Chapter 6

Audit Planning,
Understanding the
Client, Assessing
Risks and
Responding

Obtaining Clients

Submit a proposal

62

Contact the audit committee

Make fee arrangements

Communicate with the predecessor auditors

Topics
Disagreements over accounting principles
Predecessors understanding of reason for change
of auditors
Other

Overall procedure is important for evaluation of

management integrity

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The Audit Process--Steps

63

After obtaining a client, the audit

process includes:
1. Plan the audit
2. Obtain an understanding of the client and its
environment, including internal control
3. Assess the risks of material misstatement and
design further audit procedures
4. Perform further audit procedures
5. Complete the audit
6. Form an opinion and issue the audit report

This chapter emphasizes obtaining a

client and steps 1-3.
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64

Stages of an
Audit--Diagram

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1. Plan the Audit

65

Establish an understanding with the

client

This is ordinarily accomplished through

use of an engagement letter
Related, determine that
The firm meets professional independence
requirements
There are no issues relating to management
integrity
The client understands the terms of the
engagement

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Items Included in
Engagement Letters

Name of the entity

Management responsibilities

66

Financial statements
Establishing effective internal control over financial reporting
Compliance with laws and regulations
Making records available to the auditors
Providing written representations at end of the audit, including
that adjustments discovered by the auditors and not recorded
to the financials are not material

Auditor responsibilities

Conducting an audit in accordance with GAAS

Obtaining an understanding of internal control to plan audit
and to determine the nature, timing and extent of procedures
Making communications required by GAAS

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Engagement Letters--Optional
Items

Arrangements regarding

67

Conduct of the audit (e.g., timing, client assistance)

Use of specialists or internal auditors
Obtaining information from predecessor auditors
Fees and billing

Other services to be provided, such as examination

of internal control over financial reporting
Limitation of or other arrangements regarding
liability of auditors or client
Conditions under which access to the auditors
working papers may be granted to others

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Audit PlanningOverall

68

Develop an overall audit strategy and

an audit plan
Plan use of clients staff
Plan involvement of other CPAs
Arrange for specialists
On first year audits:

Communicate with predecessor auditors

Establish opening balances on the
financial statements

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2. Obtain an Understanding
of the Client and its
Environment

69

Perform risk assessment procedures,

including

Inquiries of management and others within the

entity
Analytical procedures
Observation and inspection relating to client
activities, operations, documents, reports and
premises.
Other procedures, such as inquiries of others
outside the company (e.g., legal counsel, valuation
experts) and reviewing information from external
sources such as analysts, banks, rating
organizations, journals.

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Understanding the Clients

BusinessNature of the Client

610

Competitive position
Organizational structure
Accounting policies and procedures
Ownership
Capital structure
Product and service lines
Critical business processes
Internal control

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Understanding the Clients Business,

Industry, Regulatory, and Other
Factors

611

Competitive environment
Supplier and customer
relationships
Technology developments
Major laws and regulations
Economic conditions

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Understanding the Clients Business

Attractiveness of the Industry

612

Barriers to entry
Strength of competitors
Bargaining power of suppliers of
raw materials and labor
Bargaining power of customers

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Understanding the Clients Business

Objectives, Strategies & Business
Risks

613

ObjectivesOverall plans
Operating and financial strategies
Operational actions to achieve
objectives
Business risksThreats to
achieving objectives

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Understanding the Clients

Business--Basic Strategy

614

Product differentiation
Cost leadership

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Understanding the Clients Business

Measuring and Reviewing
Performance

615

Budgets
Key performance indicators
Segment performance reports
Balanced scorecard
External parties

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Understanding the Clients

BusinessSources of
Information

616

Inquiries of management
Industry Accounting and Auditing Guides
Industry Risk Alerts
Trade journals and news stories
Government publications
Prior company annual reports and SEC
filings
Prior tax returns
Electronic sources
Tour of plant and offices
Analytical procedures

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3. Assess the Risks of Material Misstatement

and Design Further Audit Procedures

Overall approach

What could go wrong?

How likely is it that it will go wrong?
What are the likely amounts involved?

Particularly consider

617

Inherent risks
Risks of material misstatement due to
fraud (fraud risks)

Design further audit procedures

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Assessing Fraud Risks

Two types

618

Fraudulent financial reporting (management

fraud)
Misappropriation of assets (defalcations)

Procedures to assess fraud risks

Discussion among engagement team

Inquiries of management and other personnel
Planning analytical procedures
Considering fraud risk factors
Incentives
Opportunity
Attitude

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Assessing Fraud Risks

Identifying Fraud Risks

619

Considerations in identifying fraud

risks

Type
Significance
Likelihood that it will result in a
material misstatement
Pervasiveness

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Responding to Fraud Risks

Overall response

Professional skepticism and audit evidence

Assigning personnel and supervision
Accounting principles
Predictability of auditing procedures

Alterations in audit procedures

620

More reliable evidence

Shifting timing to year end
Increasing sample sizes

Response to the possibility of management override

Examining journal entries

Review accounting estimates for biases
Evaluating the business rationale for significant
unusual transactions

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Consideration of Fraud
Throughout
the Audit

621

Evaluating the results of audit

tests
Discovery of fraud

Communication to appropriate level

of management
If fraud involves senior management
or material misstatement
communicate to audit committee

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Design further audit procedures1 of

2

Types

622

Tests of controls
Analytical procedures
Tests of details of transactions and
balances

Audit procedures

Inspection
Observation
Inquiry
Confirmation
Recalculation
Reperformance

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Design further audit procedures2 of

2

Further audit procedures should include

623

Substantive procedures for all relevant assertions

Tests of controls when the auditors risk assessment
includes an expectation that controls are operating
effectively, or when substantive procedures alone are not
sufficient

Procedures should be linked with the assessed risks

of material misstatement at the relevant assertion
level
Overall responses when assessed risks of material
misstatement are high

Heightened professional skepticism

Assigning more experienced staff
Assigning staff with specialized skills
Providing more supervision

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Objectives of Substantive
Programs
for Asset Accounts

624

Establish the existence of assets

Establish that the company has rights to
the assets
Establish the completeness of recorded
assets
Verify the cutoff of transactions
Determine the appropriate valuation of the
assets and accuracy of related transactions
Determine the appropriate financial
statement presentation and disclosure of
the assets

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Transactions Affecting Accounts

Receivable

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Indirect Verification of Income

Statement Accounts

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627

Financial
Statement
Assertions
to the
Audit

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628

Direction of Audit Testing

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629

Relationships
among Audit
Objectives,
Risks of Material
Misstatement,
and Audit
Procedures

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