Chapter 6 - Preliminary Auditing Planning: Understanding the Auditee
o Describe the activities PAs undertake before beginning a financial statement audit engagement.
o Explain why auditors need knowledge of the client’s business, its environment, and the client’s risks at
the start of a financial statement audit.
o Explain the purpose of preliminary analytical procedures and business risk analysis in the audit planning
o Apply preliminary analytical procedures to management’s draft financial statements in order to identify
areas where misstatements are most likely.
o Learning Objectives
o Explain the materiality concept, the materiality levels used for planning the audit and how these
amounts are determined.
o Describe the principal assertions in management’s financial statements and their application in
establishing audit objectives.
o Explain how the preliminary planning activities are integrated in the overall audit strategy.
o Pre-engagement Arrangements
o Preliminary Understanding of Auditee’s Business, Environment and Risks
o Preliminary Analytical Procedures for Audit Planning
o Applying Analytical Procedures to Management’s Draft Financial Statements
o Materiality Levels for Audit Planning
o Financial Statement Assertions and Audit Objectives
o Developing the Overall Audit Strategy
o Auditors undertake two types of activities before beginning an audit:
Auditors try to reduce the risk (probability of something going wrong) by carefully
managing the engagement.
Auditors manage audit in accordance with quality control standards.
Audit Engagement Acceptance and Continuance
o Client selection and retention:
An important element of an accounting firm’s quality control policies and procedures is a system
to accept a new client, and
whether to resign from audit engagements.
Accounting firms are not obligated to accept undesirable clients, nor retain existing audit clients.
Client Acceptance and Retention Policies
o Client acceptance and retention procedures should include:
Obtaining and reviewing financial information about prospective client.
Evaluation of independence.
Evaluation of competency and resources
Understand business risks and determine management’s willingness to accept responsibility for
financial statements Look for news reports, consult with auditee’s banker, legal counsel or others to assess integrity
Communicate with previous auditor.
o The auditor considers:
Whether the financial statements presented in accordance with GAAP.
Whether management understands its responsibility for preparing the financial statements, and
for designing and implementing adequate internal controls
Management’s commitment to providing written representations or other scope limitations
o Decisions to continue auditing an organization are similar to acceptance decisions.
The public accounting will have more first-hand experience with the auditee.
Annual retention reviews take into account changes for the auditee.
Communication Between Predecessor and Successor Auditors
o When companies change auditors, the former auditor is the predecessor auditor, and the new auditor is
the successor auditor.
o Rules of professional conduct require the successor auditor to contact the predecessor auditor.
Ask if there are issues that should be considered in accepting the client.
Obtain information from the predecessor auditor for planning the audit.
o Predecessor auditor is required by the rules of conduct to respond to the communication.
o Successor auditor should ask the client to consent to discussions with the predecessor auditor.
Consent is not required, the communication must take place.
Consent allows the predecessor auditor to relay more information.
Predecessor auditor still has a duty to maintain confidentiality.
Audit files belong to the auditor, not the client.
o Auditor should be wary of any client who refuses consent.
o When a new audit client is accepted an engagement letter must be obtained.
The engagement letter forms the contract for the audit.
Standards require the auditor and management to agree on the terms of the audit engagement.
o A new engagement letter should be obtained every year of a continuing audit.
o When the new client is obtained, accounting firms assign a full-service team to the new client.
One or more senior audit staff members
A tax partner, a consulting services partner and a second audit partner
o For a small firm or client, audit team may be just one or two people.
o The partner or manager propose a plan for the timing of the work based on previous experience and
knowledge of the business.
o The time budget allows the audit firm to spread its workload between interim and year-end periods.
o Interim – weeks or months before the statement date.
o Year-end – shortly before or after the statement date.
o Everyone on the audit reports the time taken to perform the audit procedures. o Time reports are recorded by the time budget categories to all for:
evaluation of the efficiency of audit team members,
billing the client, and
planning the next audit of the client.
Preliminary Understanding of Auditee’s Business, Environment and Risks
o Understanding the client’s business and operating environment is very important in an audit.
o It helps to assess the risk that financial statements might contain material misstatements.
o Used to establish and overall audit strategy, design the audit plan and audit programs.
Understanding the Client’s Business
o In order to design an effective audit, auditors must understand the business and the economic
environment of the business including factors such as:
national economic condition and policies,
developments in taxation and regulation, and
specific industry characteristics.
Analytical Procedures Requirements
o Although particular analytical procedures are not required by audit standards, the timing of these
procedures is specified:
at the beginning of the audit when planning is taking place, and
at the end of the audit when the partners in charge review the overall quality of the work and
form an opinion.
General Analytical Procedures
o Compare current-year account balances with one or more comparable periods.
o Compare current-year account balances and financial relationships with similar information for the
o Compare current-year account balances with the company’s anticipated results.
o Evaluate the relationships of current-year balances to other current-year balances for conformity to
o Study the relationships of current-year balances to relevant nonfinancial information.
Preliminary Analytical Procedures