Chapter 6 Flashcards
what is the purpose of audit planning
effective conduct of an audit
audit planning helps (3)
- keep costs reasonable
- avoid misunderstandings with client
- enable auditor to obtain sufficient appropriate audit evidence
why is it good to keep costs low?
firm remain competitive and retain its clients
why is it good to avoid misunderstandings with client?
good client relations + facilitate quality work at reasonable costs
Def: Acceptable audit risk (AAR)
measure of how willing the auditor is to accept that financial statements may be materially misstated after the audit is completed and an unqualified opinion was issued
what does low AAR mean?
wants to be more certain that there is no misstatement
what does high AAR mean?
can allow more flexibility
Def: risk of material misstatement
risk that the financial statements are materially misstated prior to audit
two components of material misstatement
inherent risk + control risk
def: inherent risk
measure of the auditor’s assessment of the likelihood of material misstatement in an account balance before considering effectiveness of controls
def: control risk
risk that material misstatement will not be prevented, detected or corrected on a timely basis
def: client business risk
risk that the entity will fail to achieve its objectives or execute its strategy
what factors can increase client business risk?
1) changes in industry conditions
2) regulatory changes
3) setting inappropriate objectives or strategies
Quality control policies assure that firm will only take clients where it is (3)
- competent to perform the engagement (capabilities, time and resources)
- comply with relevant ethical requirements
- integrity of the client
before accepting an engagement what should happen?
client investigation
what is looked at during client investigation?
- standing in business community
- financial stability
- relation with previous public accountant
the successor audit must
communicate with predecessor auditor to find out if reason be to refuse engagement
for the successor to contact the predecessor
permission must be obtained from the client
if the client does not grant permission the successor should
consider declining the engagement
indicators that raise doubt about management integrity (7)
- history of non-compliance
- poor reputation
- suspicions on management criminal activities
- highly complex transactions or activities that dont seem necessary
- poor tone at the top
- management reluctant to give info
- history of keeping things secret
existing clients should be evaluated _____ for reasons to not continue the engagement
annually
reasons to discontinue association with client (4)
previous conflicts over audit scope, type of opinion to issue or fees, excessive risk
two things to consider when evaluating ethical requirements
- competence
2. independence
elements to evaluate competence (2)
- capable staff
2. time and resources
how to evaluate independence criteria?
independence threat analysis
what are the five threats to independence?
- self-interest
- self-review
- advocacy
- familiarity
- intimidation
steps to conduct independence threat analysis
- 5 threats assessed and potential ones described
- possible to implement safeguards to mitigate threat
- in threats can be diminished –> yes
if threats cannot be diminished –> no
two pre-conditions for an audit
- use by management of acceptable financial reporting framework
- agreement with mgmt and governance terms of engagement
how to get understanding of terms of engagement?
engagement letter
what should be included in an engagement letter
restrictions on auditor’s work, deadlines, assistance to be provided by personnel or internal audit, schedules, fees
auditor must obtain knowledge of entity’s ___+___ to reduce audit risk to acceptably low level
business and environment
what items to evaluate for business and environment analysis (5)
- industry, regulatory and external environment
- nature of business (ops and processes)
- management and governance
- client objectives and strategies
- measurement and performance
reasons for obtaining a good understanding of industry (3)
- certain specific industries have greater risk
- certain inherent risk are common to all clients of one industry
- many industries have unique accounting treatments that auditor must understand
key areas to consider in business ops and processes (5)
- tour client facilities and operations
- organizational and ownership structure
- operational and reporting structure
- technology infrastructure
- identifying related parties
examples of items for auditor to know regarding operations and processes
major sources of revenue, key customers and suppliers, sources of financing, related parties
why tour client facilities? (3)
- observe operations firsthand and meet key personnel
- risks from unused equipment or unsalable inventory
- discussion with non-accounting people to assess risk
with related parties the auditor must disclose
description of transaction (with $), amounts due from and to
related party transactions lead to
high inherent risk
why does related party lead to higher risk
disclosure requirements and lack of independence
what makes a party related?
it has ability to influence decisions directly or indirectly
how to identify related parties?
inquiry management, review shareholder and board minutes, review of OSC or SEC filings and examine shareholder listing
what elements to look for when assessing management
philosophy, operating style, ability to identify and respond to risk
to understand a client’s governance system the auditor should get
- articles of incorporation and bylaws
- code of ethics
- minutes of meetings
what are business strategies?
approaches followed by the entity to achieve organizational objectives
auditors should understand client objectives related to (3)
- reliability of financial reporting
- effectiveness and efficiency of operations
- compliance with laws and regulations
risk of material misstatement may be increased if
client has set unreasonable objectives or performance system encourages aggressive accounting
preliminary procedures for risk assessment?
analytical procedures (ratios)
purpose of preliminary analytical procedures
help auditor better understand the client’s business and business risk + areas with high risk of misstatement + fraud risk
preliminary tests can reveal unusual changes in ratios compared to
prior years or industry averages
the overall audit strategy sets out (3)
- types and allocation of resources to be deployed for specific audit areas
- timing of audit procedure
- materiality
auditors develop and document a strategy that sets which three items
scope, timing and direction
resources requirement for engagement (4)
- select staff
- evaluate need for outside specialist
- evaluate whether help from internal audit
- evaluate reliance on other auditors
major consideration when selecting staff for engagement
continuity of staff to help maintain familiarity and close interpersonal relations with client
does the use of specialist affect auditor’s responsibility?
no, the report should not refer to use of a specialist unless his report’s results change the audit opinion
to use a outside specialist, the auditor must
have sufficient understanding of business, evaluate specialist’s qualifications and understand objectives and scope
why would auditor use internal auditor’s work?
because they have different purpose, they look at if operations are running fluently
general guideline for the use of internal auditor
the higher the assessed risk of material misstatement, the more restricted the nature and extent of work should be assigned to internal auditors
if external auditor decides to use an internal auditor he must
directly supervise and review the internal auditor’s work + obtain written agreement that they are allowed to follow external auditor
the audit firm may need to engage other auditors if
a client has multiple locations or subsidiaries
critical element of multi-location audit is
determine the amount of work to be performed at each component
def: materiality
misstatements and omissions are considered material if they individually or in aggregate could be expected to influence the economic decision of users taken on the basis of financial statements
how are judgements about materiality made?
in light of surrounding circumstances
what affects judgement of materiality?
size or nature of a misstatement or a combination of both
judgement about matters that are material to users of financial statements are based on
consideration of common financial info needs of users as a group
is it possible to establish dollar value guidelines for materiality applicable to all audit clients?
NO
materiality is a driver of entire audit process in
planning audit, evaluate results and completing the audit
decisions during the planning phase provides benchmark for decisions through the audit about
overall or planning materiality
def: overall or planning materiality
determining materiality for financial statements as a whole
example of numbers for overall materiality
total sales or total income
3 steps in determining overall materiality
- selecting appropriate benchmark
- determine the percentage to be applied to benchmark
- justify your decision
the choice of appropriate benchmark depends on
your client (and USERS!!!!)
examples of benchmarks
revenue, profit before taxes, total assets and expenses
factors that affect selection of benchmark (6)
- elements of financial statement
- items users focus on
- past history with audits (a lot of adjustments?)
- nature of entity and industry
- ownership structure and financed
- relative volatility of benchmark (if NI changes always not good)
if the current year end results are unavailable
use prior year, period to date, budgets and forecasts or average of past years
the % chosen depends on
user’s sensitivity or tolerance for misstatements
i.e % example
if user low tolerance (high sensitivity) to small errors, auditor use lower end of % threshold
def: trivial amounts
clearly inconsequential whether taken individually or in aggregate and whether judged by criteria of size, nature or circumstances
def: performance materiality
this is set at an amount less than overall and serves two functions
two functions of performance materiality
- reduce aggregation risk
2. provide safety buffer against risk of undetected misstatements
def: aggregation risk
the risk that aggregate uncorrected and undetected misstatements individually below materiality will exceed overall for financial statements
performance materiality is recommended to be between
50% (high risk) and 75% (low risk)
performance materiality guides
the level of work performed (high-less work and low-more work)
in the planning stage, which materiality is used to identify what areas need to be audited, how much and what type of work and sample size
performance materiality
factors that suggest lower materiality (10)
- fraud risk
- non compliance with laws
- misstatements in prior audits
- related party transactions
- change in accounting methods or lots of judgement or estimates
- change in ops (more locations, high turnover of senior management)
- deficient internal controls
- nature of business
- new client?
- public client?
auditors also need to consider _____ factors
qualitative
can you revise overall materiality throughout audit
yes if the results of your audit are different from what you had set at beginning
def: specific materiality
amount less than materiality used to plan and conduct financial statement audit engagement to reduce likelihood of uncorrected errors > overall materiality
specific materiality involves considerable
professional judgement
which type of materiality gears sample sizes and conclusions on material misstatements of accounts?
performance materiality
specific performance materiality is
materiality level determined for a particular class of transactions, account balance or disclosure
specific performance materiality must be equal to or less than
performance materiality
qualitative factors used to set specific performance materiality
analytical procedure results, prior period adjustments, consequences of misstatements and account data for other purposes
def: tolerable misstatement
application of performance materiality to a specific sampling procedure
tolerable misstatement is either less than or equal to
performance materiality
how to categorize misstatements during the audit
- factual misstatements
- judgemental misstatements
- projected misstatements
def: factual misstatements
those about which there is no doubt
def: judgemental misstatements
differences in management’s judgement concerning recognition, measurement, presentation and disclosure AND auditor’s judgement
def: projected misstatement
the auditor’s best estimate based on a sample
which category of misstatements would auditors share with management?
request to correct factual misstatements, discuss adjustments for judgemental differences
how to conclude overall reasonableness of financial statements
misstatements > overall materiality benchmark
if uncorrected material misstatement, the auditor must decide if
materially pervasive or isolated to specific accounts or disclosures
auditor must communicate with
those in charge of governance
