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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.
Chapter Five Audit Planning and Types of Audit Tests McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 The Phases of an Audit That Relate to Audit Planning McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Prospective Client Acceptance Obtain and review financial information Inquire of third parties Communicate with the predecessor auditor Consider unusual business or audit risks Determine if the firm is independent Determine if the firm has the necessary skills and knowledge Determine if acceptance violates any applicable regulatory or ethical requirements McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Continuing Client Retention Evaluate client retention periodically Near audit completion or after a significant event Conflicts over accounting & auditing issues McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Dispute over fees Establish Terms 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 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 McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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 McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Internal Auditors McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Those Charged with Governance Board of Directors Audit Committee McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Preliminary Engagement Activities Determine the Audit Engagement Team Requirements Assess Compliance with Ethical Requirements, including Independence McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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 McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Substantive Analytical Procedures Decision Process McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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 • • • • • McGraw-Hill/Irwin Budgets and forecasts Industry publications Competitor information Management’s analyses Analyst’s reports © The McGraw-Hill Companies 2010 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! McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Compare and Investigate Compare the expectation to the recorded amount and investigate any differences greater than the tolerable difference McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 The Investigation of Differences for Planning and Final Analytical Procedures McGraw-Hill/Irwin Preliminary Analytical Procedures Differences Final Analytical Procedures Differences Corroborating evidence is not required Corroboratin g evidence is required © The McGraw-Hill Companies 2010 Audit Testing Hierarchy McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Filling the Assurance Bucket McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Example of Filling the Assurance Buckets for Each Assertion (Accounts Payable) McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Short-Term Liquidity Ratios Current Ratio Quick Ratio Operating Cash Flow Ratio McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Activity Ratios Receivables Turnover Inventory Turnover McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Days Outstanding in Accounts Receivable Days of Inventory on Hand Profitability Ratios Gross Profit Percentage Return on Assets McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Profit Margin Return on Equity Coverage Ratios Debt to Equity Times Interest Earned McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Audit of Group Financial Statements Entity or business activity in which financial information is included in the group financial statements Component of a Group 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 McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Audit of Group Financial Statements McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 End of Chapter McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 ... Assessment Auditors are limited in the types of consulting services that they can offer their audit clients McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Document Overall Audit Strategy and Audit. .. balances and transactions T S McGraw-Hill/Irwin Extent © The McGraw-Hill Companies 2010 Document Overall Audit Strategy and Audit Plan McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Types of Audit. ..The Phases of an Audit That Relate to Audit Planning McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Prospective Client Acceptance Obtain and review financial information Inquire of third parties