.
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Management Responsibilities
Management Responsibilities are described in CAS
210:
Adoption of sound accounting policies.
Maintenance of adequate internal controls.
Providing fair representations in the financial
statements.

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Types of Misstatements
Error: unintentional misstatement.
Fraud and other irregularities: intentional
Theft of assets, often employee fraud;
Fraudulent financial reporting, often management
fraud;
Computer fraud; and
Illegal acts (direct-effect or indirect-effect).


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The Audit Engagement
As noted last week, there are three categories of
standards:
General standards;
Examination standards; and
Reporting standards.

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The Audit Engagement
General standards deal with the qualifications of
the auditor and the quality of the auditors work:
adequate technical training and proficiency in
auditing;
due care (the degree of skill required by the
profession); and
objective state of mind (in fact and appearance).

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The Audit Engagement
Examination standards deal with the performance
of the auditors work:
Proper planning and performance;
Understanding of the clients environment and
internal control; and
Obtaining sufficient appropriate audit evidence.
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The Audit Engagement
Reporting standards identify the financial
statements and distinguish between the
responsibilities of management and the auditor:
Describes the scope of the examination (what was
done, and what was not done)
Expresses an opinion, or asserts that an opinion
cannot be expressed (explains why not)
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The Audit Engagement
Reporting standards identify the financial statements
and distinguish between the responsibilities of
management and the auditor:
Makes clear what the subject matter of the opinion is,
and that it is in accordance with an acceptable
financial reporting framework.
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The Audit Engagement
Phase 1 Preplanning
Phase 2 Client Risk Profile
Phase 3 Plan the Audit
Phase 4 Design Further Audit Procedures
Phase 5 Perform Tests of Controls
Phase 6 Perform Substantive Tests
Phase 7 Ongoing Evaluation, Quality Control and Final
Evidence Gathering
Phase 8 Issue an Auditors Report
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The Audit Engagement
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Things to Consider
Prior to accepting or continuing an audit, the
auditor consider three key factors:
The risks associated with an audit engagement (page
133);
Threats to independence (page 70); and
Auditability of the auditee (page 131).
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Risks Associated with the Engagement
The auditor must assess risks associated with the
engagement:
How widely distributed will the audited financial
statements be?
How strong is the financial condition of the auditee?
How trustworthy is auditee management?
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Risks Associated with the Engagement
The auditor must assess risks associated with the
engagement:
How complex is the financial reporting required?
How knowledgeable are the users of the financial
statements likely to be?
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Risks Associated with the Engagement
The auditor must consider why the client
wants/needs an audit:
Who are the users?
What are the intended uses of the financial
statements?
For publicly held companies, the auditor is likely to
set audit risk at a low level because of the large
number of unknown users.
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Independence
The auditor must assess independence.
If there are any threats to independence, the auditor
must take steps to reduce those threats to an
acceptably low level.
If that is not possible, then the auditor cannot accept
or continue the engagement.
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Auditability
The auditor must determine whether the auditee is
(or remains) auditable.
Are the financial statements presented in accordance
with an acceptable financial reporting framework?
Does management understands its responsibility for
preparing the financial statements, and for designing
and implementing adequate internal controls.
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Auditability
The auditor must determine whether the auditee is
(or remains) auditable.
What is managements commitment to providing
written representations ?
Are there any scope limitations?
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The Audit Engagement
Make sure you understand the steps and the
approach described in Exhibit 5-1.
It is fundamental to the balance of the course .

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The Audit Engagement
CAS 300 requires the auditor to develop an audit
plan that includes the following components:
The nature, timing, and extent of audit procedures
for the purpose of risk assessment;
The nature, timing, and extent of additional audit
procedures, linked to the individual audit
assertions; and
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The Audit Engagement
CAS 300 requires the auditor to develop an audit
plan that includes the following components:
Any other audit procedures that are needed for
the audit to be conducted in accordance with
GAAS (CASs).
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Client Risk Profile
The Client Risk Profile is developed to assess the
clients business risk AND to document portions of
the audit risk model.
This requires obtaining knowledge of the industry,
the clients business environment, and the clients
control environment.
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Client Risk Profile
The nature of the clients business and industry
affects client business risk and the risk of material
misstatements in the financial statements.
CAS 315 requires the auditor to obtain knowledge
of the entitys business and environment in order to
assess risks and conduct the audit.
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Industry and External Environment
Why is this necessary?
Many industries have unique accounting
environments.
Risks in the industry may affect the auditors
assessment of audit risk for this client
Some inherent risks are common to all businesses in
an industry.

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Business Operations and Processes
The auditor needs to understand factors such as
major sources of revenue, key customers and
suppliers, sources of financing, and information
about related parties that may indicate areas of
increased client business risk.
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Management and Governance
The auditor should assess managements
philosophy and operating style and its ability to
identify and respond to risk, as these significantly
influence the risk of material misstatements in the
financial statements.
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Objectives and Strategies
Auditors need to understand client objectives
related to:
Reliability of financial reporting.
Effectiveness and efficiency of operations.
Compliance with laws and regulations.
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Assess Client Business Risk
Business risk is the risk that the client will fail to
achieve its objectives.
Client business risk can arise from any of the factors
affecting the client and its environment.
The auditors primary concern is the risk of material
misstatements in the financial statements due to
client business risk.
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Client Risk Profile Evidence Gathering
During the risk assessment process, the auditor
uses primarily four of types of evidence:
Inquiries of management and others.
Observation.
Inspection.
Analytical procedures.
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Preliminary Analytical Review
Auditors perform preliminary analytical procedures
to better understand the clients business and to
help assess client business risk.
One such procedure compares client ratios with
industry or competitor benchmarks to provide an
indication of the companys performance.
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Related Parties
A related-party transaction is any transaction
between the client and a related party.
The auditor must identify all related parties and
related-party transactions.
What could go wrong if we did not find out about
related parties?
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Related Parties
Related party transactions must be disclosed in the
financial statements:
if they are material, or
information about them could affect decision making.
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Communication with Predecessor Auditor
When the auditor is asked to take on a new client,
communication with the predecessor auditor is
required.
What could go wrong if this communication is not
initiated?
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Engagement letter
The engagement letter provides documentation of
the understanding of the terms of the engagement
between the client and the public accounting firm.
What are several of the issues that are included in
the engagement letter?
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Staffing Capabilities and Meetings
Overall, the audit team needs to have sufficient
training and proficiency to conduct the engagement.
This includes continuity of staff, complying with rules
of conduct (familiarity threat), and assigning internal
or external specialists as needed.
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Corporate Governance Process
Corporate governance processes include the tone
at the top how senior executives are
monitored, how management is managed.
It also includes the control environment policies
and procedures that affect all aspects of the
business.
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Corporate Governance and Control
Environment
What happens when management does not pay
attention to the ethical environment?
If a business is well run, with a corporate code of
ethics that is demonstrated and enforced by
management, what is the effect upon the auditors
assessment of inherent risk?
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Decide on Need for Outside Specialists
What type of specialist would you need for the
following types of clients? Why?
A retail store that sells fashion clothing.
A distributor of electronics products.
An insurance company.
A fuel oil exploration and development company.
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Materiality
The term materiality is NOT specifically defined in
Canadian Auditing Standards.
The notion of materiality in information economics
embodies the concept that a piece of information
can affect a decision about to be taken or confirms
a decision already made.
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Materiality
Paragraph 2 of CAS 320, Materiality in Planning and
Performing an Audit, states that:
misstatements, including omissions, are considered to
be material if they, individually or in the aggregate,
could reasonably be expected to influence the
economic decisions of users taken on the basis of the
financial statements;
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Materiality
Paragraph 2 of CAS 320, Materiality in Planning and
Performing an Audit, states that:
judgments about materiality are made in light of
surrounding circumstances, and are affected by the
size or nature of a misstatement, or a combination of
both; and
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Materiality
Paragraph 2 of CAS 320, Materiality in Planning and
Performing an Audit, states that:
judgments about matters that are material to users of
the financial statements are based on a consideration
of the common financial information needs of users as
a group.
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Materiality
Paragraph 8 of CAS 320 requires that:
the auditor apply the concept of materiality
appropriately in planning and performing the audit.
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Materiality
Paragraph 9 of CAS 320 goes on to say that:
performance materiality means the amount or
amounts set by the auditor at less than materiality for
the financial statements as a whole to reduce to an
appropriately low level the probability that the
aggregate of uncorrected and undetected
misstatements exceeds materiality for the financial
statements as a whole.
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Materiality
Paragraph A1 of CAS 320 summarizes the goal:
1. In conducting an audit of financial statements, the
overall objectives of the auditor are to obtain
reasonable assurance about whether the financial
statements as a whole are free from material
misstatement, whether due to fraud or error
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Materiality
Paragraph A1 of CAS 320 summarizes the goal:
thereby enabling the auditor to express an opinion
on whether the financial statements are prepared, in
all material respects, in accordance with an applicable
financial reporting framework; and to report on the
financial statements, and communicate as required by
the CASs, in accordance with the auditors findings.
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Materiality
Paragraph A1 of CAS 320 summarizes the goal:
2. The auditor obtains reasonable assurance by
obtaining sufficient appropriate audit evidence to
reduce audit risk to an acceptably low level.
3. Materiality and audit risk are considered
throughout the audit
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Materiality
Materiality is therefore, a dollar amount.
An auditor will reach a preliminary judgment about
materiality by establishing the maximum amount
by which the auditor believes the financial
statements could be misstated and still not affect
the decisions of reasonable users.
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Potential Bases for Materiality
Common bases include the following:
5 to 10% of net income before taxes.
% to 5% of gross profit.
% to 1% of total assets.
% to 5% of shareholders equity.
% to 2% of revenue.
% to 2% of expenses or revenue as suggested by the
guideline for non-profit entities.
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Materiality
The final determination of materiality is based on
professional judgment, considering how much
misstatement users could/would tolerate.
The problem is are the users a homogenous
group?
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Materiality
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Management Assertions
Management assertions are implied or expressed
representations by management about
components of the financial statements.
They are directly related to GAAP, and are part of
criteria used by management to record and disclose
information in the financial statements.
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Management Assertions
Assertions are made about items that appear in:
The Income Statement
The Balance Sheet
The Notes to the financial statements.
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Management Assertions
Assertions about classes of transactions and events
in the Income Statement for the period under audit:
Occurrence
Completeness
Cut-off
Accuracy
Classification


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Management Assertions
Assertions about account balances in the Balance
Sheet as at the end of the period under audit:
Existence
Completeness
Valuation
Rights and obligations controlled by the entity


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Management Assertions
Assertions about presentation and disclosure in the
NOTES to the financial statements:
Occurrence
Rights and obligations controlled by the entity
Completeness
Classification and understandability
Accuracy and valuation

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Management Assertions Relate to Audit
Objectives
Financial statements and financial statement cycles
are used to develop management assertions about
accounts.
Each assertion directly relates to an audit objective
(either general or specific).
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Developing General and Specific Audit
Objectives
Each management objective is related to either a
GENERAL transaction-related audit objective (for
transactions) or a GENERAL balance-related audit
objective (for general ledger ending balances).
When applied to a specific transaction or account,
it becomes a SPECIFIC audit objective.
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Existence
Do assets, obligations (liabilities) and equities exist?
Are they REAL?
General Balance-Related Audit Objective: Existence
Specific Balance-Related Audit Objective for Inventory:
All recorded inventories exist at the balance sheet date
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Occurrence
Did included transactions actually happen? Are they
REAL?
General Balance-Related Audit Objective: Occurrence
Specific Balance-Related Audit Objective for Sales:
Recorded sales are for shipments made to non-
fictitious customers
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Completeness
All transactions and amounts that happened are
included? Was anything MISSED or FORGOTTEN?
General Balance-Related Audit Objective: Existence
Specific Transaction-Related Audit Objective for Sales:
Existing sales transactions are recorded
Specific Balance-Related Audit Objective for
Inventory: All existing inventory has been counted
and included in inventory
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Valuation
Is the asset at lower of cost or net realizable value?
Is the liability at cost?
General Balance-Related Audit Objective: Valuation
Specific Balance-Related Audit Objective for
Inventory: Inventories have been written down where
net realizable value is less than book value
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Accuracy
Were transactions and amounts recorded and
processed properly?
General Transaction-Related Audit Objective:
Accuracy
Specific Transaction-Related Audit Objective for Sales:
Recorded sales are for the amount of goods shipped
and are correctly billed and recorded
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Accuracy
Were transactions and amounts recorded and
processed properly?
General Balance-Related Audit Objective: Accuracy
Specific Balance-Related Audit Objective for Inventory:
Inventory quantities agree with items physically on
hand
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Classification
Were transactions and amounts recorded in the
correct account?
General Transaction-Related Audit Objective:
Classification
Specific Transaction-Related Audit Objective for Sales:
Sales transactions are classified in the correct account
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Classification
Were transactions and amounts recorded in the
correct account?
General Balance-Related Audit Objective: Classification
Specific Balance-Related Audit Objective for Inventory:
Inventory items are properly classified as raw
materials, work in process, or finished goods
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Presentation and Disclosure
Do the statements include all relevant information
in a way that financial statement users can
understand?
General Balance-Related Audit Objective:
Presentation and Disclosure
Specific Balance-Related Audit Objective for
Inventory: Major categories of inventories and their
bases of valuation are disclosed.

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Rights and Obligations
Rights/Obligations: Do the assets on hand belong to
the company? Were the obligations incurred by the
company (not by someone else)?
General Balance-Related Audit Objective: Rights and
obligations
Specific Balance-Related Audit Objective for Inventory:
The company has title to all inventory items listed.
Inventories are not pledged as collateral
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5-74
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Allocation
Were transactions and amounts recorded on the
right dates in the correct period?
General Transaction-Related Audit Objective: Timing
Specific Transaction-Related Audit Objective for Sales:
Sales are recorded on the correct dates
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Allocation
Were transactions and amounts recorded on the
right dates in the correct period?
General Balance-Related Audit Objective: Cutoff
Specific Balance-Related Audit Objective for Inventory:
Purchases at year end are recorded in the correct
period.
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Measurement
Were transactions and amounts updated and
aggregated to the correct account?
General Transaction-Related Audit Objective: Posting
and Summarization
Specific Transaction-Related Audit Objective for Sales:
Sales transactions are updated correctly to the
customer master file, and totals posted to the GL
account correctly.
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Measurement
Were transactions and amounts updated and
aggregated to the correct account?
General Balance-Related Audit Objective: Detail tie-in
Specific Balance-Related Audit Objective for Inventory:
Total of inventory items agrees with the GL.
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Exhibit 5-8 (pages 166 to 169)
Study this till you understand it inside and out, and
then study it again

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