Chapter 6 - Client Acceptance, Preliminary Planning, and Materiality Flashcards
What are the three main reasons that auditors should plan engagements properly?
- To enable the auditor to obtain sufficient appropriate audit evidence
- To help keep audit costs reasonable
- To avoid misunderstandings with the client.
What are the three parts of the audit plan?
The nature, timing, and extent or risk assessment procedures
The nature, timing, and extent of further audit procedures
Any other audit procedures required
What is the client business risk?
The risk that the entity will fail to achieve its objectives or execute its strategies.
What is engagement risk?
The extent of risk that the audit firm is willing to tolerate (firms risk tolerance in accepting or continuing with a client)
What is the risk of material misstatement? What are the two parts of RMM?
Risk that the financial statements contain material misstatements due to fraud or error prior to the audit. Inherent risk - Susceptibility as a whole or individual accounts and control risk - Clients controls do not prevent or detect material misstatements.
What does RMM help auditors to plan and determine?
How much persuasive evidence is required and the experience level of staff needed to perform an appropriate audit.
What does assessing client business risk help to plan and determine
It is good in determining the engagement risk and the RMM. A company that has ongoing losses may eventually become bankrupt.
What are the 4 preliminary engagement activities?
- Perform procedures to assist the auditor in deciding whether to accept or continue doing the audit for the client. (Decision made by experienced auditor)
- Consider ethical requirements, like independence
- Identify purpose of the financial statements
- Obtain an understanding with the client about the terms of the engagement. The purpose of this is to avoid misunderstandings.
How do we decide whether to accept a client or not?
You want to avoid clients that lack integrity or always argue about audit fees. Assess whether the audit firm has quality management like their integrity, compliance with relevant ethical requirements, and competence to perform the engagement.
- In addition, each firm will have their own continuance policies.
What are 3 factors to consider in engagement risk factors?
- The degree to which external users rely on the statements.
- Likelihood that the client will have financial difficulties after the audit
- Integrity of the management
What are the 2 factors for the degree to which external users rely on financial statements
- Distribution of ownership - Public companies statements are normally relied upon more than users of the private companies
- Nature and the amount of liabilities - If there is a large amount of liabilities it will be used more extensively by actual or potential creditors.
What are 5 indications of going concern issues?
- Liquidity problems - Short of cash and working capital cannot pay obligations
- Profits going down from previous years - Increased likelihood of solvency problems
- Method of financing growth - Reliance on debt is more risky especially is operations decline.
- Nature of the clients operations - Start up tech more risky than food manufacturer
- Competence of management - Those who are not alert and try to enhance their operating methods are risky
What are considerations when investigating a new client
- Standing in the business community and their financial stability
- Communication with the previous auditors (Note: Require permission from the client)
What are considerations when deciding on continuing clients?
- Consider conflicts regarding fees, scope, or the type of opinion issued
- Consider if they have lost integrity
- Consider if there are pending lawsuits
- Consider if the engagement risk has risen though none of the above criteria exist.
What are the two ethical requirements on the auditors side to decide whether to accept a client or not?
- Competence - Can you perform the work, do you have the time and resources
- Independence - Assess independence threat analysis and describe them. Determine if safeguards exist and if not remove yourself from the engagement
What are the two pre conditions for an audit?
- The use by management of an acceptable financial reporting framework - IFRS or ASPE and purpose of the statements and nature of reporting entity.
- Agreement with management / governance on the terms of the engagement - Clear understanding of the terms of the engagement should exist.
What is an engagement letter?
A written agreement between the public accounting firm and the client as to the terms of the engagement for the conduct of the audit and related services.
What are the 8 components of the engagement letter?
- Objective, scope, and limitation of the audit engagement
- Responsibility of the auditor and management
- The framework used by management
- Expected form and content of the audit report
- Restrictions on the auditors work
- Deadlines
- Client assistance in obtaining records and documents
- Internal audit department - Assistance in actual audit work / schedules to be prepared for the auditor.
What is a scope limitation?
When the client imposes a restriction on the auditor like denying access to certain information , which can make the auditor disclaim the opinion on the financial statement
What does the overall audit strategy set out?
- Types and allocation of resources to be deployed for specific audit areas.
2.Timing of audit procedures - Materiality
What are resources required for an engagement
- Select staff for the engagement - Ensure have sufficient competence and experience, specialists may also be assigned like an IT specialist.
- Evaluate need for external experts - Specialized knowledge may be required, thus requiring to consult a specialist.
- Evaluate whether internal audit work can contribute - May be able to use the internal auditors work or the internal auditor provides direct assistance
- Evaluate reliance on other auditors - If multiple locations or subsidiaries may need to engage other auditors
What is the staff continuity consideration?
Ensure continuity from year to year as it helps the PA maintain familiarity with the business operation and interpersonal relationships, however it may create an independence threat.
Describe the use of internal auditors?
If they have the competence, integrity, and objectivity you may use their work. However if RMM is high restrict using their work. If they assist then review the internal auditors work.
What are component auditors?
What are group auditors?
What should be assessed with the component auditor?
Component - The auditor for a particular division or subsidiary
Group - Auditor responsible for the consolidated financial statements
Assess the competence, independence, and they operate in a regulatory environment that is overseen
What is the critical element of the multi-location audit?
- Determine the amount of work to be performed at each location.
- Clearly communicate the requirement of the engagement team from each component
- Group auditor and component must understand the extent of the work and provide guidance on materiality
Describe timing of engagement?
Based upon the client reporting deadlines and practical matters like inventory counts that the auditor will observe
Describe engagement team discussions
- Key partners and members who are experienced can share insights about the entity, understanding controls providing more understanding all in all.
- Brainstorming ideas about business risk and RMM
- Identify risks through understanding the entity.
What is the key difference between the NYSE and the Canadian
There must be an internal audit function in the NYSE the Canadians do not
What are the foundations for understanding RMM?
Understanding the entity, understanding the environment, the applicable framework, and internal controls.
What are the 5 considerations to understand entity and the environment?
- Industry, regulations, other factors
- Organizational structure and ownership
- Governance
- Entity business model
- Performance measures.
What are some considerations with the industry?
- The competitive environment
- Supplier and customer relationships
- Technological developments
What are some considerations with the regulations?
- Legislations and regulations that significantly affect the clients operations.
- Taxation legislation and regulations
- Environmental and climate related laws and regulations
What are 4 other external factors?
- General economic conditions
- Interest rates and availability of financing
- Inflation or currency revaluation
- Climate related events.
What are the aspects of understanding organizational structure?
- Complexity - Some are small, some are large, some have one location or multiple locations, there may be complex accounting issues.
- Ownership - Who is in charge, who is overseeing, what are the relationships
What is a key factor of management and governance?
Key factor is managements philosophy and operating style, its ability to identify and respond to risk, as it affects the RMM in financial statements. In addition assess board of directors and audit committee., ensuring they perform their functions.
What is an organizations business model?
Describes how it creates, preserves, and captures financial or broader value for its stakeholders.
What are three considerations in the business model?
- Business operations - Like major sources of revenue
- Investment and investing activities
- Financing and financing activities.
What is a clients performance measurement systems? Why does it help auditors?
Key performance indicators that management uses to measure progress towards its objectives. Includes market share, sales per employee, unit sales growth. Allows for the detection of areas where they may be additional pressure to achieve the performance targets.
What are 5 key indicators for evaluating financial performance?
- KPI’s like ratios and trends
- Financial performance analysis
- Budgets and Variances
- Employee performance measures and incentive policies
- Comparison with competitors.
What are 5 parts of understanding the applicable framework.
- Revenue recognition
- Accounting policies and specific accounting practices
- Accounting for financial instruments
- Accounting for unusual or complex transactions.
- The ability of the firm to adapt to new legislation and policies
What are the three items that form the foundation for identifying and assessing RMM?
- Assess the client acceptance and continuance
- Assess the prior experience with the client and similar types of audits
- Audit engagement discussions.
What is the following step after assessing the RMM foundation?
- Understand the entity
- Understand environment
- Understand the internal controls
- Understand the overall framework
What are the sources of evidence for risk assessment procedures?
- Interactions with management, governance, entity personnel.
- External parties - Direct or indirect
- Public information about the entity.
What are the risk assessment procedures?
- Inquiry of management and others in the entity.
- Analytical procedures
- Observation and inspection.
- May be enhanced with ATT, audit analytics and advanced technologies.
What is the impact of a code of ethics on the business and understanding the entity?
The code of ethics are powerful signals to the corporate conduct. Changes to the code have implications on the governance systems and integrity / ethical values.
What are corporate minutes?
The official record of the meetings of the board of directors and the shareholders. Includes summaries of the most important topics discussed and decisions made by the directors and the shareholders.
What are examples of important information arising from corporate minutes?
- Compensation of the officers
- New contracts and agreements
- Acquisition of Property, and loans
- Dividend payments
What are 3 examples of information from other sources that may provide important information?
- Past misstatements or restatement
- Significant changes in their operations
- Complex transactions or account balances that were difficult to audit.
What are examples of preliminary analytical procedure?
- Ratio analysis - Compare ratios to previous years or to the industry
- Compare account balances of sales in current year to the previous year
- Preparation of common sized financial statements
What are the 3 types of preliminary analytical procedures?
- Ratio analysis
- Horizontal Testing
- Vertical testing
What is ratio analysis
Comparison of ratios to current years to look for odd changes, comparison to the budget, or ratios that seem to high or too low.
What are your two key liquidity ratios?
- Inventory turnover
- Accounts Receivable Turnover
What is a horizontal analysis?
It is the comparison of account balances in the current year to account balances in the previous year and you calculate the percentage change to look for discrepancies.
What is vertical analysis?
The comparison of an account balance to a common base such as sales to determine what percentage of it accounts to the sales and comparing it to previous year values.
What does vertical analysis allow companies to do?
The creation of common sized financial statements allow for the comparison between companies or for the same company over different periods, revealing trends and insight into how different companies compare.
What is materiality for financial statements
It is the size of misstatements that when aggregated or disaggregated are likely to impact the users of the financial statement view on the firm and will influence their decision making.
What is a common misconception of determining materiality, how should we do it? What is the most common way to apply this?
It is as simple as taking a percentage and applying it to an account therefore creating materiality. While we can use it we must have professional judgement and determine why we applied that particular amount. The most common way is to take 5% of the net income.
What are the two factors that guide determinations in materiality?
- Judgements are made in light of the circumstances surrounding the entity and are affected by the size and the nature of the misstatements or a combination of both.
- Judgements about what is material to users of the financial statement are based on the common financial information need of users as a group, not on each user individually.
What is the driver of the entire audit process?
Materiality from planning to evaluating results and completing the audit.
What materiality decisions are made in planning the audit stage?
- Performance materiality
- Overall materiality
- Specific materiality
What materiality decisions are made in evaluating the results stage?
- Estimate total misstatement in a segment
- Estimate combined misstatements
- Compare combined misstatement with the overall materiality.
What materiality decisions are made in completing the audit?
- Conclude on the overall reasonableness of financial statements
- Report to those in charge of governance.
What is overall materiality?
Materiality for all financial statements as a whole.
What is overall materiality based on?
Identifying the financial statement users and determining what would be of most importance to them. It is based on the needs and expectations of the user, not those of the auditor based on the audit risk.
What are the three steps in determining the overall materiality?
- Select an appropriate benchmark
- Determine the percentage to be applied to the selected benchmark.
- Justify the choice.
How do we select a benchmark? Examples of benchmarks
Based upon the auditors understanding of the needs and expectations of the users of the financial statements as well as their tolerance for misstatements. Revenue, assets, profit, expenses.
What are possible factors when selecting an appropriate benchmark?
- Elements of the financial statements
- Whether there are items on which users tend to focus
- Past history with audits
- Nature of the entity and industry
- Ownership structure and the way it is financed.
- Volatility of the benchmark.
How do we identify the financial data?
Usually when planning the audit year end results are not yet available. They will usually use the prior year financial results, period to date, budgets or forecasts that are adjusted for significant changes.
How do auditors account for risks in the financial data.
They may take an average of the past previous years or they may eliminate an unusual one to normalize the benchmark.
What should overall materiality be set at?
The highest amount of misstatements that would not influence the economic decisions of the financial statement users.
What are the rules of thumb in calculating materiality for NPO’s?
What is the common rule of thumb for calculating materiality for for profit organizations?
1-3% for revenue, expenses, and assets
- 1-3% for revenue and assets
3-7% for normalized income from continuing operations
3-5% for shareholders equity
How do we justify the materiality decisions?
Materiality decisions are based on professional judgement. There are no specific percentages and benchmarks that should be used, however audit firms may develop guidelines to help them choose what is best. The key is to write down your understanding and judgement within the working papers.
What are trivial amounts
These are amounts that when aggregated or disaggregated do not affect the overall assessment of the user of the financial statement and do not affect their decision making.
Do we revise overall materiality?
Yes, overall materiality is revised if there are decisions and actions taken that substantially affect the end results.
What is performance materiality? What is the two purposes of the performance materiality?
The materiality level set significantly lower than the overall materiality to account for the risks of misstatements that were not caught or prevented or detected in a timely manner. To provide a safety buffer and reduce the aggregation risk.
What is aggregate risk
The risk that individually an amount is inconsequential to materiality but when aggregated as a group can surpass performance and overall materiality.
How do we determine performance materiality?
It is all about risk, how much lower you may go would depend on business / fraud risks, results of the risk assessment procedures, and the nature/extent of misstatements in the previous audits.
What is the typical percentage set for performance materiality?
If it is high risk you will set it at 50% of the overall materiality. If it is low risk you will set it at the 75% materiality. `
Why is it important to get the performance materiality at a nice middle ground?
The performance materiality guides the audit procedures. If it is too low than the auditor may perform too many audit procedures than actually necessary, and if it is too high the auditor may not have performed enough work.
What are performance materiality factors?
- First year engagement
- Weak controls
- High management turnover
- High fraud risk
- High market pressures within the organization
- High risk of bankruptcy.
How is performance materiality implemented in the planning stage?
How is performance materiality implemented later in the audit?
- Used to identify what areas need to be audited,
-determine how much and why type of work is needed, - Calculate the sample size
- Used to evaluate the results of substantive tests and conclude whether an account is materially misstated or not.
Describe adjusting performance materiality
You can change the performance materiality as required on the basis of higher risk of RMM results from previous years or the current year analytical procedure results.
What is specific materiality
It is the materiality that is applied to a specific industry for a particular nature, timing, and extent of a class of transactions, account balances, or disclosures. It is for a specific group of users needs.
Why would we apply a specific materiality?
They may be sensitive to small changes or they are sensitive to the consequences of misstatements on the transactions, balances, or disclosures on the financial statements
What are uncorrected misstatements?
These are misstatements that have been accumulated during the audit and have not been fixed by the client
What do auditors not need to accumulate during the audit?
They do not need to accumulate amounts that are clearly trivial that was determined in the planning stage, however it does not mean it is not material. Trivial amounts can be ignored when proposing adjustments to the clients management.
What are factual misstatements?
Misstatements that the auditors knows for sure have omitted or are altered
What are judgmental misstatements?
These are misstatements caused by differences in understanding between management and the auditor, with regard to an application for the completeness, accuracy, presentation, rights and obligations, and existence of a principle.
What are projected misstatements?
These are misstatements that the auditor believes exists by taking a sample, and applying it to the population, to make claim of potential misstatements.
How do auditors assess the materiality of misstatements?
Once they have accumulated and categorized the misstatements are material, individually or aggregated. They will use professional judgement in the assessment through quantitative and qualitative information. Certain misstatements may be more important than others even if the amounts are essentially the same.
How do auditors form an overall opinion and report?
They will conclude on the overall reasonableness of the financial statements using the benchmark of overall materiality. Qualitative factors are considered. If there is a material uncorrected misstatement, auditor will determine if it is pervasive or on a particular account / transaction to guide the way they report.
Describe communicating with those in charge of governance
Throughout the process they talk with management and those in charge of governance regarding overall materiality, trivial misstatements threshold. and identified misstatements. Misstatements communicated on a timely basis and talk with governance regarding uncorrected material misstatements.
