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8-1 The Need for Adequate Audit Planning
Your text points out three reasons why proper planning of an engagement is crucial: 1)
to obtain sufficient competent evidence, 2) to keep audit costs reasonable, and 3) to
avoid misunderstandings with the client. Ultimately, planning the audit pays off in
minimizing legal entanglements and maintaining good relations with your customer--
the client.
5. Set materiality and assess acceptable audit risk and inherent risk
Only the first four of the steps listed above are covered in this chapter.
The author points out two types of risk that the auditor must consider: acceptable audit
risk and inherent risk. Acceptable audit risk measures how willing the auditor is to
accept that the financial statements may be materially misstated at completion of the
audit. Inherent risk measures the likelihood of a material misstatement before
considering the effectiveness of internal control. These two measures of risk are
important in determining the quantity of evidence that must be accumulated. The
higher the risk, the more evidence it is necessary to acquire.
8-2 Make Client Acceptance Decisions and Perform Initial
Audit Planning
This first step can be broken down in to four tasks:
Client Acceptance and Continuance: Not every client is acceptable. The auditor
must consider the client's integrity, as well as the industry in which the client operates.
In short, the audit risk must be measured against the auditor's threshhold. The CPA
firm should conduct an investigation of a company to assess its desirability as a client.
If the would-be client has been audited previously by another CPA firm, that firm
must be contacted, with the client's permission. The auditor may even go further in the
investigation by contacting other entities that have had dealings with the client, in
order to further assess the client's situation.
For a continuing client, the auditor must reflect upon previous relations with the
client, evidence of the client's integrity, whether the audit fees have been paid (which
could introduce an independence violation if the fees are one year or more in arrears),
and the industry in which the client operates.
Identify the Client's Reasons for an Audit: Two factors will affect audit risk--the
likely statement users and their intended use of the statements. If the statements are to
be used widely, the auditor will need to amass more information in the audit.
Obtain an Understanding with the Client: The auditor must document the
understanding of the engagement by submitting an engagement letter to the client. A
good example of an engagement letter is shown in Figure 8-2. The engagement letter
will carefully specify what work the auditor will perform (audit, compilation, review,
tax return preparation) and should indicate that there is no guarantee of fraud
discovery. You should be aware of the stipulation by the Sarbanes-Oxley Act that it is
the audit committee of the firm being audited that is considered the client.
Select Staff for the Engagement: The staffing of the audit must meet the first general
standard of the Generally Accepted Auditing Standards relating to adequate technical
training and proficiency. Additional specialists should also be considered, if
appropriate. SAS 73 (AU 336) sets requirements for selecting and reviewing the work
of specialists. Also, continuity of personnel from year to year may help to improve
efficiency of the audit.
The author of your text refers to the strategic systems approach to understanding the
client's business. This approach examines a number of dimensions:
Industry and the external environment: There are risks associated with certain
industries; there are risks associated to all clients in certain industries. Additionally,
there are varying accounting requirements that the auditor must take into account in
assessing whether or not to serve a particular client. The auditor must also consider
the external environment in which a company operates--the economic situation,
regulatory requirements, and other factors.
Business operations and processes: The auditor must strive to understand how the
business works--how revenue is generated, how the company is financed, who the
customers are, etc. A company tour is a step toward getting some familiarity,
particularly if questions can be directed to some of the employees. Additionally,
identifying transactions with related parties is a necessary step in understanding the
business, and may involve examination of SEC filings, conversations with
management, and reading through stockholder lists. The Sarbanes-Oxley Act prohibits
related party personal loans to executives; the auditor should be on the lookout for
such illegal loans.
Management and governance: The auditor should become familiar with the
company's organization chart, as well as the corporate charter and bylaws. The SEC
requires public companies to establish a code of ethics; assuming such a code exists, it
should be reviewed by the auditor for any changes or waivers taking place. Corporate
minutes taken at board meetings or stockholders' meetings should be reviewed by the
auditor, to determine if actions required of management have been executed.
Client objectives and strategies: Auditors should be aware of client objectives
related to reliability of financial reporting, effectiveness and efficiency of operations,
and compliance with laws and regulations. Various contracts, debts, pension plans,
leases, and other legal documents should be reviewed with the purpose of evaluating
the client's legal compliance.
In Figure 8-5, the author presents a comprehensive example of how the steps in this
chapter could be applied to the Hillsburg Company example. The steps are listed,
along with the substeps, to the left, with the results stated on the right side of the
figure. Also, remember that in this chapter, only the first four steps are presented, and
that the other four steps will be introduced later.
Analytical procedures are performed at three stages of the audit: 1) in the planning
phase, 2) during the testing phase, and 3) during the completion phase of the audit.
The purposes fo analytical procedures in different phases are illustrated in Figure 8-6.
1. Cash Ratio
2. Quick Ratio
3. Current Ratio
3. Inventory Turnover
Profitability Ratios
3. Profit Margin
4. Return on Assets