Chapter 3: Audit Planning I

Stage of Audit
1. Planning Stage
Gaining an understanding of the client, identifying any factors
that may impact the risk of a material misstatement in the
financial statements, performing a risk and materiality
assessment, and developing an audit strategy.
Audit strategy a strategy that sets the scope, timing, and
direction of the audit and provides the basis for developing a
detailed audit plan.
o Plan so audit risk is at an acceptably low level
Identifying the nature and timing of the procedures to optimize
efficiency and effectiveness when conducting an audit
During Planning
o Sufficient appropriate evidence
o Assess risk of material misstatement due to fraud
o Assess corporate governance
o Assess clients closing procedures
2. Execution / Performing Stage
Detailed testing of controls and substantive testing transactions
and accounts
Detailed testing of controls, transactions, and balances.
Detailed testing provides evidence that the auditor requires to
determine whether the financial statements are fairly presented
3. Reporting Stage
Evaluating the results of the detailed testing in light of the
auditors understanding of their client and forming an opinion on
the fair presentation of the clients f/s
Conclusion based on gathered evidence
Gaining understanding of the client
Goal: assess the risk that the f/s may contain a material misstatement due to:
Nature of clients business
Industry in which the client operates
Level of competition within the industry
Clients customers and suppliers
Steps to take to gain understanding of the client:
Inquiries of management and others within the entity who may have
information to help identify the misstatements
Perform analytical procedures at the planning stage of audit to identify
any unusual or unexpected relationships that may highlight where risks
exist.
Perform observation and inspection procedures to corroborate the
responses made by management and others within the firm.
Entity level

Gains knowledge through interviews with client personnel, especially

those charged with governance
Auditor has a stronger position to assess entity-level risks and f/s
accounts that require closer examination.
Major Customers
To see if customers have good reputation, are on good terms with
client, and whether or not they will pay client on timely basis
Dissatisfied customers > withhold payment and affects allowance for
doubtful accounts and clients cash flows, or decide not to purchase
from client, which affects the going concern assumption.
Risk is increased if client only has one or few customers.
Major Suppliers
If they are reputable and supply quality goods on a timely basis
Faulty goods returned? Terms of any contracts? Terms of payments?
Major Exporter/ Importer of Goods Identified
If trades internationally, have to determine the stability of the country
and currency
Capacity to adapt to changes in technology and other trends
If adaptability level is low, may risk falling behind competitors and
losing market share, which in the long term will affect the going
concern assumption.
Warranties
If provides warranties, auditor needs to assess the likelihood that
goods will be returned and the risk that the client has underprovided
for that rate of return.
Goods returned for the same problem may signify a systematic fault.
Discounts
Given by clients to customers and given to clients by suppliers
Assessment made on clients bargaining power with customers and
suppliers to determine whether discounting policies are putting profit
margins at risk.
Clients Reputation
Poor reputation puts the firms profits at risk, and it is best for an
auditor to not be associated with such a company.
Clients Operations
Where the client operates, number of locations it operates in, and the
dispersion of these locations
Nature of employment contracts / Relation with Employees
The more complex a payroll system, the more likely the errors will
occur.
When staff are unhappy there is greater risk of industrial action (ex.
Strikes)
Clients sources of Financing
Debt sources, the reliability of future sources of financing, the structure
of debt, and the reliance on debt versus equity financing.
Assesses whether the client is meeting interest payments on funds
borrowed and repaying funds when they are due.
Example) company may agree for a certain debt to equity ratio

Ownership structure
Interested in the debt funding relative to equity, the use of different
forms of shares, and the differing right of shareholder groups.
Clients dividend policy and its ability to meet dividend payments out
of operating cash flow are also of interest.
Industry Level
Clients position within its industry, level of competition in that
industry, and the clients size relative to competitors
Level of demand for the products sold or services supplied by
companies in that industry and the factors that affect demand.
Client and competitor comparison is nationally and internationally.
Level of Competition
The greater the competition, the greater is the pressure placed on
clients profits.
Ability to withstand downturns in economy
Reputation relative to other companies
If poor reputation, customers and suppliers may shift their business to
competing firm, threatening clients profits.
Government Support
Important if client faces great international competition
Government Regulation
Tariffs on goods, trade restrictions and foreign exchange policies
Can affect a clients viability and continued profitability
Level of Demand for Goods
If seasonal demand will affect revenue flow
If industry subject to changing trends client risks inventory
obsolescence if it does not keep up and move quickly with changing
styles.
If subject to technological change, risk that a client will quickly be left
behind by its competitors.
Economy Level
Economic upturns and downturns, changes in interest rates, currency
fluctuations
Economic upturn
o Under pressure to perform well or better than competitors
o Shareholders expect consistent improvement in profits
o Risk of overstatement of revenues and understatement of
expenses
Economic Downturn
o Could purposefully understate profits to maximize write offs
o taking a bath low base to demonstrate improvement in the
following year.
Related Parties
Include parent companies, subsidiaries, joint ventures, associates,
company management, and close family members of key management

Related party transactions increase susceptibility of f/s to material

misstatement to fraud and error, and may impact the over f/s results.
Steps to Take:
Discuss with engagement team the susceptibility of f/s to material
misstatement due to related party transactions and relationships
Identify all related parties and provide explanation of nature, type, and
purpose of transactions with these entities
Obtain understanding of processes and procedures management has in
place to ensure all related party transactions are identified, authorized,
and accounted for
Remain alert when inspection of documents of related party
transactions
Identify and assess the risk that transactions may not be in the normal
course of operations.
Fraud Risk
Attitude of professional skepticism independent of client and
maintain a questioning attitude, search thoroughly for corroborating
evidence to validate information provided by the client.
Can use red flags to alert them to the possibility that a fraud have
occurred.
o High turnover of key employees
o Overly dominant management
o Unusual transactions
o Weak internal control
o Inadequate training programs.
Financial reporting fraud intentionally misstating items or omitting
important facts from financial statements
o Improper asset valuation
o Unrecorded liabilities
o Inappropriate application of accounting policies
Misappropriation of assets some form of theft
o Using company credit card for personal use
o Theft of inventory by employee or customer
o Using company car for unauthorized personal use
Incentives and pressures to commit Fraud

Opportunities to perpetrate a fraud

Accounts that rely on estimates and judgements
High volume of transactions near year-end

Significant related party transactions

Complex or unusual transactions
Significant adjusting entries and reversals after year-end
Poor corporate governance, poor internal controls
High staff turnover

Attitudes and Rationalism to Justify a Fraud

Ethical beliefs about right and wrong, ability to justify an act.
Examples
o Implementation of effective internal control is not seen as a
priority
o Excessive focus on maximization of profit/ share price
o Poor attitude to compliance with accounting regulations
o Rationalization that other companies make the same
inappropriate accounting choices.
Audit Procedures relating to fraud
1. Ask management and those charged with governance if they are aware
of a known fraud or suspect there has been a fraud.
2. All members of audit team should attend a team-planning meeting.
a. Significant fraud risk factors and where the f/s are particularly
susceptible to fraud should be reviewed.
3. Auditor should perform preliminary analytics to identify unusual
relationships that may indicate fraud and thus require further
investigation during the audit.
4. Auditor must consider the risk of management override (because
management has ability to manipulate accounting records or override
controls to prevent such fraud)
Going Concern
The assumption made that states that the company will remain in
business for the foreseeable future.
o Assets will be valued on the basis that they will continue to be
used for the purposes of conducting a business and liabilities are
recorded and classified as current/ non current
Indicators
o Significant debt/ equity ratio
o Prolonged losses
o Inability to pay back debt when fall due
o High staff turnover
o Loss of key, long-standing personnel
o Staff regularly on strike
o Being under investigation for non-compliance with legislation
Mitigating Factors
o Letter of guarantee from parent company
o Availability of non-core assets, which can be sold to provide
needed cash
o Ability to raise additional funds through sales of shares

o
o

Ability to raise addition funds through borrowings

Ability to sell an unprofitable segment of the business.

Corporate Governance
Rules, systems, and processes within companies used to guide and
control.
Controls are designed to reduce identified risks and ensure the future
viability of the company.
Important part of gaining understanding of the client.
o Client that does not take corporate governance obligations
seriously may not fulfill its obligations to ensure its financial
statements are fairly presented.
Information Technology
The use of computers to store and process data and other information
Includes transaction initiation, recording, processing, correction as
necessary, transferring to the general ledger and compilation of the f/s
Risks
o Unauthorized access to computers software and data
o Errors in program
o Lack of backup
o Loss of data
General Controls policies and procedures that relate to many
applications ad support the effective function of application controls
o Include procedures for purchasing, changing, and maintaining
new software
o Use of passwords / other security measures to minimize risk of
unauthorized access
o Procedures to ensure appropriate segregation of duties between
staff who maintain program and staff who use the program.
Application Controls
o Manual or automated procedures that typically operate at a
business process level and apply to the processing of
transactions by individual applications.
Closing Procedures
Auditor is concerned that transactions and events have been recorded
in the correct accounting period.
Determine the risk associated with the clients closing procedures.
Clients that report monthly is more likely to have in place wellestablished closing procedures than clients that only report annually.
Can look at earnings trends to assess whether the reported income is
in line with similar periods in prior years
Trace transactions close to year end to source documentation and
confirm that all transactions are recorded in the appropriate
accounting period.

If auditors understand how bonus arrangements work, they will be

more alert to the type of profit shifting likely to be attempted by
managers.

Audit Report
- The need to write down production costs, capitalize production costs.
Taking expenses off income statement until it shows that there is profit.
Why is this case of interest?
- The ICAO found that there is an audit failure (a breach). Auditors
suspected irregularly, even deemed the risk of error as sky high, but
still issued a clean audit opinion of the financial statements.
- Should be highly skeptical while dealing with the accounts.
Two Problems
1. Said that the contract was cancelled. The auditor found out contract
was never cancelled but still is in place. Management said to not worry
about it and told auditor to look at other documents, which is
conflicting with themselves and with the contract.
o They lied, you asked them about why its like that, and
management told them it is okay and bombarded them with
other information
2. Write down of production costs
o Write down assets because they will not be recoverable.
o Auditors should be doing more work.

Tutorial
November 2, 12
3.1

Evidence that there are no related parties and that there are no issues
with the clients corporate governance structure?
Risk of misstatement the same for a dollar of rental revenue as a dollar
of retail revenue?
o The risk of material misstatement should drive the audit plan
New client understanding the client, the industry (both retail and
rental elements) and the effect of economy factors on the client.
Significant transactions and accounts?
Risk of fraud directly proportional to revenue? If not, how should the
fraud work be allocated?
Impact IT would have on the risks associated with the two segments of
the business? How does IT relate to the rest of the clients internal
controls?

Are closing procedures the same for the two segments of the business?
Any going concern risk? What are the risks and mitigating factors that
are likely to occur in a rental and retail company?

3.3
a) Issues
Change from good economic conditions (solid employment growth,
rising oil prices, easy access to credit for consumers) to financial crisis
(recession with lower employment growth, failing oil prices, difficult
access to credit)
Changing conditions such as lower oil prices and lower employment
growth have slowed consumer demand for scooters
Consumer demand also likely to be affected by limited access to
consumer credit for scooter purchases
Changed economic conditions also likely adversely impact Scooter
Ltds access to financing (tighter finance market, slower cash flow to
service debt)
b) Impact on Audit plan
Greater risk of fraudulent reporting pressure on Scooters
management to meet performance targets (bonuses /bank covenants)
Impact on Profit
Risk of fraudulent misstatement on revenue recognition
Impact On Expense
Could be postponed to next period to increase current present profit
Going concern?
3.4
a)

Incentives BoD selected new CEO with reputation of toughness and

turning around the business -> BoD want a change in company results
CEO 5 year contract with incentives for growth, profit and share price
Also incentive for CEO to preserve his reputation
Opportunities CEO has a bonus tied to profit from continuing
operations
Any write-offs that can be labeled as discontinuing operations will not
affect his bonus
Take a bath by writing down assets more than is required without
affecting his bonus
Bonus payments will be higher in the future lower amount of
depreciation charged to continuing profits
Selling off certain division, reduces recurrent depreciation charges,
provides cash resource to invest in other areas favored by CEO
CEO also has 5-year period to make these changes without risking
termination.
Attitudes/ Rationalizations focus is on maximizing profits by
increasing sales and cutting cots
Less emphasis on compliance, more on pleasing the CEO

Efforts to boost profit received favourable

Any attempt to obstruct the CEO such as questioning accounting
policies or business decisions not received favorably
Increasing share prices market approves of the new actions
CEO rewarded by BoD, further encouraging this behavior.
b) Fraud
Consider if risk of fraudulent financial reporting greater than risk of
asset misappropriation
Examples
Backdating sales to current period, postdating expenses to next period
-> increased revenues, lower costs
Reclassifying assets and expenses as part of discontinued operations,
overstating asset impairments, overstating losses on disposal of
discontinued operations
Inappropriate classification of revenues and expenses in current period
to increase reported growth in profit, greater capitalization of expenses
in current period as assets (to increase profit), understanding liabilities
(non-recognition of accruals, etc.)
c) Fraud Procedures
Auditors should comply with CAS 240
1. Ask management and those charged with governance if they are aware
of fraud/ suspect there has been a fraud. Also ask internal audit
department. Document discussions
2. All members of audit team (including partner) should attend a teamplanning meeting discuss significant fraud risks, where the f/s may be
particularly susceptible to fraud. Allows more experienced team
members to share knowledge/ experience with more junior members
3. Perform preliminary analytics to identify unusual relationships that may
indicate fraud and require further investigation during audit
4. Consider risks of management override. Management in position to
manipulate accounting records or override controls designed to
prevent such fraud - test a sample of JEs, review accounting estimates
for reasonableness, contemplate risk of earnings management (rev
rec), examine unusual business transactions to ensure they have
business substance

If during the audit, auditor finds fraud contemplate legal and

professional responsibilities
Bound by confidentiality seek legal advice to determine if there is a
requirement to report fraud to an outside third party
May consider withdrawing from engagement
Must report fraud to level of management above the level where fraud
occurred and also report to audit committee.

3.8
a) Risk Assessment
CAS 315 audit required to understand risks of the clients business
that increase likelihood of material misstatement

Doubts about Dunks ability to continue growing in current economy

Risk of financial stress on company lower revenues and cash
collections from customers, increased costs of adverse currency
fluctuations ( importer)
Difficulty sourcing products form other companies in financial distress
Increased risk of bad debts, improper revenue recognition, volatile
currency exchange rates increased risk of incorrect purchase costs
and exposure to foreign currency exchange risk (which could be
hedged)
Seenior managements bonuses pressure to find ways to increase
revenues and cut costs
Increase risk of fraudulent reporting
General attitude within company toward profit targets could be poor
attitude towards preventing fraudulent financial reporting
Slower month reporting concern
Increases risk that exceptions / performance evaluation not dealt with
on timely basis
Reporting system under pressure, increasing risk that reports are not
accurate

b) Audit closing Procedures

Ensures revenues are not overstated, expenses not understated
Search for backdated revenues, post dated expenses
Documents (invoices, cash receipts, payments) related to sales for first
weeks of New Year and expenses for the last few weeks of year would
be inspected.
Vouch sales journal entries for old year, trace expense documents to
journal for new year
Interim audit procedures investigate monthly closing procedures
Monthly closing entries will not impact on overall profit for year, they
provide a guide to managements attitude towards closing entries and
adequacy of closing entry system controls
Problem 3-13

Fraud triangle
Pressure company needs bank loan to expand
Opportunity president of company has great deal of authority.
Internal controls, if they exist, may not prevent president from
recording sales revenue early.
Rationalization We will never notice the loss of these sales then,
since our sales revenue will dramatically increase once expanded plant
is in place