Chapter 04 - Engagement Planning CHAPTER Engagement Planning LEARNING OBJECTIVES Review Checkpoints Exercises, Problems and Simulations List and describe the activities that auditors undertake before beginning an engagement 1, 2, 3, 53, 54, 55, 65 Identify the procedures and sources of information auditors may use to obtain knowledge of a client’s business and industry 5, 6, 7, 8, 52, 56, 59, 63, 64 Perform analytical procedures to identify potential problems 10, 11, 12, 13, 14, 15 47, 48, 49, 51, 58, 62 List and discuss matters of planning that auditors should consider for clients who use computers, and describe how a computer can be used as an audit tool 16, 17, 18, 19, 20, 21, 22 57, 60 Review audit documentation for proper form and content 23, 24, 25 50, 61 4-1 Chapter 04 - Engagement Planning SOLUTIONS FOR REVIEW CHECKPOINTS 4.1 Auditors can use the following sources of information to help decide whether to accept a new audit client Financial information prepared by the prospective client: Annual reports to shareholders Interim financial statements Securities registration statements Annual report on SEC Form 10-K Reports to regulatory agencies Inquiries directed to the prospect’s business associates: Banker Legal counsel Underwriter Other persons, e.g., customers, suppliers Predecessor auditor, if any, communication, re: Integrity of management, Disagreements with management Analysis: Special or unusual risk related to the prospect Need for special skills (e.g., computer or industry expertise) Internal search for relationships that would compromise independence Auditors can search business press articles and stories and legal files on the Lexis-Nexis system or on the Internet for news about chairman of the board, the CEO, the CFO, and oftentimes other high-ranking officers Auditors can engage an outside search firm (private investigators) to conduct additional searches for information Auditors are looking for information about client risk factors-companies accused of fraud, companies under SEC or other regulatory investigation, companies that have changed auditors frequently, and companies showing recent losses 4.2 Client consent is required because the Code of Professional Conduct prohibits the predecessor audit firm from revealing confidential information to the successor audit firm without the consent Confidentiality remains even when the auditor-client relationship ends A successor audit firm should inquire specifically about:     Management’s integrity Disagreements the predecessor may have had with management about accounting principles and audit procedures Communications the predecessor gave the former client about fraud, illegal acts, and internal control recommendations The predecessor’s understanding about the reasons for the change of auditors (particularly about the predecessor’s termination) 4-2 Chapter 04 - Engagement Planning 4.3 Engagement letter benefits:     Helps establish an understanding between client and public accounting firm of the terms of the engagement and the nature of the work Helps avoid quarrels and misunderstandings between client and auditor Helps avoid disputes over the audit fee Helps avoid legal liability assertions based on failure to work that the CPA may not have contemplated or agreed to A termination letter is a letter from a former public accounting firm (fired or resigned) to a former client specifying terms for future services and the auditors’ understanding of the circumstances of termination 4.4 Persons and skills normally assigned to a “full service” audit team: Audit personnel: Engagement partner Second (concurring) audit partner Audit manager Senior accountant(s) Statistical auditing specialist, if needed Computer auditing specialist, if needed Industry specialist, if needed Tax partner 4.5 Methods and sources of information for understanding a client’s business and industry: Inquiry, including review of prior year audit documentation personnel who worked on the audit in prior years are available to convey their understanding of the business, inquiry and interviews with the company’s management, directors, and audit committee Observation take a tour of the company’s physical facilities, keeping eyes open for activities and things that should be reflected in the accounting records The tour is the time to see company personnel in their normal workplaces Study numerous sources AICPA industry accounting and auditing guides, specialized trade magazines and journals, registration statements and 10-K reports filed with the SEC, general business magazines and newspapers (Business Week, Forbes, Fortune, Harvard Business Review, Barron’s, and The Wall street Journal) 4.6 Find information about real estate valuation (tax appraisal) in the city and county tax assessor-collector files About aircraft ownership from the Federal Aviation Administration Names of licensed doctors in the state medical society directory Assumed business names in the state or county assumed named registry Liens on personal property in the UCC documents filed, by borrower name, in the county clerk or State’s Secretary of State or commercial department office 4.7 The problem with evidence obtained from related parties is that the source is potentially biased, and the information may be self-serving and misleading 4-3 Chapter 04 - Engagement Planning 4.8 Benefits of preliminary assessment of materiality: Fine-tune the audit for effectiveness and efficiency Help auditors avoid surprises related to: Finding out too late about not auditing enough Finding out later about auditing too much 4.9 Prior to using internal auditors, external auditors should consider internal auditors’ objectivity and competence 4.10 The purpose of performing preliminary analytical procedures in the audit planning stage is to direct attention to potential problem areas so the audit work can be planned to reduce the risk of missing something important 4.11 The steps auditors can use to apply comparison and ratio analysis to unaudited financial statements are: (1) develop an expectation, (2) define a significant difference, (3) calculate predictions and compare them with the recorded amount, (4) investigate significant differences, and (5) document each of the above steps 4.12 The ratios in Appendix 4.A are: current ratio, days’ sales in receivables, doubtful accounts ratio, days’ sales in inventory, receivables turnover, inventory turnover, cost of goods sold ratio, return on equity, and Altman’s financial distress ratios and discriminant score Students may be able to name other relevant ratios 4.13 Analytical procedures are required (1) at the beginning of an audit—the planning stage application of analytical procedures discussed in this chapter and (2) at the end of an audit when the partners in charge review the overall quality of the work and look for apparent problems They are optional as substantive audit procedures 4.14 A planning memo summarizes all the important overall planning information and documents that the audit team is following generally accepted auditing standards The memo becomes a basis for preparing the audit program 4.15 Auditors usually prepare a planning memorandum summarizing the preliminary analytical procedures and the materiality assessment with specific directions about the effect on the audit This planning memo also usually includes information about: (1) Investigation or review of the prospective or continuing client relationship (2) Provision of special services or reports and needs for special technical or industry expertise (3) Staff assignment and timing schedules (4) The assessed level of control risk (5) Significant industry or company risks (6) Computer system control environment (7) Utilization of the company’s internal auditors (8) Identification of unusual accounting principles problems (9) Schedules of work periods, meeting dates with client personnel, and completion dates 4.16 General characteristics of transactions that are typically computerized: Frequent, repetitive, large number General characteristics of transactions that typically are not computerized: Infrequent, occasional, small number 4-4 Chapter 04 - Engagement Planning 4.17 The “audit trail” (sometimes called “management trail” as it is used more in daily operations than by auditors) is the source documents, journal postings and ledger account postings maintained by a client in order to keep books These are a “trail” of the bookkeeping (transaction data processing) that allow auditors to follow the sequence of processing on (or because of) a transaction with a tracing or vouching procedures In a manual system this “trail” is usually visible to the eye with posting references in the journal and ledger and hard-copy documents in files But in a computer system, the audit trail in advanced systems may not be in a human-readable form and may exist for only a fraction of a second Further, the posting references may not exist, and the records must be read using the computer rather than the naked eye Most systems still have hard-copy papers for basic documentation, but in some advanced systems even these might be absent There are several control implications of an electronic audit trail The first implication is that concern for an audit trail needs to be recognized at the time a system is designed Techniques such as integrated test facility, audit files and extended records must be specified to the systems designer The second control implication is that if the audit trail exists only momentarily in the form of transaction logs or master records before destructive update, the audit team must review and evaluate the transaction flow at various times throughout the processing period Alternatively, the audit team can rely more extensively on internal auditors to monitor the audit trail 4.18 The important differences between manual and computer accounting systems are in these areas: (1) transaction trails, (2) uniform processing of transactions, (3) separation of functions, (4) potential for errors and frauds, (5) potential for increased management supervisions, and (6) initiation or subsequent execution of transactions by computer 4.19 Additional planning considerations when computer processing is involved are:       The extent to which the computer is used in each significant accounting application The complexity of the computer operations used by the entity, including the use of an outside service center The organizational structure of the computer processing activities The availability of data The computer-assisted audit techniques to increase the efficiency of audit procedures The need for specialized skills 4.20 Computer assisted audit techniques (CAATs) collectively is a set of preprogrammed editing, operating, and output routines that can be called into use with a simple, limited set of programming instructions by an auditor who has one or two weeks intensive training 4.21 Six audit procedures that can be performed using CAATs software are: Recalculation Confirmation Document Examination (limited) Scanning Analytical Procedures Fraud Investigation 4-5 Chapter 04 - Engagement Planning 4.22 Advantages of using CAATs to perform recalculations are primarily speed and accuracy With CAATS it is just as easy to recalculate all client computations as it would be to test a sample of calculations Any differences from client computations can be printed out for investigation When using CAATs to select samples and print confirmations, the advantages include the use of preprogrammed statistical routines to randomly select the sample and the speed with which confirmations can be prepared on preprinted forms 4.23 a In the permanent audit file: b Copies or excerpts of the corporate or association charter, bylaws, or partnership agreement Copies or excerpts of continuing contracts such as leases, bond indentures, and royalty agreements A history of the company, its products, markets and background Copies or excerpts of stockholders, directors, and committee minutes on matters of lasting interest Continuing schedules of accounts whose balances are carried forward for several years, such as owners’ equity, retained earnings, partnership capital and the like Copies of prior years’ financial statements and audit reports In the front of the current working paper file 10 11 12 13 14 15 16 17 18 Engagement letter Staff assignments Client organization chart Memoranda of conferences with management Memoranda of conferences with the director’s audit committee Preliminary analytical review notes Initial risk assessment notes Initial materiality assessment notes Engagement planning memorandum Audit engagement time budget Internal control questionnaire and control analyses Management controls questionnaire Computer control questionnaire Internal control system flow charts Audit programs A working trial balance of general ledger accounts Audit documentation of preliminary adjusting and reclassifying entries Memoranda of review notes and unfinished procedures (all cleared by the end of the fieldwork.) 4.24 The most important facet of the current audit documentation files is the requirement that they show the audit decision problems and their conclusions These papers must record the proposition to be audited, the evidence gathered, and the final decision The documentation should demonstrate satisfaction of the standards of fieldwork and provide support for the audit report 4.25 Word processing can be used in an audit to prepare audit programs, write audit memoranda, and write audit reports A computer electronic spreadsheet can be used instead of paper and pencil to create the form of a bank reconciliation, with space provided for text lists of outstanding items (using the label input capability), and math formulas inserted for accurate arithmetic in the reconciliation Printing such a reconciliation is easy (and much prettier than most accountants’ handwriting!) 4-6 Chapter 04 - Engagement Planning SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 4.26 a b c Incorrect Incorrect Correct d Incorrect a Incorrect b c d Correct Incorrect Incorrect a Incorrect b Correct c Incorrect d Incorrect 4.29 d Correct (All of the above) Analytical procedures can be used when planning the audit, when performing substantive procedures during an audit, and as a method of overall review at the end of an audit 4.30 a Incorrect b Incorrect c Incorrect d Correct Weaknesses in the company’s internal control are not a subject for preliminary analytical procedures because auditors can’t examine the internal controls at this particular time with these kinds of analyses Individual transactions are not used in preliminary analytical procedures Management assertions in financial statements are not the direct object of preliminary attention-directing analytical procedures With preliminary analytical procedures, the auditors are looking for signs of accounts and relationships that may represent specific potential problems and risks in the financial statements a True b c True True d Correct 4.27 4.28 4.31 Confirmation is not an analytical procedure Physical observation is not an analytical procedure Analytical procedures incorporate information from a variety of sources Tests of details are not analytical procedures Analytical procedures are performed after the engagement letter is obtained This is the “attention-directing” purpose All the assertions are always important This answer could be good even though it evokes the control risk assessment standard, but restriction to inventory makes it a poor choice Physical production statistics are not a source of information for “comparison of current account balances with prior periods.” A client’s budgets and forecasts are sources of information for “comparison of current account balances with expected balances.” Published industry ratios are not a source of information for “evaluation of current account balances with relation to predictable historical patterns.” The company’s own historical financial statements are not a good source of information for “evaluation of current account balances in relation to nonfinancial information.” The successor must take responsibility for obtaining the client’s consent for the predecessor to give information about prior audits Cooperation from the predecessor is expected Cooperation includes obtaining copies of some or all of the predecessor auditors’ documentation All of the above are expected 4-7 Chapter 04 - Engagement Planning 4.32 4.33 4.34 4.35 4.36 4.37 4.38 a Incorrect b c d Incorrect Correct Incorrect a Incorrect b c d Incorrect Correct Incorrect a b c Correct Incorrect Incorrect d Incorrect a Incorrect b Incorrect c Incorrect d Correct a Incorrect b Incorrect c Correct d Incorrect a Incorrect b c Incorrect Correct d Incorrect a b c d Incorrect Correct Incorrect Incorrect Although strongly encouraged, U.S GAAS not require a written engagement letter for audits Client consents not have to be in writing A written audit program is required (SAS 22, AU 311) Written time budgets and schedules may be a good idea but they are not required Audit documentation is necessary to document compliance with GAAS Extracts of contracts should go in the permanent file Independence is not really a working paper matter Materiality judgments will affect the amount of evidence shown in audit documentation Evidence bears on the year under audit Current-year evidence is usually not in the permanent file The administrative audit documentation not contain current-year evidence about particular balances The planning memo does not contain evidence Internal control analysis for the current year would be in the administrative or current file The latest engagement letter would be in the administrative or current file Memoranda of conference with management would be in the administrative or current file Excerpts of the corporate charter and by-laws would not change often and would be in the permanent file Materiality determination helps concentrate the audit work where it is most needed Materiality determination helps auditors to the “sufficient” amount of work The kind of opinion cannot be determined until all the evidence is obtained and evaluated Materiality determination helps auditors to the “sufficient” amount of work Spreadsheet software would not be appropriate for testing internal controls over computerized accounting applications Word processing software would be best to prepare an audit program Spreadsheet software is ideal for preparing a comparison of current year expenses with those from the previous year Word processing software would be best for drafting a planning memo All CAATs are not in the same language CAATs can be transported to various clients having various systems Input controls are important in their own right The use is the means to accomplish testing, but the complete set of audit procedures can rarely be done entirely on the computer 4-8 Chapter 04 - Engagement Planning 4.39 a b c d Incorrect Correct Incorrect Incorrect These are functions of a client’s computer system Auditors can use the computer with ease Machine operations not leave “visible” evidence Computer auditing is meant to gather good evidence with the least quantity of storage 4.40 a b Incorrect Correct c Incorrect The ratio of cost/sales does not increase The numerator (cost of goods sold) increases relatively less than the denominator (sales) increases The ratio of cost/sales does not remain unchanged a b c Correct Incorrect Incorrect d Incorrect a Incorrect b Correct c Incorrect d Incorrect a Incorrect b Incorrect c Incorrect d Correct 4.41 4.42 4.43 Client cooperation should be specified Technical details are not in the engagement letter Litigation matters are covered with respect to the request for an attorney’s letter Client representations about board minutes should be in the client’s written representation letter The auditors’ report should not mention the fact that a specialist was used, unless the specialist’s findings affect the auditors’ conclusions The auditors’ report should only mention the use of the specialist when the specialist’s findings affect the auditors’ conclusions The auditors’ report need not mention the use of a specialist if the auditors decide not to take responsibility for the specialist’s findings The auditors’ report should only mention the specialist if Vandalay does not agree with the specialist’s findings, resulting in an opinion other than unqualified Interviewing internal auditors about their reporting responsibilities would assist the audit team in determining whether the internal auditors were objective, but would provide little evidence of related-party transactions Reviewing accounting records for nonrecurring transactions occurring throughout the year would raise suspicions of fraud, but not necessarily related-party transactions Inspecting communications with the client’s legal counsel regarding recorded contingent liabilities would be helpful in determining contingent liabilities Scanning the minutes for significant transactions with members of the Board of Directors would be helpful in identifying transactions with parties related to the client 4-9 Chapter 04 - Engagement Planning 4.44 4.45 4.46 a Incorrect b Incorrect c Incorrect d Correct a Incorrect b Incorrect c Incorrect d Correct d Correct A report to the audit committee on the results of testing of internal control over cash receipts would typically occur after the entire period could be tested, and therefore would be written after the balance sheet date Confirmation letters to vendors confirming the amounts they owe to the client are part of substantive procedures performed on balance sheet account amounts An attorney’s letter regarding contingent liabilities would be written as close to the end of fieldwork as practicable An engagement letter would be written before accepting an engagement, and therefore before the balance sheet date Surprise counts of the client’s petty cash fund may occur during planning, but are more typically performed close to the balance sheet date Reporting internal control deficiencies to the audit committee would typically occur after internal control testing was complete Performing a search for unrecorded liabilities would be performed as a substantive procedure after planning Identifying related parties is an important part of planning Prior to accepting a new audit engagement, an audit firm should (a) attempt to contact the predecessor auditor, (b) evaluate the integrity of management, and (c) assess the firm’s resources 4-10      Kaplan CPA Exam Simulation: Planning Kaplan CPA Exam Simulation: Planning (Continued) ... establish an understanding between client and public accounting firm of the terms of the engagement and the nature of the work Helps avoid quarrels and misunderstandings between client and auditor Helps... industry accounting and auditing guides, specialized trade magazines and journals, registration statements and 10-K reports filed with the SEC, general business magazines and newspapers (Business... accountant(s) Statistical auditing specialist, if needed Computer auditing specialist, if needed Industry specialist, if needed Tax partner 4.5 Methods and sources of information for understanding a client’s