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Audit Planning With Analytical Procedures, Risk, and Materiality

Edward A. Dion County Auditor's Office

Audit Planning

Audit planning tools used to guide and direct audit work are classified as
 preliminary  preliminary  preliminary  audit

risk assessment, materiality decisions, analytical procedures, and


The Audit Risk Model

Audit risk is the probability that an auditor will give an inappropriate opinion on financial statements. The auditing profession has no official standard for an acceptable level of overall audit risk, except that it should be acceptably low.

The Audit Risk Model (Client)

Inherent risk is the probability that material misstatements have occurred in transactions entering the accounting system used to prepare financial statements. Control risk is the probability that the client's internal control system will fail to detect material misstatements. Control risk should not be assessed so low that complete reliance is on controls and no other audit work is performed.

The Audit Risk Model (Auditor)

Detection risk is the probability that audit procedures will fail to produce evidence of material misstatements. Detection risk is realized when substantive procedures fail to detect material misstatements. Substantive procedures include
y audit of the details of transactions or balances, and y analytical procedures.

The Audit Risk Model

Audit risk can be expressed in the following model which assumes the elements to be independent:

Audit risk (AR) = Inherent risk (IR) x Control risk (CR) x Detection risk (DR).

The Audit Risk Model


DR = AR (IR x CR) Control risk)

(Detection risk) (Audit risk) (Inherent risk x

Preliminary Assessment of Planning Materiality

Materiality is considered to be the largest amount of uncorrected dollar misstatement that could exist in published financial statements, yet still be fairly presented in conformity with GAAP (i.e., not misleading).

Planning Materiality

Some of the common factors auditors use in making judgment are

y y y y y y

absolute size, relative size, nature of the item or issue, circumstances, uncertainty, and cumulative effects.

Assignment of Materiality

Bottoms-up approachjudging materiality amounts in each account separately, then combining them to determine the overall effect. Top-down approachjudging an overall material amount for the financial statements and then allocating it to particular accounts.

Planning Materiality

The concept of materiality is used by auditors as a guide

to planning the audit program, to evaluation of the evidence, and for making decisions about the audit report.

Preliminary Analytical Procedures

Analytical procedures must be applied in the beginning stages of each audit. Preliminary analytical procedures are primarily attention directing.

Preliminary Analytical Procedures

Five general types of procedures for analysis of current year account balance are as follows:

to balances for one or more comparable

periods.  Compare to anticipated results (budget and forecasts).  Evaluate relationships to other current-year balances for conformity with predictable patterns.  Compare with similar industry information.  Study relationships with relevant nonfinancial information.

Planning Memorandum


It provides a summary of the preliminary analytical procedures and the materiality assessment with specific directions about the effect on the audit. It is used to prepare an audit program. An audit program is a specification of procedures that auditors use to guide the work of inherent and control risk assessment and to obtain sufficient competent evidence that serves as a basis for the audit report.

Audit Programs

An internal control program contains procedures to obtain an understanding of the client's business and management's control structure, and for assessing the inherent and control risk. A balance-audit program contains substantive procedures for gathering direct evidence about the five assertions about dollar amounts in the account balances

Internal Control Evaluation: Assessing Control Risk

The Second Standard of Field Work  A sufficient understanding of the internal control structure is to be obtained to plan the audit and to determine the nature, timing, and extent of tests to be performed.  How will the auditor's understanding of the internal control structure influence the nature, timing, and extent of audit tests?  The Audit Risk Model (Assessment of Control Risk) AR = IR x CR x DR Competence of Evidential Matter (AU326.19b.): The more effective the internal control structure, the more assurance it provides about the reliability of the accounting data and financial statements.

The COSO Report


In 1992, the Committee of Sponsoring Organizations of the Treadway Commission (COSO) produced a report titled Internal ControlIntegrated Framework. Definition. The COSO report defines internal control as a process designed to provide reasonable assurance that objectives are achieved in three areas.
y y y

Effectiveness and efficiency of operations. Reliability of financial reporting. Compliance with applicable laws and regulations.

Fundamental Concepts.

The COSO report identifies four fundamental concepts.

 Internal control

is a process to achieve objectives.  People establish objectives, implement controls, and operate controls.  Internal control provides reasonable assurance, not absolute assurance, that control objectives will be achieved.  Internal control is designed to achieve objectives, as described above.

Internal Control Components.


Control environment Risk assessment Control activities Control monitoring Control information and communication

Management versus Auditor Responsibility

Management is responsible for establishing and maintaining components of the entity's internal control. External and internal auditors are responsible for evaluating existing internal controls and assessing the related control risk.

General Categories of Internal Control Errors, Irregularities, and Misstatements



Invalid transactions are recorded (validity). Valid transactions are omitted from the accounts (completeness). Unauthorized transactions are executed and recorded (authorization). Transaction amounts are inaccurate (accuracy). Transactions are classified in the wrong accounts (classification). Transaction accounting and posting is incorrect (accounting/posting). Transactions are recorded in the wrong period (proper period).

Internal Control Deficiencies

Reportable Conditions
 Reportable conditions

represent significant deficiencies in the design or operation of the internal controls that could adversely affect the organization's ability to record, process, summarize, and report financial data in the financial statements. (AU32) material weakness in internal control, which is a more serious reportable condition, is a condition in which internal controls do not adequately lower the risk level of material errors in the financial statements and may not be found on a timely basis by employees of the entity. (AU325)

Material Weaknesses.

The Auditors Evaluation Process


Understand a client's financial reporting controls. Document the understanding. Assess the control risk. Use the control risk assessment to plan remaining audit work.

y y y

Control Objectives


Validity. Ensure that recorded transactions are the ones that should have been recorded. Completeness. Ensure that valid transactions are not omitted entirely from the accounting records. Authorization. Ensure that transactions are approved before they are recorded. Accuracy. Ensure that dollar amounts are figured correctly. Classification. Ensure that transactions are recorded in the right accounts. Accounting and Posting. Ensure that the accounting process for a transaction is completely performed and in conformity with GAAP. Proper period. Ensure that transactions are accounted for in the period in which they occur.

General Control Activities



Capable personnel. Segregation of responsibilities. Authorization to execute transactions, Recording transactions, Custody of assets involved in the transactions, and Periodic reconciliation of existing assets to recorded amounts. Controlled access. Periodic comparison.

Segregation of Technical Responsibilities and Application Controls

Phases of a Control Evaluation

y y

Phase 1: Understanding the Internal Control. Phase 1: Documentation of the Control Structure Elements. Phase 2: Assess the Control Risk (Preliminary). Phase 3: Perform Test of Controls Audit Procedures.
y Tests of control procedures are performed. y Direction of the test.

y y

Phase 4: Assess the Control Risk.

Control Evaluation and Cost/Benefit

Revenue and Collection Cycle

Revenue and Collection Cycle: Typical Activities


Receiving and processing service requests. Delivering services to agencies and the public. Billing entities or agencies and accounting for accounts receivable. Collecting and depositing cash received from all sources. Reconciling bank statements.

Cash Receipts and Cash Balances

Authorization: Approving adjustments or cancellation of indebtedness. Custody: Control and custody of the physical cash. Recording: Accountants who record cash receipts and credit individual accounts should not handle the cash. Periodic Reconciliation: Bank accounts should be reconciled carefully.

Audit Evidence in Management Reports and Data Files

Receipts received but not posted to Master File. Contains payment transactions started but not completed. Fine and Fee structure. File of fees mandated by the State, County or Judicial Order. Receipt Detail File. Contains detailed receipt entries.

Audit Evidence in Management Reports and Data Files

Receipts Analysis Reports.


receipt analyses, for example, by fee type or by section, division or department.

Accounts Receivable Aged Trial Balance (each office should have one if they are due funds). List of balances owed by individual or agency including aging information.

Control Risk Assessment


General Control Considerations. Proper segregation of responsibilities for authorization, custody, recording and reconciliation. Persons who handle cash should be insured under a fidelity bond. Provide for detail error-checking activities. Information about the control system can be gathered by an internal control questionnaire, a walk-through or a sample of one.

Detail Test of Controls Audit Procedures


The general control objectives (validity, completeness, authorization, accuracy, classification, accounting and posting, and proper period recording) must be related to the revenue cycle activities.

Detail Test of Controls Audit Procedures

Detail tests of control procedures include

 identification of

the data population from which a sample will be selected for audit, and  the action to be taken to produce relevant evidence (the action involves vouching, tracing, observing, scanning, and recalculation).

Test of controls audit procedures can be used to audit the accounting transactions in two directions:
 Completeness  Validity.

Control Risk Assessment (completed)


Summary: Control Risk Assessment and the Audit Risk Model AR = IR x CR x DR

Substantive Testing

Existence/Occurrence Completeness Valuation Rights/Obligations Presentation and Disclosure Confirmations

Confirmation of Cash and Receivable Balances

Auditors use a standard bank confirmation form approved by AICPA, ABA, and BAI.

Confirmation of Accounts and Notes Receivable


Positive confirmation Negative confirmation

Confirmation Evidence Issues


Assertions Negative v. Positive Respondent Facsimile responses (faxes) Alternative Procedures

Bank Reconciliations

Accounts Receivable Lapping

 Lapping is

the process whereby an employee takes receipts and attempts to cover up by using later receipts to credit accounts of customers from which receipts were taken. kiting is the practice of building up apparent balances in one bank account based on uncollected checks drawn against similar accounts in other banks.

Check Kiting

Bank Reconciliations

of Cash The proof of cash is a reconciliation in which the bank balance, the bank report of cash deposited, and the bank report of cash paid are all reconciled to the client's general ledger.