The Audit Process: Client Acceptance and Planning

What are the four main stages of a financial statement audit?

Client Acceptance, Planning, Testing, Decision/Conclusion

What are key engagement risks in client acceptance?

Litigation, Regulatory penalties, Loss of reputation, Lack of profitability

What preconditions must be present for an audit?

Acceptable financial reporting framework, Management takes responsibility for financials and internal control, Full cooperation

What is included in an engagement letter?

Scope and limitations, Auditor's responsibilities, Management's responsibilities, Fees and other terms

How do auditors gather information for client acceptance?

Communicate with predecessor auditor, client personnel, third parties, and review media/industry info

What are the three components of audit risk?

Inherent Risk, Control Risk, Detection Risk

What is Inherent Risk?

The risk of misstatement in absence of controls

What is Control Risk?

Risk that internal controls fail to detect/prevent a misstatement

What is Detection Risk?

Risk that audit procedures fail to detect a misstatement

How is audit risk calculated?

Audit Risk = Inherent Risk × Control Risk × Detection Risk

What is the purpose of materiality in an audit?

To guide planning and evaluation of audit evidence

What are the steps to determine materiality?

1. Set overall materiality, 2. Allocate to accounts (performance materiality), 3. Allocate to transactions (tolerable misstatement)

What are examples of qualitative factors affecting materiality?

Income trends, Management compensation, Debt covenant compliance, Fraud or illegal acts

What is Performance Materiality?

Portion of overall materiality allocated to accounts

What is Tolerable Misstatement?

Portion of overall materiality allocated to transactions

What kind of testing is performed in the testing phase?

Tests of internal controls (if applicable), Substantive tests

What are key wrap-up activities in an audit?

Evaluation of contingencies, going concern status, and subsequent events

What determines the type of audit opinion issued?

The evaluation of audit evidence and findings

Case: What was the revenue recognition issue with Logics Corporation?

Revenue was recognized before equipment was installed, which is against GAAP

Why was the Logics revenue issue significant despite being quantitatively immaterial?

It turned income into a loss and affected analyst expectations

What does the auditor consider when evaluating uncorrected misstatements?

Both quantitative and qualitative factors