Audit Holt Exam 1 Ch. 3

phases of the audit related to audit planning

-client acceptance

-preliminary engagement activities

-plan the audit

what two things should you consider when evaluating a prospective client?

-are we capable of performing the engagement? (industry knowledge, enough personnel, can meet deadline)

-what is the integrity of the client? (reputation, any illegal involvements, why did predecessor auditor leave)

communication with the predecessor auditor

an attempt to communicate is required by the prospective auditor (after securing approval from audit client to receive confidential information)

communication with the predecessor auditor should include:

-basic information regarding issues that reflect the *integrity of management*

-any *disagreements* about audit procedures or accounting principles

-communications that the predecessor auditor gave the client about *fraud, illegal acts, and internal control*

-reason for the auditor *change*

continuing client retention

you should periodically evaluate client retention after audit completion, conflicts, fee disputes, or excessive risk

3 preliminary engagement activities

-determine the audit engagement team requirements (size, risk, specialty, time-frame, etc.)

-assess compliance with ethical and independence requirements

-establish an understanding with the entity (engagement letter, internal auditor, audit committee)

engagement letter

your contract with your client

what is included in the engagement letter?

-scope of services being provided

-responsibilities and limitations of auditor and management

-timing and fees

-arrangements with internal audit

-limitations of liability

-other arrangements

who is the engagement letter sent to and signed by?

the head of the audit committee for a public company or the CEO/owner of a private company

who else signs the engagement letter?

the partner

you must make two assessments before you rely on the work of the internal audit function:

competency and objectivity

Section 301 of SOX requires: (6 things)

-audit committee members must be independent of the company

-audit committee is responsible for overseeing audit process (appointment and payment)

-pre-approval of all audit and non-audit services provided by the auditor

-establishment of procedures for complaints (tip-lines)

-the authority to engage in independent counsel (hire lawyer)

-must all be financially literate (+1 financial expert)

audit strategy and plan (8 steps)

-assess business risk

-establish materiality

-consider multilocations

-assess the need for specialists

-consider violation of laws and regulations

-identify related parties

-consider additional value-added services

-document the overall audit strategy, audit plan, and prepare audit program

group audits

audits of entities with multiple locations or business units; auditor must select which locations to look at and how in depth they must go

2 types of illegal acts:

-direct and material (ex: tax evasion) - must directly test for as auditor

-indirect and material (ex: contingent liabilities due to violating environmental protections) - don't have to specifically test for unless you are aware of them

2023 PCAOB proposal regarding illegal activities

auditors must test for both direct and indirect violations of laws; this proposal has not made it past the proposal stage, and has drawn a lot of backlash from accounting firms

audit strategy and audit plan

evaluate business objectives, strategies, and related business risks, understand how they are managing those risks, and document the effects of the risks and controls on the planned audit

Audit Program

contain specific audit procedures for testing accounts and related assertions

types of audit procedures

-risk assessment

-test of controls

-substantive procedures

test of controls

test the effectiveness of internal controls on preventing, detecting, and correcting material misstatements (required for an integrated audit)

substantive procedures

the detailed audit and analytical procedures designed to detect material misstatements in account balances and footnote disclosures

more costly, but if controls tested well, then you don't have to do as many

two main types of substantive procedures

-test of details

-substantive analytical procedure

test of details

most costly; look at details of balances and trace back to source documents

substantive analytical procedure

develop expectations of what account balances should be and compare them

dual purpose test

testing controls and details at the same time

Audit Data Analytics

Using analysis, modeling, and visualization to discover and analyze patterns, anomalies, and other information in data in the context of the audit.

*Materiality is a matter of ______*

judgement

a fact is material if there is:

*substantial likelihood* that it is viewed by a *reasonable investor* as having *significantly altered* the total mix of evidence

what is the point of materiality?

to protect the investor

3 steps of applying materiality on an audit

1 - determine overall materiality (planning materiality)

2 - allocate overall materiality to individual accounts (tolerable misstatement or performance materiality)

3 - evaluate audit findings

most common benchmark for overall materiality and when it is effective

net income before taxes

good for for-profit entities with stable income

when income is not stable, what should you do?

apply normalized earnings instead (average of x amount of years)

if entities are reporting at a loss or breaking even, which benchmark is more effective?

total revenues

if the entity is not-for-profit, which benchmark is better?

total assets

if the entity is not-for-profit and asset based, which benchmark is better?

net assets

if the company is public, should you use the higher or lower end of the percentile range?

Lower end, because they are more risky

what other reasons are there to lower the percentile range?

if any qualitative factors are present

qualitative factors

-material misstatements in prior years

-high risk of fraud

-potential loan covenant violations

-highly regulated industry

-etc.

tolerable misstatement

typically 50-75% of overall misstatement