Module 1

ENGAGEMENT PLANNING

Approach to Designing Tests of Details of Balances

Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between the assertions and established criteria and communicating the results to interested users. Planning the engagement 1. Overall audit planning requirements. 2. Procedures followed Prior to obtaining a new client. 3. Audit planning procedures.

A.OVERALL AUDIT PLANNING RE QUIREMENTS a. Management Assertions . Existence (assets) or occurrence (transactions)
. Completeness - all accounts included . Valuation or allocation . Valuation or allocation . Presentation and disclosure

General Transaction-Related Audit Objectives

1. 2. 3. 4. 5. 6. Existence-Recorded transactions exist Completeness-Existing transactions are recorded Accuracy-Recorded transactions are stated at the correct amount Classification-transactions included in the clients journals are properly classified Timing-Transactions are recorded on the correct dates. Posting and Summarization-Recorded transactions are properly included in the master files and are correctly summarized.

General Balanced-Related Audit Objectives

1. 2. 3. 4. 5. 6. Existence-Amounts included exist Completeness-Existing amounts are included Accuracy-Amounts included are stated at the correct amounts. Classification-Amounts included in the clients listing are properly classified. Cutoff-Transactions near the balance sheet date are recorded in the proper period. Detail Tie-In Details in the account balance agree with related master file amounts, foot to the total in the account balance, and agree with the total in the general ledger. Realizable Value-Assets are included at the amounts estimated to be realized. Rights and Obligations Presentation and Disclosure-Account balances and related disclosure requirements are properly presented in the financial statements.
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7. 8. 9.

In planning and performing an audit, the auditor consider these assertions for the various financial statement accounts. When all of these assertions have been met for an account, the account is in conformity with GAAP. (The Evidence Module)

b. Audit Risk Model

Audit risk = Inherent risk Control risk Detection risk

Audit risk is a measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued. Inherent risk refers to the likelihood of material misstatement of an assertion. This risk differs by account and assertion. Control risk is the likelihood that a material misstatement will not be prevented or detected on a timely basis by internal control. This risk is assessed using the results of TOC. Detection risk is the likelihood that an auditors procedures lead to an improper conclusion that no material misstatement exists in an assertion when in fact such a misstatement does exist. The auditors substantive tests are primarily relied 6 upon to restrict detection risk.

c. Materiality
Analyze a materiality determination case and decide upon a maximum amount of misstatement acceptable in a companys financial statement. An auditor must consider materiality both in (1) planning the audit and designing audit procedures and (2) evaluating audit results. The measure of materiality may be either quantitative or nonquantitative. The auditor apportions the amount of materiality among the various accounts (tolerable misstatement). This apportionment may be based on factors such as the relative size of various accounts and on professional judgment. The measures of materiality used for evaluating purposes will ordinarily differ from measures of materiality used for planning. This is the result of information encountered during the audit. For evaluation purposes, the auditor is aware of qualitative aspects of actual misstatements that s/he is not aware of during the planning stage.
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d. Errors and fraud

An audit should be planned and performed to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. Fraud includes (1) fraudulent financial reporting that makes the financial statements misstatements (sometimes called management fraud) and (2) misappropriation of assets (sometimes called defalcation). Auditor responsibility for error, fraud, and illegal acts.

e. Illegal Acts

When an auditor discovers an act that might be illegal, s/he should inquire of management at a level above those involved, if possible. If management does not provide satisfactory information that there has been no illegal act, the auditor should: 1. Consult with the clients legal counsel or other specialists 2. Apply additional procedures such as - Examine supporting documents such as invoices, canceled checks, and agreements and compare them with accounting 8 records.

Confirm significant information with the other involved party or with intermediaries, such as banks or lawyers. Determine whether the transaction has been properly authorized. Consider whether other similar transactions may be have occurred and apply appropriate procedures.

When, based on procedures such as the above, the auditor believes that an illegal act has or is likely to have occurred, the auditor should 1. Consider its financial statement effect 2. Consider its implications to other aspects of the audit, particularly the reliability of representation by management. 3. Communicate it to the audit committee. 4. Consider the need to modify the audit report as follows: - Lack of disclosure is departure from GAAP and either a qualified or an adverse opinion may be appropriate. - Client-imposed scope restrictions will generally lead to a disclaimer of opinion. - Circumstance-imposed scope restrictions may lead to either a qualified opinion or a disclaimer of opinion.
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B. PROCEDURES FOLLOWED PRIOR TO OBTAINING A NEW CLIENT

The overall goal is to determine whether to attempt to acquire the client, and to gather adequate information so as to allow the auditor to develop a proposal to be presented to the prospective client. a. Communications Between Predecessor and Successor Auditor Concepts such as the following: 1. Initiating the communication is the responsibility of the successor. 2. If the prospective client refuses to permit the predecessor to response, or limits the predecessors response, the successor should inquire as to the reasons and consider the implications in deciding whether to accept the engagement. 3. The successors inquiries of the predecessor should include Information bearing on integrity of management Disagreement with management as to accounting principles, 10 auditing procedures or other similarly significant matters.

 Communications to audit committee regarding fraud, illegal acts, and internal control related matters. Predecessors understanding of the reasons for the change in auditors. b. Obtaining a General Understanding of the Client and Industry Concerning the company itself, an auditor will generally tour the clients facilities, and obtain an overall understanding of the clients organization, including the adequacy of its accounting records. In addition to communicating with the predecessor auditor, the potential successor will generally communicate with the companys audit committee, its lawyers, and possibly with other practitioners and bankers. The process typically ends with a proposal to the client. If this proposal is accepted, an engagement letter is ordinarily sent to the client. c. Establishing an Understanding With the Client (Engagement Letters) Auditors should establish an understanding with the client regarding the services to be performed. Although this understanding may be obtained orally or in writing, it must be documented in the working

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papers and is generally obtained through use of an engagement letter. The engagement letter is sent to the client, who indicates approval through returning a signed copy to the CPA. The understanding must include four general topics: (1) objectives of the engagement, (2) managements responsibilities, (3) auditors responsibilities, and (4) limitations of the audit. If an auditor believes that an understanding has not been established, s/he should decline to accept or perform the audit.

C. AUDIT PLANNING PROCEDURES

a. Developing an Overall Strategy The nature, timing, and extent of planning will vary with the size and complexity of the audit client, experience with the client, and knowledge of the clients business. To develop an overall audit strategy, the auditor may consider the following client and audit considerations: Client considerations 1. Business and industry 2. Accounting policies and procedures 3. Methods of processing accounting information (e.g., computer service center)

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4. Financial statement items likely to need adjustment

5. Considerations requiring extension of audit procedures (e.g., risk of misstatement, related-party transactions) Audit consideration 6. Planned assessed level of control risk 7. Preliminary judgments about materiality levels 8. Nature pf reports to be issued by auditor In addition, the auditor may consider performing the following review and Inquiry procedures during planning (this material has appeared as the Solution to an essay question). Review of records 1. Correspondence, prior working papers, financial statements 2. Current years interim financial statements Inquiries within CPA firm 3. Effects of nonaudit services 4. Extent of assistance from specialists and consultants 5. Timing of audit work 6. Staffing requirements

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Inquiries of client 7. Current business developments 8. Discussion of audit (e.g., type, scope, timing) 9. Effects of new accounting and auditing pronouncements 10. Coordinate client assistance, including that from internal auditors

b. Communicate With Predecessor Auditors

This communication relates primarily to the review of working papers related to opening balance and the consistency of application of accounting principles. With regard to working papers: 1. Areas generally examined include Documentation of planning Internal control Audit results Other matters of continuing accounting and auditing significance such as analyses of balance sheet accounts 2. If in reviewing the working papers the successor identifies financial statement misstatements, the successor should request that the client inform the predecessor and arrange a meeting of the three parties.
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c. Analytical Procedures
During the planning stage the objective of analytical procedures is to assist in planning the nature, timing, and extent of audit procedures that will be used to obtain evidence for specific accounts. 1. Compare client and industry data 2. Compare client data with similar prior period data 3. Compare client data with client-determined expected results 4. Compare client data with auditor-determined expected results 5. Compare client date with expected results, using nonfinancial data

d. Consideration of Internal Control

This understanding must be sufficient to allow the auditor to (1) identify type of potential misstatements, (2) consider factors affecting the risk of misstatements, and (3) design substantive tests.

e. Audit Program
A written audit program must be developed and used for the audit.
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f. Supervision Requirement
Supervision includes instructing assistants. The work of each assistant should be reviewed (1) to determine whether it was adequately performed and (2) to evaluate whether the results are consistent with the considerations to be presented in the audit report.

g. Timing of Audit Procedures

Timing of test of controls and substantive tests

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