Midterm 2 Ch 8 Audit

Why plan the audit?

1. Required by auditing standards

2. To enable auditor to evaluate how much evidence needs to be collected

3. To perform audit efficiently (control audit costs)

4. To minimize misunderstandings with client

Four considerations of initial audit planning

1. New or continuing client?

2. Identify the reasons the client needs the audit

3. Obtain an understanding with the client engagement letter

4. Develop overall audit strategy

New client? (Four considerations)

• New client: Before accepting, firms investigate the company for financial stability, accounting quality, management quality, fit with existing client base, relations with prior CPA firm

SAS 84

New auditor required to communicate with old auditor. New auditor responsibility to contact. Used to evaluate whether to accept the client.

Continuing client? (Four considerations)

• Firms evaluate each year whether to retain the client

• Why they may drop: risk increased, change in auditor industry mix, management turnover/quality has changed

Identify the FS users and their intended use of financial statements (Four considerations)

• Creditors: SEC requires IPO and M&As

• Users: Investors

• Regulators: Government

• Can affect timing and level of complication of audit

• Important for assessing acceptable audit risk

Obtain an understanding with the client

• This helps auditor obtain clear understanding of work to be performed, due dates, audit costs, etc.

• Helps minimize understandings between auditor and client

Things needed for audit strategy

• Select staff for the engagement: Staff must be knowledgable about industry and try to use same staff for continuity

• Evaluate the need for audit specialists: litigation, engineers, actuaries (ex. evaluate pension assumptions), asset evaluators (ex. geologist, appraisers)

What should auditors know about an industry?

• General economic factors on the client’s industry

• Life cycle of the industry and client’s business

• Factors critical for success or failure in that industry

• Risks associated with specific industries

• Any unique accounting requirements

Examples of general economic factors affecting client industry

• Inflation

• disasters

• Oil prices

• Tariffs

• Subsidies

Where in the life cycle is the client & industry

• Newer Company: in growth stages

• Mature Company: with solid customer base

Examples of success/failure critical for success in that industry

Ex. obsolescence in the high tech industry, evaluation of investments in financial industry, and drilling reserves in oil business

Risks associated with specific industries

Can affect the auditor’s assessment of client’s business risk and acceptable audit risk. ex. auditor can understand the risk common to all clients in certain industries

Examples of unique requirements auditor must understand

Ex. Natural gas, construction, banks, government

Understand basic business operations

• Auditors should understand client’s major revenue sources, key customers, sources of financing that can increase client business risk

• Tour plant and offices

• Identify related parties

Steps to understand corporate management and governance

• Read board of directors MMs: Helps identify major events that occurred during the year

• Review new contracts: Helps with assessing risk and auditor may need to determine compliance with contract provisions

• Read the corporate charter: Frequency of shareholder meetings, method of voting for directors, and voting rights over stock

• Understand client performance measurement system: Key performance measures management uses and measurements that may encourage aggressive behavior

Definition of related party transaction (article)

Transaction between client and related party where party can influence management or policies

Examples of related party transactions (article)

• Loaning money

• CEO son’s hobby

• FTX and another co

• Attorneys on board and client uses their service

• Investment bankers on board and client uses their services

Are RPT legal?

• Most are

• SEC/SOC bars loans between client and management

• Material RPT must be disclose in FS

Potential problems with RPT

• Reporting is foggy: malicious actions can obscure

• Potential conflict of interest

• Related party may not be qualified

• Breach of board member fiduciary role

• Investors don’t like them if there were a lot of them, questioning mgt integrity

Benefits of RPT

• Can negotiate a better deal

• Obvious when it’s RPT, so investors are aware

• Facilitates business and understanding of each other