Chapter 06

Audit Planning,
Understanding the
Client,
Assessing Risks
and
Responding

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6-1

Obtaining Clients

Submit a proposal
Contact the audit committee
Make fee arrangements

Communicate with the predecessor auditor

Topics
Integrity of management
Disagreements over accounting principles
Communications to those charged with governance regarding fraud

and noncompliance with laws

Communication to management and those charged with
governance concerning internal control significant deficiencies and
material weaknesses.
Predecessors understanding of reason for change of auditors
Other

Overall procedure is important for evaluation of management

integrity

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6-2

The Audit ProcessSteps

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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6-3

Stages of an
AuditDiagram
Figure 6.1

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6-4

1. Plan the Audit

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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6-5

Items Included in
Engagement Letters

Name of the entity

Management responsibilities

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

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6-6

Engagement LettersOptional Items

Arrangements regarding
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
6-7

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Audit PlanningOverall

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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6-8

2. Obtain an Understanding of the

Client and its Environment

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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6-9

Understanding the Clients Business

Nature of the Client

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

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6-10

Understanding the Clients

Business,
Industry, Regulatory, and Other
Factors
Competitive environment
Supplier and customer relationships
Technology developments
Major laws and regulations
Economic conditions
Attractiveness of the industry

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

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6-11

Understanding the Clients

BusinessObjectives, Strategies &
Business Risks

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

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6-12

Understanding the Clients Business

Measuring and Reviewing
Performance

Budgets
Key performance indicators
Variance analysis
Segment performance reports
Balanced scorecard
External parties

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6-13

Understanding the Clients Business

Internal Control

Need knowledge and understanding of

how a clients internal control works:
What controls exists
Who performs them
How various types of transactions are
processed and recorded
What accounting records and supporting
documentation exist

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6-14

Understanding the Clients

BusinessSources of Information

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

Ex. www.fasb.org, web pages for company

Tour of plant and offices

Analytical procedures
The statement of cash flows and obtaining an
understanding of the client

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6-15

Determining Materiality

Use professional judgment and based on

reasonable person
Considers both

Quantitative and qualitative factors

Materiality used in

Planning the audit

At the overall financial statement level
Allocate to individual accounts

Evaluating audit findings

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6-16

Materiality Definitions

FASB (included in SASs)The magnitude of an

omission or misstatement of financial information
that, in the light of surrounding circumstances,
makes it probable that he judgment of a reasonable
person relying on the information could have been
changed or influenced by the omission or
misstatement.

PCAOB interpretation of federal securities lawsA

fact is material if there is a substantial likelihood
that the fact would have been viewed by the
reasonable investor as having significantly altered
the total mix of information made available.

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6-17

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

Design further audit procedures

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6-18

Assessing Fraud Risks

Two types
Fraudulent financial reporting (management
fraud)
Misappropriation of assets (defalcations)

Procedures to assess fraud risks

Discussion among engagement team
Inquiries of management and other personnel
Risk assessment analytical procedures (to aid
in planning the audit)
Considering fraud risk factors

Incentives
Opportunity
Attitude
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6-19

Assessing Fraud Risks

Identifying Fraud Risks

Considerations in identifying fraud risks

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

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6-20

Responding to Fraud Risks

Overall response

Alterations in audit procedures

Professional skepticism and audit evidence

Assigning personnel and supervision
Accounting principles
Predictability of auditing procedures
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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6-21

Consideration of Fraud
Throughout the Audit

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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6-22

Design Further Audit Procedures (1/2)

Types

Tests of controls
Analytical procedures
Tests of details of transactions

balances

and

Audit procedures

Inspection
Observation
Inquiry
Confirmation
Recalculation
Reperformance

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6-23

Design Further Audit Procedures

(2/2)

Further audit procedures should include

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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6-24

Audit Documentation

Audit Documentation

Risk assessment
Discussion of the audit team, elements of understanding,

assessment of risk of material misstatement and risks identified

Procedure results
Overall responses, nature, timing and extent of further audit

procedures, linkage of procedures with assessed risks, results of

audit procedures, conclusions reached about operating
effectiveness of controls, significant risk identified, circumstances
in which substantive procedures alone will not provide sufficient
evidence

Consideration of fraud
Similar to risk assessment as document discussion, procedures

used to identify fraud risks, fraud risk and response, any other
conditions that caused fraud-related procedures and
communications with management or audit committee.

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6-25

Audit Trail

A trail of evidence that links source

documents, journal entries and ledger
entries
Auditor may follow the audit trail in either
of two directions related to the direction
of testing
Test for existence or occurrence
Test for completeness

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6-26

Direction of Audit Testing Figure

6.4

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6-27

Transaction cycles

Auditors consideration of internal control

is often organized around clients major
transaction cycles (examples)
Revenue cycle
Acquisition cycle
Conversion cycle
Payroll cycle
Investing cycle
Financing cycle

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6-28

Transactions Affecting Accounts

Receivable Figure 6.5

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6-29

Audit Plan

Systems portion
Deals with clients internal control
Evidence of test of controls and assessing
control risk

Substantive test portion

Deals with financial statement account
balances
Indirect and direct verification of income
statement accounts

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6-30

Indirect Verification of Income

Statement Accounts Figure 6.6

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6-31

Objectives of Substantive Programs

for Asset Accounts

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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6-32

Relationship
of Financial
Statement
Assertions to
the Audit
Figure 6.7

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6-33

Relationships
among Audit
Objectives,
Risks of
Material
Misstatemen
t, and Audit
Procedures
Figure 6.8

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6-34