Chapter 3 : Planning & Auditing

 The f ir st GAAS of Process

f ie ldwork requires adequate
planning to be made before auditing is carried out.
 Reasons for proper Audit Plan are:
- To enable auditor to obtain suff ic ient competent
evidence
- To help keep audit costs reasonable
- To avoid misunderstanding with the client
 O b ta ining su f f ic ient c o m p etent evid enc e is
essential if the CPA firm is to minimize legal liability
and maintain a good reputation in the business
community.
Planning & Auditing Process Cont…
 Planning & Auditing Process Cont…
A. Preplan the audit-It involves three things, all of
which should be done early in audit.
1.The auditor decides whether to accept a new client
or continue serving an existing one.
2.The auditor identif ies why the client wants or need
an audit. This information is likely to affect the
remaining part of the planning process.
3.The auditor obtains an understanding with the
client about the terms of the engagements to avoid
misunderstandings and staffing the engagements.
Client acceptance procedure:
1. Search & Obtaining clients
 Planning & Auditing Process Cont…
 The auditor should investigate the history of
prospective client, including such matters as the
identities & reputations of the directors, off ic ers
and major stockholders, f in ancial strength &
credit rating of a prospective client to help assess
the overall risk associated with particular business
(business risk).
2. Submitting a proposal- To obtain the audit
 A c o m p etitive p ro p o sa l tha t w ill inc lu de
information on the nature of services that the
audit f irm offers, the qualif ic ations of the f irm’s
personnel, anticipated fees, and other
information to convince the prospective client to
 Planning & Auditing Process Cont…
3. Communication with audit committees (if any)- An
audit committee must be composed of at least three
independent directors.
During the course of the audit the discussions with
the audit committee members will focus on:
-Weakness in internal control
-Proposed audit adjustments
-Disagreement with management as to accounting
principles
-The quality of accounting principles used by the
company
-Indications of management fraud other illegal
 Planning & Auditing Process Cont…
4. Fee Arrangements-ask for estimate of z cost of the
audit.
Staff time is z basic unit of measurements for audit
fees.
Other direct costs such as staff travel costs, report
p ro c essing c o sts a nd o ther o u t-o f -p o c ket
expenditures are also included in the cost of audit.
5. Communication with predecessor auditors – about:
- Disagreement with mgt over accounting principles
- The predecessor’s auditors understanding of the
reasons for the change in auditors.
-On the nature of client’s internal control structure
 Planning & Auditing Process Cont…
6. Engagement Letters- The auditors should establish
an understanding with the client regarding the
services to be performed, the objectives of the
engagement, management’s responsibilities, auditor’s
responsibilities, scope and/or limitations of the
engagements and other related issues.
B. Obtain background information
There are three primary reasons for obtaining a
good understanding of the client’s industry:
1. M a ny industries have unique accounting
requirements that the auditor must understand to
evaluate whether the client’s financial statements are
in accordance with GAAP.
 Planning & Auditing Process Cont…
 For example, if an auditor is doing an audit of a
city, the auditor must understand governmental
accounting.
2. The auditor can often identify risks in the industry
tha t may a f fect z auditor’s assessments of
accepting audit risk.
3. There are inherent risks that are typically common
to all clients in certain industries. Understanding
those risk aids the auditor in identifying the
client’s inherent risks. Examples, include potential
inventory obsolescence inherent risk in the fashion
clothes industry.
 Knowledge of the client’s can be obtained in
 Planning & Auditing Process Cont…
 A tour of the client’s plant & off ic e is helpful in
obtaining understanding of the client’s business
and operations because it provides opportunity to
observe operations f ir sthand and to meet key
personnel.
 Id entif y rela ted p a r ties- Tra nsa c tio ns a re
important to auditors because GAAP require that
they be disclosed in the f in ancial statements if
they are material . Because they are not arm’s
length transactions.
 Common examples related party trxs include sales
or purchase trx ns b /n a parent company &
subsidiary , exchange of equipment b/n tw o
 Planning & Auditing Process Cont…
 Evaluate need for outside specialists-when the
auditor encounters situations requiring specialized
knowledge , it may be necessary to consult a
specialist. For example consulting with attorneys on
the legal interpretations of contracts & titles.
C. Obtain information about client’s obligations
 Three closely related types of documents & records
should be examined early in the engagement:
corporate charter & bylaws, minutes of board of
directors’ & stockholders’ meetings, and contracts.
 The corporate charter is granted by the state, It
includes the exact name of the corporations, the
date of incorporations , the kinds & amounts of
 Planning & Auditing Process Cont…
 The correct disclosure of the stockholder’s equity,
including the proper payments of dividends ,
depends heavily on corporate charter & bylaws.
 T he c o rp o ra te m inu tes o f m eeting s inc lu d e
summaries of the most important topics discussed
at these meetings and the decisions made by the
directors & stockholders.
 Tw o of relevant information in minutes:
Authorizations and discussions by the board of
directors affecting inherent risk.
 Common authorizations in the minutes include
compensation of off ic ers , new c o ntra c ts &
agreements, acquisitions of property, loans, and
 Planning & Auditing Process Cont…
 The auditor should compare the authorizations of
loans with notes payable to make certain that
these liabilities are recorded.
D. Perform preliminary analytical procedures
 Analytical procedures performed during the
p l a n n i n g p h a s e s e n h a n c e t h e a u d i t o r ’s
understanding of the client’s business & events
occurring since the prior year’s audit.
 As Analytical procedures auditors might consider
key financial ratios such as efficiency ratio, return
on assets, liquidity ratio, inventory & accounts
receivable turn over ratios and other similar ratio.
 Planning & Auditing Process Cont…
E. Set materiality & assess acceptable audit risk &
inherent risk
Materiality is important because it is impractical for
auditors to provide assurance on immaterial amounts.
The auditor’s responsibility is to determine whether
financial statements are materially misstated. If the
a u d ito r d e t e r m i n e s th a t th ere is a m a t e r i a l
misstatement , he or she will bring it to the client’s
attention so that a correction can be made.
There are five steps in setting materiality:
Step-1: Set preliminary judgment about materiality.
Step-2: Allocate preliminary judgment to segments
 Planning & Auditing Process Cont…
Step-3: Estimate total misstatement in segments.
Step-4: Estimate the combined misstatements
Step-5:Compare combined estimate with preliminary
judgment about materiality.
The reason for setting a preliminary judgment
about materiality is to help the auditors to plan the
appropriate evidence to accumulate. If the auditor
sets a low Birr amount, more evidence is required than
for a high amount.
F. Understand internal control and assess control risk
 Planning & Auditing Process Cont…
 To effectively assess internal control for the
purpose of reducing planned audit evidence ,
auditors need to understand key internal control
& control risk concepts.
G. Develop over all audit plan & audit program
 It is critical step because it results in the entire
audit program the auditors plans to follow in the
audit, including all audit procedures, sample size,
items to select, and timing.
 Auditing Process
Audit Process
The phases of an audit include client acceptance &
retention , establish the terms of the engagement,
Plan the audit, Consider internal control, Conduct
substantive tests, Feedback on the results of the audit
work in these phases, Complete the audit & Issue
audit report.
1. Client Acceptance and Retention
If an auditor is associated with a client who lacks
integrity, material misstatements may exist and not
be detected by the auditor. This can lead to lawsuits
brought by users of the financial statements.
 Auditing Process Cont…
 If the client has not previously been audited, the
CPA firm should complete all the procedures listed
b el o w, ex c ep t f o r c o m m u n ic a t io n w it h t h e
predecessor auditor:
A) Obtain & review available f in ancial information
(annual reports, interim f in ancial statements,
income tax returns).
B) Inquire of third parties (such as prospective
client’s bankers & attorneys, credit agencies, and
other) about any information concerning the
in teg rity o f th e p ro s p ec tiv e c l ien t a n d its
management.
C) Consider whether the prospective client has any
 Auditing Process Cont…
D) Determine if the firm has the necessary technical
skills & knowledge of the industry to complete the
engagement.
E. Determine if acceptance of the client would violate
any applicable regulatory agency requirements or
the Code of Professional Conduct.
2. Audit Planning
 The audit plan serves as a starting point for the
engagement, but adjustments may be required as
the audit progresses.
3. Assessment of Internal Control
 Auditing Process Cont…
 Internal control is a process made by an entity’s
board of directors, management, & other
personnel that is designed to provide reasonable
assurance regarding the achievement of objectives
in the following categories:
(1) Effectiveness & efficiency of operations,
(2) Reliability of financial reporting, and
(3) Compliance with applicable laws & regulations.
 The auditor’s tests are intended to ensure that the
internal controls are operating in the manner
i n t e n d e d a n d t h e re f o re a re e f f e c t i v e i n
preventing or detecting misstatements.
 Auditing Process Cont…
 When control risk is assessed low, based on tests of
the internal controls (referred to as tests of
controls), less audit work is required to audit the
account balances (referred to as substantive tests)
b ec a u s e th e a u d ito r h a s ev i d e n c e th a t th e
accounting systems are generating materially
accurate financial information.
4. Conduct Substantive Tests
 In this phase, the auditor conducts more analytical
procedures and examines the details of the account
balances. For example, the auditor may calculate
an estimate of interest expense by multiplying total
debt by the average interest rate on the entity’s
 Auditing Process Cont…
 The purpose of such analytical procedures is to
d eterm ine w h eth er th e a c c o u nts c o nta in a
material misstatement.
5. Complete the Audit
 The auditor must have suff ic ient competent
evidence in order to reach a conclusion on the
fairness of the financial statements.
6. Issue the Audit Report
 The Final phase in the audit process is choosing the
appropriate audit report to issue.
 Auditing Process Cont…
 W h en th e a u d ito r h a s g a t h e re d s u f f ic i e n t
competent evidence and complied with GAAS, and
the f in ancial statements conform to GAAP, the
auditor can issue a standard unqualif ied audit
report.
Audit Risk
 Audit risk is the risk of giving an inappropriate
opinion when f inancial statements are materially
misstated.
 Audit risk is the cha nce tha t a material
misstatement exists in the f in ancial statements
and the auditors do not detect the misstatement
with their audit procedures.
 Auditing Risk Cont…
 When Audit Risk increase:
1. Perform additional audit tests
2. Modify the nature, extent and timing of the audit
procedures to obtain evidence that is more reliable.
3. Apply increased professional skepticism about
material transactions ; increase the nature and
extent of the documentation examination.
4. Assign personnel with particular skill in audit areas
with high risk
5. Obtain additional evidence about the
appropriateness of management selection and
application of significant accounting principles.
 Auditing Risk Cont…
6. Document the assessment of risk in working papers.
Components of Audit risk
1.Inherent risk: the susceptibility (exposure) of an
account balance or class of transactions to material
misstatement , irrespective of related internal
controls.
I nh erent risk is g rea ter f o r so m e f in a n c i a l
statement assertions and classes of transactions
than for others. For example, there is a greater risk
of misstatement of the f in ancial presentation &
disclosure assertion for complex transactions than for
simple ones.
Likewise, the risk of a material misstatement of the
Components of Audit risk Cont…
2. Control risk: the risk that material misstatement
could occur in a n a c c o unt ba la nc e o r c la ss o f
transactions with could not be prevented or detected
by the accounting or internal control systems.
The auditor’s understanding of the internal control
system will allow the auditor to assess control risk and
thus affect the auditor’s assessment of the risk of
material misstatements.
3. Detection risk: the risk that auditor's substantive
procedures do not detect a material misstatement in
an account balance or class of transactions. This risk
is a function of the effectiveness of an auditing
procedure and of its application by the auditor.
Components of Audit risk Cont…
 It arises partly from the uncertainties that exist
when the auditor does not examine all of an
account balance or class of transactions to gather
evidence on a particular assertion.
 Other uncertainties might arise because an auditor
might select an inappropriate auditing procedure,
misapply an appropriate procedure, or
m isinterp ret the audit results . T hese other
uncertainties can be reduced to a negligible level
through adequate planning, supervision , and
conduct of a f irm’s audit practices in accordance
with appropriate quality standards.

Audit Staffing
Audit Staffing Cont…
 Once having obtained an understanding of the
client and its business and having designed the
audit program , the auditor is in a position to
determine how the engagement should be staffed.
 At this point, the auditor selects the audit team.
The audit team should be selected based on the
number of people needed, the experience levels
desired, and the technical expertise required.
Use of the client’s staff:
 Among the tasks that may be assigned to the
client’s employers are:
1. Preparation of trial balance & general ledger:
2. Aging analysis of accounts receivables
Audit Staffing Cont…
3. Analyses of account receivables written off
4. List of property additions & retirements during the
year
5. Analyses of various revenue & expense accounts
The audit trail (way): is a continuous trail(road)
of evidence that links the business transactions with
the summary figures in the financial statements.
For example, the audit trail of a sales transaction
may enable the tracing (outlining) of the movement
in data concerning the transaction from the time the
order is placed by the customer until the time
transaction data is included in the appropriate
general ledger accounts.
Thank You!
Quizzes 1
1. Discuss about Components of Audit Risks?
Quizzes 1
1. Explain as what the auditor should do when the
audit risk Is increase?