Lecture Auditing and assurance services (Second international edition) Chapter 5 Audit planning and types of audit tests

Chapter 5 Audit planning and types of audit tests. In this chapter, the learning objectives are Understand the auditors requirements for client acceptance and continuance, understand the steps that are involved in the preliminary engagement activities, know what is required to establish an understanding with the client, know the types of information that are included in an engagement letter.

Audit Planning

and Types of Audit Tests

Chapter Five

The Phases of an Audit That Relate to Audit Planning

Prospective Client Acceptance

1 Obtain and review financial information.

2 Inquire of third parties.

3 Communicate with the predecessor auditor.

4 Consider unusual business or audit risks.

5 Determine if the firm is independent.

6 Determine if the firm has the necessary skills and knowledge.

7 Determine if acceptance violates any applicable regulatory or ethical

requirements

Continuing Client Retention

Evaluate client retention

periodically

Near audit completion or after a significant event

Conflicts over accounting & auditing

issues

Dispute over fees

Establish Terms of the Engagement

The terms of the engagement, which are documented in the engagement letter , should include the objectives of the engagement, management’s responsibilities, the auditor’s responsibilities, and the limitations of the

engagement.

In establishing the terms of the engagement, three topics must be discussed:

1.The engagement letter.

2.The internal auditors.

3.Those charged with governance.

The Engagement Letter

The engagement letter formalises the arrangement

reached between the auditor and the client

In addition to the items mentioned in the sample engagement letter in Exhibit 5-1 in the textbook,

the engagement letter may include:

• Arrangements for use of experts or internal auditors.

• Any limitations of liability of the auditor

or client.

• Additional services to be provided.

• Arrangements regarding other services.

Internal Auditors

Those Charged with Governance

Board of Directors

Audit Committee

Preliminary Engagement Activities

Determine the Audit Engagement Team Requirements

Assess Compliance with Ethical Requirements, including Independence

Planning the Audit

• The auditor will develop an overall audit strategy

for conducting the audit This will help the auditor

to determine what resources are needed to perform the engagement

• An audit plan is more detailed than the audit

strategy

• Basically, the audit plan should consider how to

conduct the engagement in an effective and efficient manner.

Planning the Audit

When preparing the audit plan, the auditor should be guided by the results of the risk assessment procedures

performed to gain an understanding of the entity.

Additional steps:

• Assess business risks and establish materiality.

• Assess the need for experts.

• Consider the possibility of compliance (illegal) acts

non-• Identify related parties.

• Conduct preliminary analytical procedures.

• Consider additional value-added services.

Let’s look at each

of these steps.

Assess Risks and Establish Materiality

Use audit risk model

Restrict risk at

account balance level

Achieve acceptable low level of audit risk

You may want to review the detailed discussion in Chapter 3 of the process used to assess the client’s

business risks and to establish materiality.

Assess Risks

Establish Materiality

A major consideration in planning the audit is the

need for an auditor’s expert (ISA 620).

The use of an IT expert

is a significant aspect

of most audit engagements.

The presence of complex information technology may require the use of an

IT expert.

Non-Compliance (Illegal) Acts

Be aware may have

occurred;

investigate if brought to attention

Non-Compliance Acts

• Review significant contracts and agreements not in the entity’s ordinary course of business.

Preliminary Analytical Procedures

To understand the client’s business and transactions

To identify financial statement accounts likely to contain errors

By understanding the client’s business and identifying where errors are likely to occur, the auditor can allocate more resources to investigate

necessary accounts.

Additional Value-Added Services

Tax Planning Transaction

Support

consultancy

IT-Internal reporting Benchmarking

Risk Assessment

Auditors are limited in the types of consulting services that they can offer

their audit clients

Document Overall Audit Strategy and

Audit Plan

Auditors ensure they have addressed the risks they identified by documenting the linkage from the client’s business, objectives, and strategy to the audit plan The auditor’s preliminary decision concerning control risk determines the level of control testing, which in turn affects the auditor’s substantive tests of the

account balances and transactions.

Document overall audit strategy and audit plan, which involves documenting the

decisions about

The auditor documents how the client

is managing its risk (via internal control processes) and the effects of the risks and controls on the planned

audit procedures

A U D I T

T E

S T S

Nature

Timing

Extent

Document Overall Audit Strategy and

Audit Plan

Types of Audit Tests

Risk Assessment Procedures

Used to obtain an understanding of the entity and its environment, including internal control.

Tests of Controls

Performed to obtain audit evidence about the operating effectiveness

of controls in preventing, detecting

and correcting material

misstatements.

Substantive Procedures

Detect material misstatements in a transaction class, account balance, and disclosure element of the

financial statements.

Tests of Controls

Substantive Procedures

Analytical Procedures

Obtains evidence about particular assertions related to account balances or

classes of transactions

Tests of Details

Tests for errors or fraud in individual transactions, account

balances, and disclosures

Dual Purpose Tests

Substantive

Tests

Tests of Controls

Dual Purpose Test

Purposes of Analytical Procedures

Preliminary Analytical Procedures

Used to assist the auditor to better understand the business and to plan the nature, timing, and extent of

audit procedures

Substantive Analytical Procedures

Used to obtain evidence about particular assertions related to account balances or classes of

transactions

Final Analytical Procedures

Used as an overall review of the financial information in the final review stage of the audit.

Purposes of Analytical Procedures (See

Table 5-5)

Trend Analysis

Ratio Analysis

Reasonableness

Analysis

Substantive Analytical Procedures

Decision Process

Develop an Expectation

Auditing standards require the auditor to have

an expectation whenever analytical procedures are used An expectation can be developed

using a variety of information sources such as:

• Financial and operating data.

• Budgets and forecasts.

• Industry publications.

• Competitor information.

• Management’s analyses

• Analyst’s reports.

Define a Tolerable Difference

The size of the tolerable difference depends on:

• The significance of the account.

• The desired degree of reliance on the substantive analytical procedures

• The level of disaggregation in the amount being tested.

• The precision of the expectation.

But the amount is always less than materiality!

Compare and Investigate

Compare the expectation to the recorded amount and investigate any differences greater than the tolerable difference

The Investigation of Differences for Planning and Final Analytical Procedures

Preliminary Analytical Procedures Differences

Corroborating evidence

is not required

Final Analytical Procedures Differences

Corroboratin

g evidence

is required

Audit Testing Hierarchy

Filling the Assurance Bucket

Example of Filling the Assurance Buckets for Each Assertion (Accounts Payable)

Short-Term Liquidity Ratios

Current Ratio

Quick Ratio

Operating Cash Flow Ratio

Activity Ratios

Receivables Turnover

Days Outstanding

in Accounts Receivable

Inventory Turnover

Days of Inventory on

Hand

Profitability Ratios

Gross Profit

Return on Assets

Return on Equity

Coverage Ratios

Debt to Equity

Times Interest Earned

Audit of Group Financial Statements

Component

of a Group

Entity or business activity in which

financial information is included in the group financial statements

Component Auditor

An auditor who, at the request of the group engagement team, performs work on financial information related

to a component for the group audit.

Auditing standards require the group engagement team to identify components that are

likely to be significant components

Audit of Group Financial Statements

End of Chapter 5