9.401 Auditing

9.401 Auditing

Chapters 7 and 8Chapters 7 and 8

Audit Planning and DocumentationAudit Planning and Documentation

Materiality and RiskMateriality and Risk

Audit Planning…

What?What? Developing a general strategy and Developing a general strategy and

detailed approach for the expected nature, detailed approach for the expected nature, timing, and extent of the examinationtiming, and extent of the examination

Why?Why? Ensure GAAS is fulfilledEnsure GAAS is fulfilled Keep costs reasonableKeep costs reasonable Avoid misunderstandings with clientAvoid misunderstandings with client

Sufficient Appropriate Evidence in Auditing

Managementassertions andaudit objectives

Sufficientappropriateevidence

General auditprocedures

Appropriateness of evidence: determined by its relevance and reliability

Sufficiency of evidence: determined by materiality, acceptable audit risk, inherent risk and control risk…

Key Audit Planning Decisions

MaterialityMateriality Acceptable Audit RiskAcceptable Audit Risk Inherent risk, control risk and detection riskInherent risk, control risk and detection risk Nature, timing and extent of audit evidenceNature, timing and extent of audit evidence

What kind?What kind? How much? How much? When?When?

Preliminary Assessment of Planning Materiality

How is materiality used?How is materiality used? In planning:In planning:

accounts or transactions that are “material” , or accounts or transactions that are “material” , or likely to contain “material misstatements” will likely to contain “material misstatements” will require more and better evidencerequire more and better evidence

In evidence evaluation and reporting decisions:In evidence evaluation and reporting decisions: to decide if an error is material or not / if financial to decide if an error is material or not / if financial

statements are materially misstated. statements are materially misstated.

Quantitative Materiality Guidelines

PROS:PROS: reduce reduce

inappropriate inappropriate judgmentsjudgments

more consistencymore consistency greater awareness greater awareness

of audit limitationsof audit limitations provide basis for provide basis for

discussions with discussions with clientclient

CONS:CONS: de-emphasize de-emphasize

judgmentjudgment possibility of possibility of

misinterpretation misinterpretation or misapplicationor misapplication


AuG 7 contains quantitative guidelines for assessing AuG 7 contains quantitative guidelines for assessing materiality:materiality: 5%-10% of NIBT*5%-10% of NIBT* .5%-1% of assets.5%-1% of assets .5%-5% of equity.5%-5% of equity .5%-1% of revenue.5%-1% of revenue .5%-5% of gross profit.5%-5% of gross profit

*NIBT is frequently adjusted for abnormal or X items, mgmt *NIBT is frequently adjusted for abnormal or X items, mgmt bonuses and related party transactionsbonuses and related party transactions


Steps for assessing materiality:Steps for assessing materiality: Who are the users? What decisions will they Who are the users? What decisions will they

make? What are their circumstances?make? What are their circumstances? What base to use? Any adjustments necessary?What base to use? Any adjustments necessary? What % to apply to the base?What % to apply to the base?

The materiality level chosen will then affect the extent of The materiality level chosen will then affect the extent of work that the auditor plans to do.work that the auditor plans to do.


At end of audit, auditor will decide if the errors At end of audit, auditor will decide if the errors discovered in total result in a material misstatement of f/s. discovered in total result in a material misstatement of f/s. Consider: Consider: Known errors (errors actually seen in sample)Known errors (errors actually seen in sample) Most likely errors (errors that most likely exist in Most likely errors (errors that most likely exist in

population if it is exactly like the sample)population if it is exactly like the sample) Possible errors (errors that could exist in population if Possible errors (errors that could exist in population if

it differs from the sample)it differs from the sample)In relation to materiality. See AuG7. In relation to materiality. See AuG7.


In addition to relative size, auditors must also consider In addition to relative size, auditors must also consider other aspects when assessing if something is material:other aspects when assessing if something is material: Absolute SizeAbsolute Size Nature of the Item or IssueNature of the Item or Issue CircumstancesCircumstances Cumulative EffectsCumulative Effects

Audit Risk Model In addition to materiality, the auditor needs to In addition to materiality, the auditor needs to

consider RISK when determining the nature, consider RISK when determining the nature, timing and extent of worktiming and extent of work

RiskRisk affects affects extent extent through the audit risk model: through the audit risk model:

Acceptable Audit Risk Acceptable Audit Risk

= Inherent risk= Inherent risk

* Control risk* Control risk

* Detection risk* Detection risk Auditors need to assess AAR, IR, and CR to Auditors need to assess AAR, IR, and CR to

calculate DRcalculate DR

To gather sufficient To gather sufficient appropriate audit appropriate audit evidence evidence

to provide reasonable to provide reasonable assurance assurance

that the financial that the financial statements do not statements do not contain a material contain a material misstatementmisstatement

Basic Goal of The Audit= To gather sufficient To gather sufficient

appropriate audit appropriate audit evidence evidence

= to reduce the risk to an to reduce the risk to an acceptable level.acceptable level.

that the auditor fails to that the auditor fails to detect a material detect a material misstatement in the misstatement in the financial statements financial statements

Acceptable Audit Risk

Provide clean Provide clean opinionopinion

Qualify opinionQualify opinion

F/S contain no F/S contain no material material misstatementmisstatement

okayokay Unhappy client: Unhappy client: auditor may do auditor may do more work to more work to resolve conflictresolve conflict

F/S contain F/S contain material material misstatementmisstatement

SCARY!!!!SCARY!!!!

Reduce risk to Reduce risk to acceptable levelacceptable level

okayokay

Assessment of Acceptable Audit Risk Extent of user reliance on FSExtent of user reliance on FS

Publicly traded company or private?Publicly traded company or private? Significant creditors?Significant creditors? Size of company?Size of company? Special reliance on report?Special reliance on report?

Likelihood of fraudLikelihood of fraud Likelihood of financial difficulties after issuance of FSLikelihood of financial difficulties after issuance of FS

Competence of managementCompetence of management IndustryIndustry Financial results, key ratiosFinancial results, key ratios

Assessment of Acceptable Audit Risk As risk of engagement increases, level of As risk of engagement increases, level of

assurance to provide increases, so acceptable assurance to provide increases, so acceptable audit risk will decreaseaudit risk will decrease

as audit risk is reduced, more work must be done as audit risk is reduced, more work must be done and fees will be higher. So, auditors usually and fees will be higher. So, auditors usually can’t set audit risk too low or they will lose can’t set audit risk too low or they will lose clients.clients.

Appropriate Levels of Audit Risk Auditors must perform sufficient audit procedures to reduce Auditors must perform sufficient audit procedures to reduce

audit risk to an “appropriate level”audit risk to an “appropriate level”

AuG 7 suggests that the highest limit should not exceed 5%AuG 7 suggests that the highest limit should not exceed 5% protects consumers of audit reportsprotects consumers of audit reports protects the professionprotects the profession protects the auditorsprotects the auditors

Typically the lowest achievable level of audit risk is 1%. Typically the lowest achievable level of audit risk is 1%. Why do you think that is?Why do you think that is?

Components of Audit Risk

AR AR = Audit Risk = probability of material error in FS = Audit Risk = probability of material error in FS remaining undetected after the audit. This will occur if the remaining undetected after the audit. This will occur if the following three events occur.following three events occur.

IR IR = inherent risk = probability of material error occurring = inherent risk = probability of material error occurring in the first place. For a list of factors affecting see in the first place. For a list of factors affecting see HB5135A.HB5135A.

CR CR = control risk = probability of control system failing to = control risk = probability of control system failing to detect material error after it occurs.detect material error after it occurs.

DRDR = detection risk = probability that auditor fails to = detection risk = probability that auditor fails to detect material error given that internal controls fail to detect material error given that internal controls fail to detect the material.detect the material.

Preliminary Assessment Of Audit Risks Audit risk: determine acceptable levelAudit risk: determine acceptable level Inherent risk: assess and justifyInherent risk: assess and justify Control risk: assess and test if requiredControl risk: assess and test if required Detection risk: perform sufficient work to Detection risk: perform sufficient work to

result in audit risk being reduced to desired result in audit risk being reduced to desired levellevel

AR = IR * CR * DR AR = IR * CR * DR for each assertion for for each assertion for each f/s itemeach f/s item

Factors affecting inherent risk Nature of business, industry, productsNature of business, industry, products

economic conditions, regulations, technological changes, economic conditions, regulations, technological changes, locationlocation

Nature of data processing systemsNature of data processing systems Management incentives and integrityManagement incentives and integrity Related party transactionsRelated party transactions Amounts involving estimatesAmounts involving estimates Assets susceptible to misappropriationAssets susceptible to misappropriation Complex or non-routine transactions or those involving Complex or non-routine transactions or those involving

complex calculationscomplex calculations HistoryHistory

Importance of assertions

Audit programs are lists of procedures to Audit programs are lists of procedures to recognize management assertions and produce recognize management assertions and produce related evidencerelated evidence

so, within each transaction cycle, the auditor so, within each transaction cycle, the auditor gathers evidence regarding gathers evidence regarding eacheach assertion for assertion for eacheach of the financial statement accounts. of the financial statement accounts.

For each assertion of each account, use audit risk For each assertion of each account, use audit risk model to determine detection risk (which model to determine detection risk (which determines amount of workdetermines amount of work

Preliminary Definitions of Key Concepts Internal Controls related to f/s auditInternal Controls related to f/s audit

the system of methods and the system of methods and procedures to help assure the procedures to help assure the accuracy of accounting records.accuracy of accounting records.

Compliance TestsCompliance Tests Tests of the internal control system. Used to justify a Tests of the internal control system. Used to justify a

CR < 100%CR < 100% Substantive TestsSubstantive Tests

Direct tests of transaction and balances to detect Direct tests of transaction and balances to detect errors. There are two general types:errors. There are two general types:

Analytical ReviewAnalytical ReviewTests of Details (if detection risk is low, sample size Tests of Details (if detection risk is low, sample size

increases)increases)

The Audit Planning Steps

1)1) PreplanPreplan

2)2) Obtain Background InformationObtain Background Information

3)3) Client legal obligationsClient legal obligations

4)4) Preliminary Analytical ProceduresPreliminary Analytical Procedures

5)5) Set Materiality and elements of risk modelSet Materiality and elements of risk model

6)6) Understand IC and assess control riskUnderstand IC and assess control risk

7)7) Develop overall audit plan and audit Develop overall audit plan and audit programprogram

1: Preplanning

1)1) Client acceptance or continuanceClient acceptance or continuance

2)2) Identify reasons for auditIdentify reasons for audit

3)3) Obtain engagement letterObtain engagement letter

4)4) Select staff for engagementSelect staff for engagement

Purpose of client acceptance or continuance Integrity of clientIntegrity of client

Availability/quality of audit evidenceAvailability/quality of audit evidenceAvoiding lawsuits, violating rules of Avoiding lawsuits, violating rules of

P.C.P.C. Financial health of clientFinancial health of client

Going concernGoing concernAvoiding lawsuitsAvoiding lawsuitsPayment of feesPayment of fees

assessment of your ability to conduct assessment of your ability to conduct audit audit competence, resources,competence, resources,independenceindependence

Information for client selection and retention decision

Communication Between Predecessor and Successor Communication Between Predecessor and Successor AuditorsAuditors required by Rules of Professional Conductrequired by Rules of Professional Conduct must obtain client consent to release predecessor from must obtain client consent to release predecessor from

obligation of confidentiality. If client refuses obligation of confidentiality. If client refuses ((danger!!!!)danger!!!!) communication is still required but communication is still required but information conveyed by predecessor will be limited. information conveyed by predecessor will be limited.

Information for client selection and retention decision

Other sources of information:Other sources of information: financial information regarding client and industryfinancial information regarding client and industry communication with bankers, lawyers and others who communication with bankers, lawyers and others who

do business with clientdo business with client InternetInternet Private investigationsPrivate investigations

Other Pre-engagement Activities:2)2) Identify reasons for auditIdentify reasons for audit

Will affect nature, timing and extent of evidenceWill affect nature, timing and extent of evidence

3)3) Engagement LetterEngagement Letter = the audit contract= the audit contract reduces risk of misunderstanding, legal liabilityreduces risk of misunderstanding, legal liability May contain:May contain:

description of audit and other servicesdescription of audit and other services agreement about feeagreement about fee other arrangements eg. Deadlines, work to be other arrangements eg. Deadlines, work to be

performed by clientperformed by client

Other Pre-engagement Activities:

4)4) Select staff for audit, need for Select staff for audit, need for specialistsspecialists

If specialists are needed, must:If specialists are needed, must:

• Evaluate objectivityEvaluate objectivity

• Ensure professional rules such as Ensure professional rules such as confidentiality are maintainedconfidentiality are maintained

• Review specialist’s workReview specialist’s work– Methods, data, assumptions, findings Methods, data, assumptions, findings

appear reasonableappear reasonable

– Accounting data used is accurateAccounting data used is accurate

2. Obtain Background Information

Purpose:Purpose: Determining materiality levels and assessing risk Determining materiality levels and assessing risk

model componentsmodel components Understanding nature of ICUnderstanding nature of IC Nature and sources of audit evidenceNature and sources of audit evidence Designing proceduresDesigning procedures Assessing sufficient apppropriate audit evidenceAssessing sufficient apppropriate audit evidence Understanding substance of transactionsUnderstanding substance of transactions Understanding accounting principles of industry Understanding accounting principles of industry

and assessing appropriatenessand assessing appropriateness Evaluating overall f/s presentationEvaluating overall f/s presentation

2. Obtain Background Information

Where to look:Where to look: Tour of plantTour of plant

Visualize assets and operationsVisualize assets and operationsIdentify problem areas, risksIdentify problem areas, risks

Identify related partiesIdentify related parties

3. Information about client legal obligations

Purpose:Purpose: Understand client operationsUnderstand client operations Commitments and contingencies requiring Commitments and contingencies requiring

disclosuredisclosure Corporate formCorporate form

Need for auditNeed for auditTaxation issuesTaxation issuesF/S disclosureF/S disclosureRisks to stakeholders, use of f/sRisks to stakeholders, use of f/s

3. Information about client legal obligations

What to look for:What to look for: ContractsContracts Minutes of meetingsMinutes of meetings Articles of incorporation and corporate by-Articles of incorporation and corporate by-

lawslaws

3. Performing Preliminary Analytical Procedures

Purpose:Purpose: Required by GAASRequired by GAAS Understanding client’s industry and Understanding client’s industry and

businessbusiness Assess going concernAssess going concern Indicating possible misstatements, (areas Indicating possible misstatements, (areas

of high inherent risk)of high inherent risk) Reducing substantive tests in some Reducing substantive tests in some

instancesinstances

Working Papers

Used throughout audit to document work Used throughout audit to document work donedone

Purpose:Purpose: Required by GAASRequired by GAAS Basis for planning auditBasis for planning audit Record evidence accumulated, results of Record evidence accumulated, results of

tests and conclusionstests and conclusions Data for determining proper type of reportData for determining proper type of report Basis for review by managers and partnersBasis for review by managers and partners

Working Papers

Characteristics of typical working paper:Characteristics of typical working paper: Properly identified: company, period, Properly identified: company, period,

description of contents, initials of preparer, description of contents, initials of preparer, date of preparation, and index codedate of preparation, and index code

Indexed and cross referencedIndexed and cross referenced Statement of work performed (often by Statement of work performed (often by

written statement and/or tick marks) to written statement and/or tick marks) to ensure goals were fulfilledensure goals were fulfilled

Results and conclusion reachedResults and conclusion reached

Documents

9.401 Auditing