ba 202 auditing lecture 2 audit engagement and audit planning

BA 202 Auditing

Lecture 2

Audit Engagement and Audit Planning

The Audit Process

Planning

Risk Assessment

Ascertaining & Recording of Accounting System & Internal Control

Increased Substantive

Test

Final review and Concluding the Audit

Audit Report

Compliance Test

Final Evaluation of IC

Reduced Substantive Test

Preliminary Evaluation of Internal ControlBad IC Good IC

Bad IC Good IC

Preliminary Engagement Activities ISA 220

Continuance of the client relationship and specific audit engagement

ISA 220 Ethical requirements, including independent

ISA 210 Terms of engagement

Engagement Letter ISA 210

Sent to the client by auditors upon appointment

To confirm Appointment Scope of the audit Objective of the audit Extent of auditors responsibilities and reports

Engagement Letter AI 210

Circumstances require engagement letter to be revised?

Need to remind client of terms of engagement?

If change in terms, client and auditor must agree on the new terms.

Consider withdrawal & any obligation

(AI 250 para. 39 – 40)

Audit Planning

ISA 300 para.2 : The auditor should plan the audit work so that the audit will be performed in an effective manner

ISA 300 para. 13: The auditor should develop an audit plan for the audit in order to reduce audit risk to an acceptably low level

Audit Planning

Conduct planning in accordance with AI 300 Planning AI 310 Knowledge of the Business

AI 230 para. 6 - Record in the working paper information on planning the audit work

AI 1005 – Audit of small business

Audit Planning

AI 210 Term of audit engagement AI 320 Audit materiality AI 400 Risk Assessment AI 530 Audit Sampling AI 520 Analytical procedures AI 620 Using the work of an expert AI 4410 Engagement to compile financial

information

Audit Planning – WHY PLAN?

Overall Audit Strategy and Direction Identify laws and standards affecting the

audit Appropriate attention is devoted to important

areas of audit Potential problems are identified Work is completed expeditiously

Audit Planning – WHY PLAN?

Assists proper assignment of work to assistance

Coordination of work done by other auditors and experts

Nature, timing, extend of audit procedures Reduce risk of material misstatements Conduct audit effectively and efficiently

Extent of planning

Size of entity

Complexity of audit

Auditor’s experience with entity

Auditor’s knowledge of business

Preliminary Planning Activities Client Acceptance and Continuance

Assess Competence and Independence

Establishing the Terms of the

Engagement

Audit Planning

ISA300 para.8 The auditor should plan the audit

so that the engagement will be

performed in an effective manner.

Other Matters

Analytical Review

Coordination,Direction,

Supervision &Review

Nature, TimingAnd

Extent ofProcedures

Risk and

Materiality

UnderstandingAccounting and Internal Control

System

Knowledge ofBusiness

PLANNING

ISA 315 Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement

Why auditor should obtained knowledge of business? To enable the auditor to identify and

understand the events, transactions and practices that, in the auditor’s judgment, may have a significant effect on the financial statements or on the examination of audit report.


Does the auditor need to know more than the management? Generally no

How should auditor obtain the knowledge? Preliminary knowledge prior to engagement Further knowledge following year Update and enhance information in subsequent

years

ISA 315 Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement Where are the sources of knowledge of the

business? External sources

Prior years experience Publication Discussion with knowledgeable people

Internal sources Discussion with management and staff Documents produced by the entity

ISA 315 Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement General economic factors and industry

conditions affecting the entity’s business Important characteristics of the entity, its

business, its financial performance and its reporting requirements including changes since the date of the prior audit.

The general level of competence of management


General Economic Factors General Level of economic activity Interest rates and availability of financing Inflation, currency revaluation Government policies (financial incentives Foreign currency rates and controls


The industry The market and competition Cyclical or seasonal activity Changes in product technology Business risk (ie high tech, high fashion) Declining or expanding operations Environmental requirements

ISA 315 Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement The Entity - Management and ownership

Corporate structure – private,public, government Related parties Capital structure Organization structure Management objectives, philosophy… Board of Directors i.e. composition Operating management Internal audit function

ISA 315 Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement The Entity – Business

Nature of business Location Employment i.e. union, supply, pension Products or services and markets i.e. major

customers, contract, market share Important suppliers of goods and services Inventories i.e. location and quantities Licenses, patents


Legislation Regulatory environment and requirements Taxation Measurement and disclosure issues peculiar to

the business Audit reporting requirements Users of financial statements

Understanding the Accounting and Internal Control Systems ISA 315 & ISA 400 The accounting policies adopted by the entity and

changes in those policies The effect of new accounting or auditing

pronouncements The auditor’s cumulative knowledge of accounting

and internal control systems and the relative emphasis expected to be placed on tests of control and substantive procedures

Nature, Timing and Extent of Procedures Possible change of emphasis on specific

audit areas The effect of information technology on the

audit The work of internal auditing and its expected

effect on external audit procedures.

Coordination, Direction, Supervision and Review The involvement of other auditors in the audit

of components for example subsidiaries, branches and divisions

The involvement of experts The number of locations Staffing requirements Interim Audit and Pre-Final Audit

Other Matters

The possibility that the going concern assumption may be subject to questions

Conditions requiring special attention, such as the existence of related parties

The terms of the engagement and any statutory responsibilities

The nature and timing of reports or other communication with the entity that are expected under the engagement

Assessing risk of material misstatement

Audit Planning

Discuss overall audit plan and certain audit procedures with

audit committee management Staff

In order to improve effectiveness and efficiency of audit. However the overall audit plan and audit program remain the auditor’s responsibility.

Audit Program

The auditor should => develop and

document an audit program setting out

the nature, timing and extent of planned

audit procedures required to

implements the overall audit plan.

Audit Program

What is audit program? An audit program consists of specific audit

procedures are usually prepared for specific component of audit.

Purpose of Audit Program? Example of an audit program Standard?

Audit Program

In preparing audit program, the auditor

would consider the specific

assessments of inherent and control

risks and the required level of

assurance to be provided by

substantive procedures

Changes of overall audit plan and audit program

The auditor should

Revised as necessary during the course of

audit (because planning is continuous

through the engagements)

Record reasons for significant changes

Analytical Procedures

To conduct review of financial statements in

order to provide an insight into the financial

positions of the business and to provide

sufficient corroborative evidence to supports

conclusion drawn from other source of

evidence collected.

Analytical Procedures – ISA 520 para.8 The auditor should apply analytical

procedures at the planning stage to assist in understanding the business and in identifying area of potential risk.


Purposes of Analytical Procedures Planning Substantive Procedures Overall review in final review stage of audit

Type of Analytical Procedures Current year v. Prior Year Current year v. budget/ projection or forecasts Client Financial Info v. Industry data Financial info v. Non Financial Info


Short Term Liquidity Ratios Current Ratio Quick Ratio Operating Cash Flow Ratio

Activity Ratios Receivables Turnover and Days Outstanding in

Account Receivables Inventory Turnover and Days of Inventory on

Hand


Profitability Ration Gross Profit Percentage Profit Margin Return on Assets Return on Equity

Coverage Ratio Debt to Equity Times Interest Earned


Effectiveness and Efficiency (especially for substantive procedures) The nature of assertion or audit objective (unable

to test ownership and individual transaction but effective to detect omission)

The plausibility and predictability of the relationship

The availability and reliability of data The precision of the expectation


Advantages To improve the auditor’s understanding of the entity To enable auditors to identify recorded value which varies

from the auditor’s expectation Identify unusual transactions, trends and events Simple and easy to use

Limitations Provides conclusions on reasonableness of data rather than

precision Less persuasive than test of details Cannot easily be linked to specific assertions Financial data analysis only Require comparative figures/ratio to be meaningful


From the industries below, what are the differences you would expect in relation to the components of its individual company’s financial statement (balance sheet/ income statement): Trading Services Property Development Bank

Fundamental Concepts in Audit Materiality Audit Risk (Inherent/Control/Detection) Reasonable Assurance Going Concern True and Fair View Independence

Materiality AI 320

Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.

Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement.

Materiality ISA 320

Materiality provides a threshold or cut off point rather than being a primary qualitative characteristic which information must have if it is to be useful.

There is an inverse relationship between Materiality & level of Audit Risk

Eg: M AR

Auditor need to CR or DR

Common Bases and Qualitative Factors for Considering Materiality Common Bases for Establishing Materiality:

Total Assets Total Revenues Net Income before Tax Gross Profit Average of 3 years’ Income before Tax

Selected Qualitative Factors for Assessing Materiality Fraud or Non-Compliance with Laws or Regulations Small amounts that might violate covenants in a contracts Amounts that might affect the trend in earnings

Audit Risk ISA 400

Risk is a fundamental concept that underlies the audit process

Audit Risk =Inherent Risk X Control Risk X Detection Risk

Detection Risk Assessment

Having Determined Audit Risk Inherent Risk Control Risk

Detection Risk is just a balancing figures DR = AR/ (IR X CR)

AUDIT

RISK

Assessment of Control Risk

High Medium Low

Assessment

of

Inherent

Risk

High Lowest Lower Medium

Medium Lower Medium Higher

Low Medium Higher Highest

Interrelationship of The Components of Audit Risk

Acceptable level of Detection Risk

Significant Risks ISA 315

Significant Audit Risks that require special audit considerations Fraud Related to recent significant economic,

accounting or other development Complexity of transactions Related parties Involved in measurement uncertainty Outside normal course of business for the entity

Concept of Reasonable Assurance A term that implies some risk that a material

misstatement could be present in the financial statements without the auditor detecting it.

By expressing reasonable assurance, the auditor does not guarantee that material misstatements will be detected in an audit.

Hence, no absolute assurance due to certain inherent limitations in audit.

Concept of Reasonable Assurance Factors that cause auditor to express

reasonable assurance (pg 34 -35 of Messier and Margaret): Use of testing in audit Inherent limitations of internal control\ Audit Evidence is Persuasive and Not Conclusive Use of Judgment

Types of Audit Tests

Test of Controls Substantive Procedures

Test of Controls

The category of procedures aimed specifically to test the operating effectiveness of controls in preventing, detecting and correction material misstatements at the assertion level.

Ensure internal controls are operating in the manner intended

Substantive Procedures

Test performed to obtain audit evidence to detect material misstatements in the financial statementTest of detail of transactions and

balancesAnalytical procedures

Working Papers - Overview

Permanent File Correspondence File Tax File Current Audit File

Current Audit File - Overview

Planning Overview Risk Area Materiality Audit Objectives/Procedures Analytical Review Budget/ Team Members


Secretarial Audit Minutes/ Directors Resolutions Audit Summary Memorandum Audit Adjustments Trial Balance Audit Programme for respective section Detail of working paper


Detail Working Papers Heading Indexing and Cross Referencing Tick Marks Organization of working papers

ba 202 auditing lecture 2 audit engagement and audit planning

Documents

audit risk

audit materialityai

audit workai

audit samplingai

examination of audit

term of audit engagementai

overall audit strategy

specific audit engagementisa