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Audit Planning

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Audit Planning
Decide whether or not to accept the prospective client Obtain knowledge of clients business and industry Prepare the audit plan, preliminary program, and time budget Make preliminary arrangements with the client

Prepare the engagement letter

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Deciding Whether to Accept Clients

Obtaining Clients

Engagement risk auditors overall risk of association with a client. Reduce engagement risk by considering managements reputation and the financial strength of the prospective client. With clients permission contact third parties concerning:
Financial history and credit rating (banker) Legal environment (attorneys)

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Communications with Predecessor Auditor

Obtaining Clients

SAS 84 (AU 315) requires the successor auditor to attempt to communicate with the predecessor auditor before accepting the engagement.
Recall Rule 301 pertaining to confidential client information. Must ask client to authorize the communication.

SEC Form 8-K for public companies

Discourages opinion shopping

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Responsibilities of Each Party

Engagement Letters

Management responsibilities

Financial statements Establishing effective internal control over financial reporting Compliance with laws and regulations Making records available to the auditors Providing written representations at end of the audit, including that adjustments discovered by the auditors and not made to the financials are not material
Conducting an audit in accordance with GAAS Obtaining an understanding of internal control to plan audit and to determine the nature, timing and extent of procedures Making communications required by GAAS

Auditor responsibilities

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Engagement Letters
Other Items
Arrangements regarding

Conduct of the audit (e.g., timing, client assistance) Use of specialists or internal auditors Obtaining information from predecessor auditors Fees and billing

Limitation of or other arrangements regarding liability of auditors or client Conditions under which access to the auditors working papers may be granted to others

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Understanding the Clients Business

Attractiveness of the Industry

Barriers to entry Strength of competitors Bargaining power of suppliers of raw materials and labor Bargaining power of customers

Clients operations
Accounting policies Industry and regulatory factors Strategies and related business risks Measurement and review of performance Internal control

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Understanding the Clients Business

Basic Strategy

Basic strategies
Product differentiation Cost leadership

Implications of strategy for assessing reasonableness of financial statements

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Relationship Between Strategy and Financial Statement Results

ROA = NI / TA Dupont Analysis

ROA = (NI / Sales) x (Sales / TA) = Net Profit Margin x Asset Turnover

Assume ROA = 10% for Firms A & B

Profit Margin Asset Turnover Firm A 10% 1.0 Firm B 2% 5.0

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Consideration (but not quantification) of materiality is required most firms do quantify. No universal rules for assessing materiality only guidelines and professional judgment Some methods for quantifying overall materiality 5 to 10% of net income before taxes to 1% of total assets to 1% of total revenues 1% of total equity AICPA table

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Allocating Overall Materiality


Multiply overall materiality by a factor (usually 1.5 to 2.0) and allocate to the various accounts.
Multiplying by a factor before allocating alleviates excessive conservatism Allocation is typically to balance sheet accounts (balance sheet approach)

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Class Example

Relevant base = $4,000,000 Overall planning materiality = $38,300 + (0.0067 x $1,000,000) = $45,000 Allocation of planning materiality Allocated amount = $45,000 x 2.0 = $90,000 Base = $2,000,000 Cash allocation = (500,000 / 2,000,000) x 90,000 = $22,500 Similarly, A/R = $13,500, Inv = $31,500, A/P = $14,625, A/L = $5,625 and T/P = $2,250 Total = $90,000

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Qualitative Considerations
Remember materiality depends not only on amount, but also on nature of transaction, for example: Illegal payments Compliance with contractual agreements Reversal of earnings trend Changes a loss into income, or vice versa Items that can be measured with precision versus items that arise from estimates
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Assessing the Risk of Material Misstatement Due to Fraud (SAS 99)

Effective date: December 15, 2002. Supersedes SAS 82

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Assessing Fraud Risks

Two types
Fraudulent financial reporting (management fraud) Misappropriation of assets (defalcations)

Procedures to assess fraud risks

Discussion among engagement team Inquiries of management and other personnel Planning analytical procedures Considering fraud risk factors
Incentives Opportunity Attitude

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Assessing Fraud RisksIdentifying Fraud Risks

Considerations in identifying fraud risks

Type Significance Likelihood that it will result in a material misstatement Pervasiveness

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Responding to Fraud Risks

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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Consideration of Fraud Throughout the Audit

Evaluating the results of audit tests Discovery of fraud

Communication to appropriate level of management If fraud involves senior management or material misstatement communicate to audit committee

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Other Planning Considerations

First-year Procedures
SAS 84 recommends second communication with predecessor CPA

Use of Clients Staff Other CPAs Use of Specialists

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Audit Plans

Provides an overview of the engagement. Typically includes:

Description of client company Audit objectives Other services Scheduling of work Role of clients staff Staffing requirements Target dates Special audit risks Significant risks related to errors and fraud Preliminary judgments about materiality

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Audit Programs
Organization of the Audit Program
Systems (Internal Control)
Revenue Cycle Acquisition Production Payroll Investing/Financing

Substantive tests
Organized by major balance sheet accounts

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Direction of Audit Testing

Test for Existence

The Audit Trail



Source Documents



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Test for Completeness


Timing of Audit Work

Interim Work
Consideration of Internal Controls Substantive work on transactions to date

It should be remembered that interim work should be supplemented with additional work covering the period between the interim date and the end of the year
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