Chapter 3: Audit Planning, Types of Audit Tests, and Materiality

Analytical Procedures

Evaluations of financial information through analysis of plausible relationships among both financial and non financial data.

Audit Committee

A subcommittee of the board of directors that is responsible for the financial reporting and disclosure process.

Audit Procedures

Specific acts performed as the auditor gathers evidence to determine if specific audit objectives are being met.

Audit Strategy

The auditor's plan for the expected conduct, organization, and staffing of the audit.

Auditor Specialist

An individual or organization possessing expertise in a field other than accounting or auditing, whose work in that field is used by the auditor to assist the auditor in obtaining sufficient appropriate audit evidence. An auditor's specialist may be either an auditor's internal specialist (who is a partner or staff, including temporary staff, of the auditor's firm or a network firm) or an auditor's external specialist.

Dual-purpose Tests

Tests of transactions that both evaluate the effectiveness of controls and detect monetary errors.

Engagement Letter

A letter that formalizes the contract between the auditor and the entity and outlines the responsibilities of both parties.

Illegal Act

A violation of laws or government regulations.

Internal Audit Function

An independent, objective assurance and consulting activity designed to add value and improve an organization's operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes.

Overall Materiality (planning materiality)

The maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decisions of users.

Substantive Procedures

Audit procedures performed to test material misstatements in an account balance or disclosure component of the financial statements.

Substantive Tests of Transactions

Tests to detect errors or fraud in individual transactions

Tests of controls

Audit procedures performed to test the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the relevant assertion level

Tests of details

Substantive tests that concentrate on the details of items contained in the account balance and disclosure.

Tolerable misstatement (Performance materiality)

The amount of the overall materiality that is used to establish a scope for the audit procedures for the individual account balance or disclosures.

What types of inquiries about a prospective client should an auditor make to third parties?

The auditor should inquire of the prospective client's bankers and attorneys, credit agencies, and other members of the business community who may have knowledge about the integrity of the prospective client and its management.

Who is responsible for initiating the communication between the predecessor and successor auditors? What type of information should be requested from the predecessor auditor?

The successor auditor is responsible for initiating the communication with the predecessor auditor. It is the successor's responsibility to request permission of the prospective client before contacting the predecessor auditor. This is because the Code of Professional Conduct does not allow an auditor to disclose confidential client information without the entity's consent, the prospective client must authorize the predecessor auditor to respond to the successor's requests for information. The successor auditor should make the following inquiries of the predecessor auditor:

-Information that might bear on the integrity of management.

-Disagreements with management about accounting policies, auditing procedures, or othersimilarly significant matters.

-Communications to those charged with governance regarding fraud and noncompliance with laws or regulations by the entity.

-Communications to management and those charged with governance regarding significant deficiencies and material weaknesses in internal control.

-The predecessor auditor's understanding about the reasons for the change of auditors.

What is the purpose of an engagement letter? List the important information that the engagement letter should contain.

An engagement letter is used to formalize the arrangement reached between the auditor and client. It serves as a contract that outlines the responsibilities of both parties and is intended to prevent misunderstandings between the two parties. The letter states the responsibilities of the auditor and management, that the audit will be conducted in accordance with auditing standards, that certain types of audit procedures will be conducted and written representations will be obtained from management, and that the audit may not detect all material errors and fraud. Exhibit 3-1 in the text contains a sample engagement letter. In addition, the engagement letter might include:

• Arrangements involving the use of specialists or internal auditors.

• Any limitation of the liability of the auditor or client, such as indemnification to the auditor for liability arising from knowing misrepresentations to the auditor by management. (Note that regulatory bodies, such as the SEC, may restrict or prohibit such liability limiting arrangements.)

• Additional services to be provided relating to regulatory requirements.

• Arrangements regarding other services (e.g., assurance, tax, or consulting services).

What factors should an external auditor use to asses the objectivity and competence of internal auditors?

An understanding of: objectives and scope of the audit, management's responsibilities, auditor's responsibilities, the inherent limitations of the engagement, identification of the framework, and reference to the expected form and content of any reports. (Also: can refer to other matters, such as timing, client assistance, fees and billing, etc.)

What is an audit committee and what are its responsibilities?

An audit committee is a subcommittee of the board of directors composed of independent members. The audit committee is responsible for the financial reporting and disclosure process. The committee should encourage fair reporting from the perspective of the stockholders, creditors, and employees. The audit committee should meet regularly with the external and internal auditors.

List the matters an auditor should consider when developing an audit plan.

The nature and extent of planning activities that are necessary depend on the size and complexity of the entity and the auditor's previous experience with the entity. The auditor should be guided by the results of the entity acceptance/continuance process, procedures performed to gain the understanding of the entity, and preliminary engagement activities. The auditor should modify the overall audit strategy and the audit plan as necessary if circumstances change significantly during the course of the audit. Additional steps that should be performed include:

Assess business risks.

Establish materiality.

Consider multilocations.

Assess the need for specialists.

Consider violations of laws and regulations.

Identify related parties.

Consider additional value-added services.

Document the overall audit strategy, audit plan, and prepare audit programs

Distinguish between illegal acts that are "direct and material" and those that are "material but indirect." List five circumstances that may indicate that an illegal act has occurred.

Direct and material - Tax laws and regulations that may affect the amount of revenue recognized under a government contract.

Auditor's responsibility same as that for errors and fraud.

Material but indirect - Violations of securities acts, environmental protection, equal employment regulations, price fixing, and antitrust violations.

What are some of the sources of information that may be used to identify transactions with related parties?

Ask management

Look at minutes

Conflict of interest statements

Contracts

What actions should the engagement team members be informed of by the engagement partner and other engagement team members as part of their supervisory role?

The engagement partner has the overall responsibility for the engagement and its performance and should supervise the audit engagement team so that the work is performed as directed and supports the conclusions reached. The engagement partner and other engagement team members performing supervisory activities should

• Inform engagement team members of their responsibilities, including:

o the objectives of the procedures that they are to perform;

o the nature, timing, and extent of procedures they are to perform; and

o matters that could affect the procedures to be performed or the evaluation of the results of those procedures.

• Direct engagement team members to bring any significant accounting and auditing issues they identify to the attention of the engagement partner or other engagement team members performing supervisory activities so they can evaluate those issues and determine appropriate actions.

• Review the work of engagement team members to evaluate whether:

o the work was performed and documented;

o the objectives of the procedures were achieved; and

o the results of the work support the conclusions reached.

What are the three general types of audit tests? Define each type of audit test and give two examples.

The three general types of audit test include risk assessment procedures, a test of controls, and substantive procedures.

The risk assessment procedures test is used to understand the entity and its environment. The auditor will use the risk assessment test to make inquiries of management and analytical procedures. One example of risk assessment procedure is to evaluating the quality of management. The auditor will determine if management is enforcing internal controls and policies. Another example of a risk assessment procedure is observation. The auditor will observe the employees of the entity at work. This allows the auditor to observe the internal operation of the entity.

The test of controls is used to test the operating effectiveness of internal controls. One example of test controls is the inspections of the internal controls and how management implements them. Another example of test controls is the use of an audit trail starting from financial statements to the original orders to the customers.

Substantive Tests are procedures designed to test for dollar misstatements that directly affect the correctness of financial statement balances; Substantive tests of transactions are used to determine whether all six transaction related audit objectives have been satisfied for each class of transactions

Why is it important for CPA firms to develop policies and procedures for establishing materiality?

Professional standards provide very little specific guidance on how to assess what is material to a reasonable user. As a result, auditing firms should develop policies and procedures to assist their auditors in establishing materiality judgments for clients in order to minimize the variability of such judgments by firm personnel. In other words, firms would prefer to have their auditors establish similar materiality judgments for clients with similar circumstances.

List and describe the three major steps in applying materiality to an audit.

Step 1: Determine a materiality level for the overall financial statements. The auditor should establish a materiality level for the financial statements taken as a whole. This will be referred to as planning materiality. Planning materiality is the maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decisions of users. Materiality, however, is a relative, not an absolute, concept.

Step 2: Determine tolerable misstatement. This step involves determining tolerable misstatement based on planning materiality. Tolerable misstatement is the amount of planning materiality that is allocated to an account or class of transactions so that the auditor can plan the scope of audit procedures for the individual account balance or class of transactions.

Step 3: Evaluate audit findings. Based on the results of the audit procedures conducted, the auditor aggregates misstatements from each account or class of transactions. The aggregate amount includes known and likely misstatements. In evaluating likely misstatements, the auditor should be very careful in considering the risk of material misstatement in accounts that are subject to estimation. Examples of such estimates include inventory obsolescence, loan loss reserves, uncollectible receivables, and warranty obligations. Seldom can accounting estimates be considered accurate with certainty. If, based on the best audit evidence, the auditor believes the estimated amount included in the financial statements is unreasonable, the difference between that estimate and the closest reasonable estimate should be treated as a likely misstatement.

While net income before taxes is frequently used for calculating overall materiality, discuss circumstances when total assets or revenues might be better uses for calculating overall materiality.

If net income is not stable, predictable, representative, or if the entity is close to breaking even or experiencing a loss, then other bases may need to be considered. Total assets or revenue is considered a better base if there is less returns and discounts

Give three examples of qualitative factors that might affect the auditor's choice of the percentage to apply to the benchmark used to establish overall materiality.

-Material misstatements in prior years

-High risk of fraud

-The entity is close to violating a covenant in a loan agreement

-Small amounts may cause the entity to miss forecasted revenues or earnings or affect the trend in earnings

-The entity operates in a volatile business environment, has complex operations, or operates in a highly regulated industry

List four factors that would cause the auditor to use a lower percentage for establishing tolerable misstatement.

-High risk of misstatement within the account balance, transaction, or disclosure

-Increased number of accounting issues that require significant judgment and/or more estimates with high estimation uncertainty

-A history of material weaknesses, significant deficiencies, and/or a high number of deficiencies in internal control

-High turnover of senior management of key financial reporting personnel

A written understanding between the auditor and the client concerning the auditor's responsibility for the discovery of illegal acts is usually set forth in an

a) Internal control letter

b) Letter of audit inquiry

c) Management letter

d) Engagement letter

D. Engagement letter

During the initial planning phase of an audit, a CPA most likely would

a) Identify specific internal control activities that are likely to prevent fraud

b) Evaluate the reasonableness of the client's accounting estimates

c) Discuss the timing of the audit procedures with the client's management

d) Inquire of the client's attorney if it is probable that any unrecorded claims will be asserted

C. Discuss the timing of the audit procedures with the client's management

When planning an audit, an auditor should

a) Consider whether the extent of substantive procedures may be reduced based on the results of the internal control questionnaire.

b) Determine planning materiality for audit purposes

c) Conclude whether changes in compliance with prescribed internal controls justify reliance on them

d) Prepare a preliminary draft of the management representation letter

B. Determine planning materiality for audit purposes

As generally conceived, the audit committee of a publicly held company should be made up of

a) Representatives of the major equity interests (preferred stock, common stock)

b) The audit partner, the chief financial officer, the legal counsel, and at least one outsider

c) Representatives from the client's management, investors, suppliers, and customers

d) Members of the board of directors who are not officers or employees

D. Members of the board of directors who are not officers or employees