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Chapter 5

CHAPTER 5.docx

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Department
Accounting
Course Code
ACC 521
Professor
Kathryn Bewley

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CHAPTER 5: PRELIMINARY AUDIT PLANNING – UNDERSTANDING THE AUDITEE’S BUSINESS Preliminary risk assessment, engagement acceptance, and planning • Before audit is accepted, the auditor must gain familiarity with the entity and terms of the audit and consider the risks the auditor will be taking on if the engagement were accepted Overview of Financial Statement Audit Process CAS requires additional dimensions that are required to complete financial statement audit that complies with GAAS as follows: • Communication among audit team members throughout the process • Documentation of audit decisions and findings • Revision to risk assessments and planned responses if appropriate due to knowledge obtained during audit process • Communication with those charged with the auditee’s governance and its management Elements of Risk assessment • Pre-engagement activates o Obtain understanding of entity and engagement o Determine if pre-conditions for audit are present, including management integrity and responsibility o Assess auditor’s independence from auditee o Identify auditor’s risk arising from engagement o Engagement acceptance or continuance decision • Preliminary audit planning: risk identification o Understand auditee’s business environment, risks, and management control o Determine materiality levels o Identify key financial statement assertions and related risks of material misstatement o Identify significant risks in the auditee, including governance, fraud, going concern, related parties, controls over financial reporting o Assess risks of material misstatement at overall financial statement level o Develop the overall audit strategy • Risk assessment procedures to plan audit o Understand accounting information system and financial reporting process o Assess inherent and control risk, combined as risk of material misstatement, at the assertion level for account balances, transactions classes and disclosures o Determine whether control reliance’s is appropriate for specific assertion o Assess fraud risk and risk of non compliance with laws o Determine nature and timing of control tests and substantive procedures required to respond to assessed risks at the assertion level o Develop audit plan and detailed program o Document the planning by creating working paper files Independent audit engagement characteristics • Private corporations with significant non management shareholders or creditors may also need audit • Corporations with publicly traded shares/bonds often require audit • Private corporation with few external stakeholders don’t need audit • Government, public sector corporations require audit Those charged with governance: person(s) or organization(s) with responsibility for overseeing the strategic directions of the entity and obligations related to the accountability of the entity o Includes overseeing the financial reporting process • It is important for the auditor to understand what kind of entity is being audited, who the people are who are charged with governance of the entity, the stakeholders to whom they are accountable, and the client’s reasons for wanting the audit Audit engagement acceptance decisions Pre-engagement activities Pre-audit risk management activities: Procedures auditors perform before accepting an audit engagement to ensure that client and the engagement do not pose an unacceptably right risk of audit failure Auditor’s risk from taking the engagement: Possibility that negative consequences will arise for an auditor’s professional practice as a result of taking on a particular audit engagement, such as damage to reputation, litigation, or financial loss o Negative consequences include, damages to professional reputation, getting sued for being associated with misleading financial information, suffering financial loss due to not recovering the cost of doing the audit • Once engagement is accepted, auditors will try to reduce risk by carefully conducting the audit to reduce the probability that something will go wrong that might lead to misstated financial statements being released to user CAS 220 • The objective of the auditor is to implement quality control procedures at the engagement level that provides the auditor with reasonable assurance that: o The audit complies with professional standards and applicable legal and regulatory requirements o The auditor report issued is appropriate in situation Audit engagement acceptance and continuance Acceptance and continuance decisions involve the following policies and procedures: 1) Obtain and review financial information about the prospective auditee organization to determine purpose and main users of the financial statements 2) Evaluate the public accounting firm and individual auditor’s independence and ability to comply with relevant ethical requirements with regard to the prospective auditee 3) Consider whether the public accounting firm has the competence and resources to perform the audit 4) Obtain information from the prospective auditee’s management in order to understand the business and its risk, and to assess whether the organization’s managements and those charged with its governance are willing and able to accept responsibility for preparing financial statements in accordance with acceptable financial reporting framework and implementing controls to reduce risk of error or fraud 5) Consider whether engagement requires special attention of involves unusual risks 6) Search for information about organization by looking for news reports, asking perspective auditee’s banker, legal counsel, underwrite; particular attention is given to indicators relating to the integrity of principal owner, managers, or those charged with governance 7) For new audits, communicate with the previous auditor, for information on integrity of management, disagreements with management and reasons for change in auditors CAS 210 3) The objective of the auditor is to accept and audit engagement only when basis upon which it is to be performed has been agreed, through: a) establishing whether the preconditions for an audit are present b) confirming that there is a common understanding between auditors and management and, those charged with governance of the terms of the audit engagement 4) Precondition of an audit: the acceptable financial reporting framework used by management in the preparation of the financial statements and the agreement of management, those charged with governance to the premise on which an audit is conducted 5) For purpose of ISA, references to “management” should be read hereafter as “management and those charged with governance” Determining auditability To determine if the organization is “auditable” the auditor must do the following: • determining whether financial statements are presented in accordance with GAAP or other acceptable reporting framework o without acceptable framework auditor cannot determine if statements are presented properly, the engagement must then be DENIED • Auditors must satisfied that the prospective auditee’s management understands their responsibilities for preparing financial statements in accordance with the acceptable financial reporting framework and for implementing and maintaining internal control adequate to ensuring financial statements are free of misstatements due to error or fraud • Management must provide unrestricted access to records, etc. o If this is not done, this imposes a limitation on the scope of the auditor’s work that could lead to a disclaimer of audit opinion; engagement should be DENIED Communication between predecessor and successor auditors Predecessor: The auditor that held the engagement previously, before a new successor auditor took on the engagement Successor: A new auditor who takes over the engagement from the predecessor • Code of ethics request a successor auditor to initiate contact and attempt to obtain basic information directly from the predecessor Former auditors can give information useful in: 1) Deciding whether to accept the new auditee 2) Planning the audit • The successor can get consent from the auditee’s management to allow them to speak with the predecessor and gain information and be able to review prior year’s audit files • The audit files belong to the auditor, not the auditee, but confidentiality must be respected, even after the auditor- auditee relationship ends Factors affecting the auditor’s risk from accepting engagement • How widely distributed are the audited financial statements o If widely distributed to public, risk from accepting engagement is higher (reputation risk) o If limited distribution, it is lower • How strong is the financial condition of the auditee? o Financial conditions are poor = risk is higher due to financial failures can lead to investor losses and lawsuits o Audit fees may not be collected o If financial conditions are strong, risk is lower • How trustworthy is auditee management? o If auditor has reason to doubt management integrity, the risk is higher o If auditor believe management is trustworthy, risk is lower • How complex is the financial reporting required? o If auditee has complicated accounting requirements, risk is higher o If auditee has straightforward activates and transactions, risk is lower • How knowledgeable are the people using the financial statement? o Naive users/completely reliant on the financial statement = risk is higher o Sophisticated and/or have direct access to relevant information other than financial statements, risk is lower ** Auditors may take on low, moderate, high risk engagement, as long s they believe the risk can be management to an acceptable level. • Very high risk levels often lead to DENIED engagements Engagement letters Engagement letter: sets forth terms of engagement, including an agreement about fee, when a new audit client is accepted. • The agreement is used to reduce risk that either the auditor or the auditee misinterprets the needs/expectations of the other party • The letter should cover the following: o The objective o Scope/limitations o Responsibilities of both parties o Applicable financial reporting framework used o Explain the form of audit report o Indicates the form of report may change if circumstances require that o Lists special requests the auditor will be performing in accordance with GAAS o Auditor’s fees • An engagement letter can be used to show auditors didn’t perform the work promised CAS 210 10) The agreed terms of audit engagement shall be recorded in audit engagement letter and shall include: a) Objective/scope of audit of financial statements b) Responsibilities of auditor c) Responsibilities of management d) Identification of the applicable financial reporting framework for the preparation of financial statements e) Reference to the expected form and content of any report to be issued by the auditor and a statement that there may be circumstances in which report may differ from expected Staff Assignment and Time budges • For larger organization the team usually consists of: o Audit engagement partner o Audit manager o One or more senior audit staff members o Staff assistant o Public account students o Information system/industry experts (if needed) o Tax partner o Second audit partner • For smaller auditees, the team may consist of only one or 2 people. • For public companies, the second audit partner will review work of audit team to ensure firm quality standards are met • Time budget is created to plan for a timing of the work and the number of hours each segment of the audit is expected to take Interim Audit Works: Covers procedures performed several weeks/months before the balance sheet date • Can consist of both internal risk assessment, and auditing balances as they exist at an early date, or examination of documents/ electronic information only available for certain period during year Year-end Audit Work: audit procedures performed at and shortly after the balance sheet date Time is taken to perform procedures for each segment of the audit work is recorded by budget category so that: • There is a record for billing the auditee • The efficiency of audit team can be measured • There is record for planning the next audit Understanding the auditee’s business, environment, and risk The objective of financial statement audit is to render an opinion on whether the financial statements are presented fairly and in accordance with generally accepted standards Material misstatement: a misstatement significant enough to affect an important decision someone might make on the basis of that information Overall audit strategy: An audit planning document that sets the scope, timing and direction of the audit, and that guides the development of the audit plan, including the reporting objectives; the nature timing, and extent of resources necessary to perform the engagement; and the nature of the communication required Audit plan: Document containing all the detailed auditing programs with procedures to be performed in response to the assessed risk of material misstatement of an audit, guided by the decision made in the overall audit strategy Audit program: a list of audit procedures auditors need to perform to produce sufficient, competent evidence as the basis for good audit decisions To determine auditee’s business risk: 1) Auditor investigates management’s understanding of its business risks 2) They independently assess both the business risk and management’s risk assessment process to determine how likely material misstatements of financial statements is CAS 315 The auditor shall obtain understanding of the following: 1) Relevant industry/external factors 2) Nature of entity a. Operations b. Ownership/governance structures c. Types of investments it makes/plans to make d. The way the entity is structured and how it is financed e. Entity’s selection and application of accounting policies f. Entity’s objectives and strategies, and those related business risk that result in risk of material misstatement g. Measurement and review of entity’s financial performance Risk of material misstatement: Assessed on the financial statements, overall and based on pervasive factors, such as fraud, going concern, or other significant business-level risks; the auditor’s assessment of combined inherent and control risk. CAS 315 10. The engagement partner and other key engagement team members shall discuss the susceptibility of the entity’s financial statements to material misstatements, and the
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