ACCT 311

chapter 3 & 4

audit timeline

• beginning of the year

• understand the entity and its environment and plan the audit

• conduct interim test of controls

• financial statement date

• issue audit report

stage of an audit

• obtain ( or retain) engagement

• engagement planning

• risk assessment

• substantive procedures

• reporting

benefits of audit planning

• identify and devote appropriate attention to significant areas of the audit

• identify and resolve potential problems on the audit

• properly organize and manage the audit engagement so that it is performed effectively and efficiently

• assists in the selection of engagement team members with appropriate levels of capabilities and competence

• facilitates the supervision of engagement team members

• assists in coordination of work done by specialists

issue if not properly planning audit

the auditor may issue an incorrect audit report or conduct an inefficient audit

prospective client acceptance decision

• evaluating a prospective client (document in memo or questionnaire/checklist)

  • review financial information

  • AS(2610) - communicate with predecessor auditor - w/ client consent ( find disagreements w/ management, reason for change of auditors)

  • management reputation and integrity, criminal background check

  • unusual business or audit risks

  • evaluate potential independence issues

  • any regulatory violation

engagement risk

is the risk of loss or injury to professional practice stemming from litigation, adverse publicity, or other events arising in connection with the audit

preliminary engagement activities

• establish engagement team and time budget (staffing needs, specialists needed, preliminary budgeted hours)

• assess compliance with independence rules (annual independence questionnaire, prior year fees have been paid)

• establish an understanding with the entity

establish an understanding with the entity discusses

• an engagement letter

• using the work of the internal audit function

• the role of the audit committee

engagement letter objectives

important dates and timing

managements responsibilities for engagement letters

use of specialists or internal controls

auditor responsibilities for engagement letters

fee estimates

limitation of the engagement letter

signed by auditor and client

factors for evaluation the reliability of internal audit functions

competence: does the person/department have the skills to do the job ( education and professional certifications)

objectivity: does the person/department have the independence of mind to report what they find honestly, even if its unwelcome news

Sarbanes-Oxley act requires audit committee members of publicly held companies

• member of board of directors and independent

• directly responsible for overseeing any work of any registered public accounting firm employed by the company

• must preapprove all audit and non audit services provided by its auditor

• establish procedures to following complaints about accounting, auditing, and internal controls

• must have authority to engage independent counsel

does Section 301 of Sarbanes- Oxley act have specific requirements for private companies

no

steps in planning the audit

• assess business risks

• establish materiality

• consider multi-locations

• assess the need for specialists

• consider violations of law and regulations

• identify related parties

• consider additional value added services

• document the overall audit strategy, audit plan, and prepare audit programs

assessing business risks

• to understand the entity and its environment

• to identify business risks that may result in material misstatements

• evaluate how the entity responds to those business risks and ensure the responses have been adequately implemented

types of audit test

• risk assessment procedures

• test of controls

• substantive procedures

what is risk assessment procedures

used to obtain an understanding of the entity and its environment including internal controls. helps determine nature, timing, and extent of testing

test of controls

directed towards the evaluation of effectiveness of the design and operation of internal controls

substantive procedures

detect material misstatements (monetary errors) in a transaction class, account balance, and disclosure component of the financial statement

what is test of controls testing

test the operating effectiveness of internal controls in preventing, detecting and correct material misstatements

the five methods to test of controls

• inquiry ( asking management, supervisors)

• inspection (looking at paper/records)

• observation (watching it happen live)

• reperformance (auditor redoes the controls themselves)

• walkthrough ( trace one transaction fully through the system)

substantive test of details/ transactions

tests for errors or fraud in individual transactions, account balances, and disclosures

substantive analytical procedures

evaluations of financial information through analysis of plausible relationships among financial and non financial data

example of substantive analytical procedures

comparison of receivables turnover and days outstanding in AR to previous year and industry & competitor data

example of substantive test of details

agree a sample of shipping documents to their respective sales invoices and to the sales journal

dual purpose tests

audit procedures can conduct both test of controls and a substantive test of detail simultaneously on the same document

concept of materiality

the magnitude of a misstatement that would likely change the judgment of a reasonable financial statement use, the determination of materiality requires professional judgment

why is materiality important

• planning: how much testing should be performs and which accounts are deemed important to test

• evidence evaluation/sampling: how important is a particular misstatement or omission that gets discovered during the audit

• reporting: is the sum of material misstatements enough to warrant an other- than- unqualified opinion

steps in applying materiality on an audit

• determine overall materiality

• determine tolerable misstatement

• evaluate auditing finding

overall materiality

materiality for the financial statements as a whole

quantitatively

materiality is a percentage of some base/benchmark

qualitatively

• 1st year engagement

• management turnover

• internal control weaknesses

• factors that increase risk

• prior year recorded and unrecorded audit adjustments

• potential of fraud

• volatile business environment

common quantitative benchmarks used for establishing overall materiality

• income gain/ loss before income taxes

• total assets

• total revenues

• net assets

• total equity

the quantitative amounts may be adjusted lower for qualitative factors such as

• material misstatement in prior years

• high risk of fraud

• potential loan covenant violations

• small amounts may cause the entity to miss forecasted revenues or earning/ affect the trend in earnings

• the entity operates in a volatile business environment, has complex operations, or operates in a highly regulated industry

what is tolerable materiality

the allocation of materiality at the individual account level, which usually is 50-75% of overall materiality

why is it necessary to allocate overall materiality across accounts

• to establish a scope for audit procedures and the individual account level

• propose adjusting journal entry for misstatements at the account level > tolerable materiality

what other factors may affect auditors tolerable materiality judgments

• complexity of account, debt covenants, closeness to meeting benchmark

• high risk of misstatements within the account balance or transactions

• prior year audit adjustments

• high turnover of senior management or key financial reporting personnel

• increased number of accounting issues that require significant judgment

when the audit evidence is gathered, the auditor

• aggregate misstatements from each account or class of transactions

• compares the aggregate misstatement to overall materiality

what should auditors do if aggregate misstatement is less than overall materiality

auditors can issue an unqualified audit opinion to conclude financial statements are fairly presented

what should auditors do if aggregate misstatement is greater than overall materiality

the client will need to record an adjustment to decrease misstatement, auditors should sample more, and modify audit opinion if a client is unwilling to make proposed audit adjustment

audit risk

is the risk than an auditor will issue an unqualified (clean) opinion on materially misstated financial statements

components of the audit risk model

inherent risk, control risk, detection risk

inherent risk

how error prone or fraud prone is an area/account due to the nature of the company

control risks

risk that the companies internal controls fail to catch an error

detection risk

risk that the auditors own procedures fail to catch the error

allowable audit risk

is the amount of risk the auditor is willing to accept that the financial statements contain a material misstatement after the audit is complete and an unqualified (clean) opinion has been issued.

audit risk model

audit risk = (Inherent risk)(Control risk)(Detection Risk)

audit risk model 2

audit risk = (Risk of material misstatement)(Detection risk)

relation of planned audit risk

decreases the amount of testing increases

relation of risk material misstatement

increases the amount of test increases

Inherent risk increases the amount of testing increases

Control risk increases the amount of testing increases

relation for allowable detection risk

detection risk decreases the amount of substantive testing increases

a low detection risks results in

more testing to achieve desired audit risk

nature

type of evidence

timing

when the evidence will be examined

extent

how much evidence will be gathered