Chapter 6 Audit

Stages involved in every engagement. (6)
1. Plan Audit
2. Obtain an understanding of the client and its environment, including internal control
3. Assess the risks of misstatement and design further audit procedures.
4. Perform audit procedures.
5. Complete the audit.
6. Form an opinion and issue audit report.
Plan the audit.
Establish and understanding with the client as to the nature of engagement.
Develop an audit:
– strategy
– plan
– program
Establish understanding with client:
– through use of an engagement letter
– determine that:
-Firm meets professional independence
-no issues relating to MGMT integrity
-client understands terms of engagement
Engagement Letters:
– Name of Entity
– MGMT responsibilities
– Auditors Responsibilities
MGMT responsibilities (5)
– Financial stmts
– Effective internal control over financial reporting
– Compliance with laws and regulations
– Records are available to auditors
– Written representation and end of audit
Auditor responsibilities
– Conducting an audit in accordance with GAAS
– Obtain understanding of internal control and determine nature, timing and extent of procedures
– Making communications required by GAAS
Obtain an understanding of the client and its environment.
Perform risk assessment procedures, including:
– inquiries of management
– analytical procedures
– observation and inspection of activities, operations, etc
– Inquiries of third party
– Review info from external sources
Perform further audit procedures
Approaches and audit procedures.
Complete audit with
Audit procedures
Form an opinion and issue the audit report
– Public company: report on internal control and financial statements
– Nonpublic Company: ordinarily only financial statements
Obtaining Clients: investigate prospective client involves:
– Reputation of management
– Financial strength
– Evaluate independence
Engagement risk
The overall risk of association with the particular business
Submit a proposal
– Contact the audit committee
– Make fee arrangements
Communicate with predecessor auditor:
– Successor auditors must ask management of prospective client to authorize predecessor auditors to disclose information
– This is important for evaluation of management integrity
Other information obtained from predecessor
– Integrity of management
– Disagreements over acct. principles
– Communications to the charged with governance regarding fraud and noncompliance laws and for internal control
– Reason for change of auditors
Audit Planning – Overall
– Develop an overall audit strategy and audit plan
– Plan to use client’s staff
– Plan involvement of other CPAs
– Arrange for specialists
On first year audits:
– Communicate with predecessor auditors
– Establish opening balances on the financial stmts
Audit program
Detailed list of the audit procedures to be performed in the course of the audit.
Time budget
Constructed by estimating the time required for each step in the audit program for each of the various levels of auditors and totaling those estimated amounts.
Understanding the Client’s Business:
– Industry, Regulatory, and other Factors
– Objectives, Strategies & Business Risks
– Measuring and Reviewing performance
Need knowledge and understanding of how a clients internal control works:
– What controls exist
– Who performs them
– How various types of transactions are processed and recorded
– What accounting records and supporting documentation exist
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 the judgment of a reasonable person relying on the information could have been changed or influenced by the omission or misstatement.
Determining Materiality
Materiality is determined during the planning phase of an audit and is based on prior year financial statement amounts, adjusted for relevant changes that have occurred, or on forecasts for the current year, or more commonly, on the client’s current annualized interim statements
Planning Materiality (PM):
Materiality for overall financial statements
Rules of Thumb include:
– 5-10% of net income before taxes
– ½-1% of total net assets
– ½-1% of total revenues
– 1% of total equity
Performance Materiality
Amount allocated to individual accounts set to reduce the probability to a low level that the aggregate of undetected misstatements exceeds materiality for the financial statements as a whole.
– 50-75% of Planning Materiality
Tolerable Misstatement (TE)
Maximum misstatement that the auditor is willing to accept (application of performance materiality to a particular sampling procedure)
– 50-75% of Planning Materiality (same or lower)
The combined Performance Materiality for all accounts will normally exceed Planning Materiality because:
1) It is highly unlikely that each account will be misstated by the full amount of its performance materiality.
2) There may be offsetting misstatements as some accounts are overstated and others are understated
Two types of fraud risk
– 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
Considerations in identifying fraud risks
– Type
– Significance
– Likelihood that it will result in a material misstatement
– Pervasiveness
Responding to Fraud Risks
– Overall response
– Alterations in audit procedures
– Response to the possibility of management overide
Overall response
– Professional skepticism and audit evidence
– Assigning personnel and supervision
– Accounting principles
– Predictability of auditing procedures
Alterations in audit 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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