Preliminary Audit Planning

An Overview of an Independent Audit of Financial Statements

Steps: Elements

Risk Assessment Pre-engagement activities

Preliminary Audit Planning: Risk Identification

Risk Assessment Procedures to Plan Audit

Response to AssessedRisks

Internal control documentation and testing

Sampling decisions

Substantive procedures

Concluding & Reporting Review audit findings

Form opinion and issue report

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The Audit Process: Ongoing Activities

• Communications among audit team members

• Documentation of

• Revisions to risk assessments and planned responses if appropriate

• Communications with those charged with the auditee’s governance.

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The Independent Audit Engagement

• A wide variety of organizations, or “entities,” are required to produce financial statements. Why?

• At the outset of an audit engagement, it is important for the auditors to understand1. what kind of entity is being audited

2. who the people are who are charged

3. the stakeholders

4. the reason that the client wants the audit.

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Pre-engagement Arrangements

Auditors undertake two types of activities before beginning an audit:

1. Risk management: • Auditors try to reduce the risk

• Audit failure:

2. Quality management:

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Audit Engagement Acceptance and ContinuanceClient selection and retention:

• An important element of an accounting firm’s quality control policies and procedures is a system for deciding:

• Accounting firms are not obligated to

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Client acceptance and retention procedures should include:

1. Obtaining and reviewing financial information about prospective client.

2. Evaluation of independence.

3. Evaluation of competency and resources

4. Understand business risks and determine management’s willingness to accept responsibility for financial statements

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5. Consider if the engagement requires special attention or involves unusual risks

6. Look for news reports, consult with auditee’s banker, legal counsel or others to assess integrity of management

7. Communicate with previous auditor

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Determining Auditability

What does auditability mean?• Are the financial statements presented in

• Does management understands its responsibility

• Management’s must be committed to providing

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Audit Continuation

Decisions to continue auditing an organization are similar to the original acceptance of a first time client except:

An auditor annual Retention Review•

This review take into account changes within the client

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Communication Between Predecessor and Successor Auditors

Who is the predecessor auditor?

Who is the successor auditor?• Rules of professional conduct require the successor auditor

to contact the predecessor auditor.

• Predecessor auditor is required by the rules of conduct

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Successor auditor should ask the client to consent to discussions with the predecessor auditor.

• Consent allows the predecessor auditor to relay more information.

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Auditor’s Risk From Accepting An Audit EngagementKey Factors to consider:

1. How widely distributed are the audited financial statements?

2. How strong is the financial condition of the auditee?

3. How trustworthy is auditee management?

4. How complex is the financial reporting required?

5. How knowledgeable are the people likely to be using the financial statements?

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The Engagement Letter

When a new audit client is accepted an engagement letter must be obtained.

• The engagement letter forms

• A new engagement letter should be

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Typical Contents of the Engagement Letter

• Addressed to the senior management (e.g. CEO) of the client.• Identification of the service to be rendered:

• Specification of the responsibilities of the auditor of the company:

• Constraints on the accounting firm:

• Deadlines:

• Description of any assistance to be provided by the client:

• Interactions with specialists, internal auditors, and the predecessor auditor needed to conduct the audit:

• A disclaimer:

• A description of the basis for fees:

• Ownership and accessibility of the auditor’s files to external parties.

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Staff Assignment

When the new client is obtained, accounting firms assign a full-service team to the new client.

• For a small firm or client, audit team may be just one or two people.

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Time Budget

The partner or manager propose a plan for the timing of the work based on previous experience and knowledge of the business.

Everyone on the audit reports the time taken to perform the audit procedures.

• Time reports are recorded by the time budget categories to all for:

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An Example of a Time Budget

Audit Time Budget (hours)Interim Year-End

Knowledge of the business 15Internal audit familiarization 10Assessment of control risk 30 10Audit program planning 25Related parties investigation 5 15Client conferences 10 18Cash 10 15Accounts receivable 15 5Inventory 35 20Accounts payable 5 35Representation letters 20Financial statement review 25Report preparation 12Total 160 175

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Understanding of the Client’s Business

Understanding the client’s business and operating environment is very important in an audit.

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Understanding the Client’s Business-Significant Risks

AUDITOR RISK ASSESSMENT IMPLICATIONS

What needs to be considered? Why is this considered?

What is the entity’s underlyingeconomic reality?

What could have gone wrong inpreparing the financial statements?

Is there any significant risk thatany of these things have gonewrong?

If there are one or moresignificant risks, what evidencecan auditors obtain to confirmor dispel suspicions that theevents occurred/exists?

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The auditor need to design an effective audit

Thus auditors must understand the business and the economic environment

Factors to consider:1. national economic condition and policies

2. geographic location

3. developments in taxation and regulation•

4. specific industry characteristics

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Analytical Procedures

Although particular analytical procedures are not required by audit standards, the timing of these procedures is specified:

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Analytical Procedures

• Usually done at the Partner/Manager level

• Compare current-year account balances with

• Compare current-year account balances and financial relationships with

• Compare current-year account balances

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Auditors look for relationships in accounts as indicators of problems and to plan further audit work.

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Applying Analytical Procedures to Management’s Draft Financial Statements

Analysis of the draft statements may show relationships that do not make sense.

Preliminary analytical procedures also:

In addition, the auditor should analyze the cash flow statement for irregularities, such as cash deficits from operations.

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Materiality Levels for Audit Planning –

Materiality is one of the first important judgments the auditor must make

• it affects

• Materiality is the largest amount of uncorrected misstatement that might exist in financial

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Financial statement materiality:• Information is material and should be disclosed

Remember that accounting numbers are not perfectly accurate because of the nature of accounting.

• Estimates

• Some inaccuracy is unavoidable.

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PERFORMANCE MATERIALITY

To leave room for error and reduce the probability that the total misstatement exceeds materiality, auditors will determined an amount of performance materiality.

1. Financial statement materiality for the audit is calculated in the planning stages

2. Performance materiality is a lesser amount that is calculated when designing audit procedures

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Materiality Judgment CriteriaMateriality is both a quantitative and a qualitative judgment.

Small misstatements may be material in some cases.

In particular:

must be considered material.

Small misstatement are also considered material if they:

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Quantitative Guidelines for Materiality

In determining materiality auditor's do not have definitive calculations

• Some quantitative guidelines:• 5% of income from continuing operations • 5% of net income before bonus,• ½ to 2% of revenues or expenses for non-for profit entities,• ½ to 1% of net asset value for the mutual fund industry, or• 1% of revenue for the real estate industry.

•In some circumstances, the auditor may also select alternative financial statement items for establishing materiality

•When income measures are used as a basis, they should be normalized or averaged

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Qualitative Guidelines for Materiality

In addition to quantitative guidelines, the auditor should consider other factors as well.

•In looking at the text it can be seen that materiality is taken very seriously by the auditor •See Exhibit 5-6 – Materiality Assessment Worksheet

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Cumulative Effects of ErrorsAuditors must consider the sum of known or potential misstatements.

• The auditor accumulates all the errors on a worksheet

• Considering five errors of $15,000 each to be immaterial is inappropriate when materiality is determined to be $50,000.

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Nature of Misstatement Assets Liabilities O/E Revenue Expenses

Unrecorded Trade Payables 2500 2500

PPE recorded as expense 5000 5000

Unrecorded Accounts Receivable

3000 3000

Total 8000 2500 3000 7500

Financial Statement Assertions and Audit ObjectivesAssertions are claims management makes in financial statements.

• Managements accounting system produces a trial balance.

• For each of the accounts in the trial balance managements is making an assertion

• Auditors take the assertions

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Management Assertions and Audit ObjectivesThe practical audit objectives are to

• Five principal assertions cover the claims made by management in the financial statements:

1. Existence (Occurrence)

2. Completeness

3. Ownership (Rights and Obligations)

4. Valuation (Measurement and Allocation)

5. Presentation (Classification and Disclosure)

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Existence (Occurrence)

Establish with evidence that:• assets, liabilities and equities • that revenue and expense

• there are cut-off considerations to existence:

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Completeness

Establish with evidence that all transactions and accounts that should be presented in the financial reports

• No items belonging to the financial statement • There are cut-off considerations:

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Ownership (Rights and Obligations)

Establish with evidence that amounts:

1.reported as assets of the company represent

2.reported as liabilities

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Valuation (Measurement and Allocation)

Determine whether proper values have been assigned to assets, liabilities, equities, revenues, and expenses.

How about A/R

Expenses

Fixed Assets

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Presentation (Classification and Disclosure)

Determine whether the accounting principles

are properly

whether disclosures are adequate

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Cash

Accounts Receivable

Allowance for Doubtful Accounts

Inventory

What is management asserting about the above accounts?

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$5,000

$250,000

25,000

$750,000

Property, Plant & Equipment

Valuation account?

Accounts Payable

Sales

Expenses

What is management asserting about the above accounts?

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$500,000

$200,000

5,000,000

4,000,000

Further Considerations Regarding AssertionsManagement asserts compliance with laws and regulations.

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Misstatement At The Assertion LevelAssertions are the fundamental management claims to be audited.

• They are the• The auditor uses the assertion to ask

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Overall Audit Strategy

Audit planning is an ongoing, iterative process.• The preliminary planning activities are

• The audit strategy guides development of:

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Problem 5-4, Page 181

Predecessor and Successor Auditors.

The president of Allpurpose Loan Company had a genuine dislike for external auditors. Almost any conflict generated a towering rage. Consequently, the company changed auditors often.

Wells & Ratley (W&R), PAs, was recently hired to audit the 2013 financial statements, the firm succeeding the firm of Canby & Company which had obtained the audit after Albrecht & Hubbard (A&H) had been fired. A&H audited the 2012 financial statements and rendered a report that contained an additional paragraph explaining an uncertainty about Allpurpose Loan Company's loan loss reserve. Goodbye, A&H! Canby & Company then audited the 2013 financial statements, and Art Canby started the work. But, before the audit could be completed and an audit report issued, Canby was fired, and W&R was hired to complete the audit.

Required:

Does W&R need to initiate communications with Canby & Company? With A&H? with both? Explain your response in terms of the purposes of communications between predecessor and successor auditors.

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Problem 5-7, Page 182Materiality Level Reduced

Your firm has done the audit of Rhea Fashions Inc. for many years. You are in charge of the fieldwork for the current year’s audit. Rhea is a manufacturer of high-fashion clothing. Its shares are publically traded, but a majority of the common shares are held by members of the family that started the business during the 1950s. During the current year, Rhea’s business shrank substantially because of losing a major customer, a country-wide department store chain that went out of business. Rhea has not been able to replace the lost business. Since many of Rhea’s long-time employees were happy to take an early retirement offer, Rhea management’s strategy now is continue to operate only a few unique clothing brands that represented about 50% of its sales volume in prior years. The materiality level used in the prior years was $80,000. The audit partner has determined that the appropriate materiality for the current year financial statement audit is $40,000.

Required:

a.Discuss the factors that the audit partner would have considered in deciding to reduce the materiality level.

b.What impact will the lower materiality level likely have on your audit procedures in the current year?

c.While reviewing the previous year’s audit file, you note that last years staff uncovered one error. Rhea failed to accrue approximately $50,000 of customer volume discounts because of a calculation error in computing the customer’s total sales. Since the error was less than materiality, no adjustments were made to the prior year’s financial statements. Explain the impact it will have on the current year’s financial statements when it reverses, and on your audit, given your new materiality level.

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Problem 5-10, Page 183Quantitative and qualitative materiality criteria

You are performing the audit of Pirouette Systems Inc. (PSI) financial statements for its year ended November 30, 20X0. PSI is a private company that sells and installs computer networks for businesses in the Toronto area. PSI has four shareholders who are all actively involved in the business. PSI’s audited financial statements are used mainly by its bank, which has made a large operating loan. The bank requires PSI to maintain a current ratio of at least 1.2 to 1, based on its year-end financial statements, otherwise the bank can require PSI to repay the loan in full immediately.

PSI’s accounting policy for recognizing revenue is to recognize 50% of the sales contract amount when the customer signs a sales contract and the balance when the network installation is complete. All sales are on account. During 20X0, PSI hired a new sales manager who has focused on making sales to larger companies. On November 30, 20X0, the sales manager reported to the PSI’s accountant that $250,000 should be recorded as sales revenue. This amount is 50% of the revenue on a large sale to a new customer. This is the largest single sale in PSI’s history. In January 20X1, while doing the audit you have discovered that the sales manager had been premature in reporting this contract as a sale, since the customer did not actually give the final approval of the contract purchase of the network until December 15, 20X0.

Before correcting this error, PSI’s draft financial statements show the following:•Net income before taxes of $6,200,000•Accounts receivable, net of allowance foe bad debts, of $850,000•Total current assets of $1,100,000•Total current liabilities of $860,000

Required:

a.Explain how the accounts in the PSI financial statements will be affected by this error. In your explanation identify the assertion(s) violated by this error.

b.Calculate the impact of this error on PSI’s current ratio. (Note: Current ration = Current assets / Current liabilities)

c.Would you consider this error material? Justify your response.

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