Accounting 403:
Chapter 3:
Section 1: Pre-Engagement Activities
Professional Standards state that the auditor should perform the following activities:
1. Perform procedures regarding the acceptance or continuance of the audit client
relationship
2. Determine compliance with independence and ethics requirements
3. Reach a contractual understanding with the client for the terms and conditions of the
audit engagement
Client Acceptance or Continuance
The public accounting firm that has been terminated or has voluntarily withdrawn from
the engagement is known as the Predecessor Auditor
Form 8-K, is required whenever certain significant events such as changes in control and
legal proceedings occur
In addition to communication with the predecessor auditor, client acceptance and
continuance policies and procedures generally include:
Obtaining and reviewing financial information about the prospective client:
annual reports, interim statements, registration statements, Form 10-Ks, and
reports to regulatory agencies
Acquiring detailed criminal background checks of all senior managers
Requesting the prospective client's bankers, legal counsel, underwriters,
analysts, or other persons who do business with the entity to provide
information about it and its management
Considering whether the engagement would require special attention or involve
unusual risks to the public accounting firm
Evaluating the public accounting firm's independence with regard to the
prospective client
Considering the need for individuals possessing special skills or knowledge to
complete the audit
Compliance with Independence and Ethical Requirements
The "state of mind" is often referred to as the auditor possessing Independence in Fact
Independence in Appearance relates to others' perceptions of auditors' independence
Engagement Letters
When a new client is accepted or when an audit engagement continues from year to
year, an Engagement Letter should be prepared
This letter sets forth the understanding with the client, including in particular:
1. The objectives of the engagement
2. Management's responsibilities
3. The auditors' responsibilities
4. Any limitations of the engagement
Many public accounting firms also have policies about sending a Termination Letter to
former clients
Such a letter is a good idea because it provides an opportunity to deal with the
subject of future services, in particular:
1. Access to audit documentation by successor auditors
2. Reissuance of the auditors' report when required for SEC reporting or
comparative financial reporting
3. Fee arrangements for such future services
Section 2: Audit Plan
An Audit Plan is a comprehensive list of the specific audit procedures that the audit team needs
to perform to gather sufficient appropriate evidence on which to base their opinion on the
financial statements
When understanding the accounting information system, the auditor should pay particular
attention to:
The complexity of the computer operations used by the entity
The organizational structure of the computerized processing activities
The availability of data for the auditor
The need for specialized skills
There are three goals of audit planning:
To make sure that the firm has the requisite staff to conduct the audit in accordance
with professional standards in a timely and profitable manner
To determine materiality
To outline the specific audit procedures, including tests of control and substantive tests
that need to be executed properly in order to mitigate assessed risks of material
misstatement and be in compliance with professional standards
Staffing the Audit Engagement
Audit Engagement Partner is the person with final responsibility for the audit, usually an
industry specialist
Quality Assurance Partner is the second audit partner who reviews the audit team's
work in critical audit areas
Considering the Work of Internal Auditors
External auditors should consider internal auditor's objectivity and competence:
Objectivity
Internal auditors can never be considered independent in the same
sense that external auditors are because internal auditors are either
directly employed or paid as contractors by the client
Competence
Internal auditors' competence is investigated by obtaining evidence
about their educational and experience qualifications, their
certifications, and continuing education status, the department's
policies and procedures for work quality and for making personnel
assignments
prevision and review activities, and the quality of reports and audit
documentation
Using the Work of an Auditor-Employed or Audit-Engaged Specialist
Audit Specialist are persons skilled in fields other than accounting and auditing
Time Budget
Time Budgets are used to maintain control of the audit by identifying problem areas
early in the engagement, thereby ensuring that the engagement is complicated on a
timely basis
Year-End Audit Work refers to procedures performed shortly before and after the date
of financial statements
These time reports are recorded by budget categories for the purpose of:
Evaluating the efficiency of the audit team members
Compiling a record for billing the client
Compiling a record for planning the next audit
Section 3: Materiality
Given the range permitted, some amount of inaccuracy is allowed in financial statements
This is because:
1. Unimportant inaccuracies do not affect users' decisions and hence are not
material
2. The cost of finding and correcting small misstatements is too high
3. The time taken to find them would delay issuance of the financial statements
As a result, to plan the nature, timing, and extent of further audit procedures to be performed,
an auditor "should establish a Materiality level for the financial statements as a whole that is
appropriate in light of the particular circumstances
Therefore, auditors use Performance Materiality to make sure that the aggregate of uncorrected
and undetected immaterial misstatements does not exceed materiality for the financial
statements as a whole
Materiality Calculation
Some examples of commonly used benchmarks per industry are noted below:
Asset based entities - total net assets
Profit based companies, such as manufacturing - PBT
High technology start-up companies - total revenue
Nonprofit entities - gross revenue or total contributions
Nature of the Item or Issue
Engagement Circumstances
Possible Cumulative Effects
To summarize, on an audit engagement, the audit team uses materiality three ways:
As a guide to planning substantive testing procedures
As a guide for determining performance materiality
Asa guide for making decisions about the audit report
Section 4: Audit Procedures for Obtaining Audit Evidence
Internal Control Audit Plan would contain the specific procedures needed to obtain an
understanding of the client's internal control system and test that understanding for those
controls that relate to the relevant financial statement assertions
A Substantive Audit Plan would contain a list of audit procedures for gathering evidence related
to the relevant assertions identified for an audit client's significant financial statement accounts
and disclosures
There are two ways to conduct substantive tests:
1. Substantive analytical procedures
2. Tests of details
1. Inspection of Records and Documents
Documents Prepared by Independent Outside Parties
Documents Prepared and Processed by the Client
Vouching-Examination of Documents
In Vouching, an auditor selects an item in the financial records, usually from a
journal or ledger, and follows its path back through the processing steps to its
origin
Tracing-Examination of Documents
When taking the Tracing direction, the auditor selects a basic source document
and follows its processing path forward to find its final recording in a summary
journal or ledger and ultimately the financial statements
Scanning-Examination of Documents
2. Inspection of Tangible Assets
3. Observation
4. Inquiry
5. Confirmation
A selection of confirmation applications includes the following:
Banks - cash and loan balances
Customers - receivables balances
Borrowers - note terms and balances
Agents - inventory on consignment
Lenders - note terms and balances
Policyholders - life insurance contracts
Vendors - accounts payable balances
Registrar - number of shares of stock outstanding
Attorneys - litigation in progress
Trustees - securities held, terms of agreements
Lessors - lease terms
6. Recalculation
7. Reperformance
8. Analytical Procedures
When an auditor compares the exception to record balance, Analytical Procedures are
being performed
Section 5: Audit Documentation
Audit Documentation - The written record of the basis for the auditor's conclusions that provides
the support for the auditor's representations, whether those representations are contained in
the auditor's report or otherwise
Audit documentation can be classified in two categories:
1. Permanent files
2. Current files
Permanent Files
The Continuing Audit Files (or Permanent Files) contain information of continuing audit
significance over many years' audits of the same client
Documentation of permanent interest and applicability include:
1. Copies or excerpts of the corporate or association charter, bylaws, or
partnership agreement
2. Copies or excerpts of continuing contracts such as leases, bond indentures and
royalty agreements
3. A history of the company, its products, markets and background
4. Copies or excerpts of minutes of meetings of stockholders and/or directors on
matters of lasting interest
5. Continuing schedules of accounts with balances that are carried forward for
several years, such as owners' equity, retained earnings, partnership capital
6. Copies of prior-years' financial statements and audit reports
7. Client organization chart
Current Files
Many public accounting firms follow the practice of summarizing these data in a
Planning Memorandum with specific directions about the impact on the audit
In other words, documentation must be sufficient, to understand:
1. The nature, timing, extent, and results of procedures
2. The overall conclusions reached with respect to the area covered by the audit
documentation
3. The audit team member performing the work, the date of work, the audit team
member reviewing the work, and the date of review
Professional audit standards require the audit documentation show that:
1. The client's accounting records agree or reconcile with the financial statements
2. The work was adequately planned and supervised
3. A sufficient understanding of the client's internal control was obtained
4. Sufficient appropriate audit evidence was obtained as a reasonable basis for an
audit opinion
Audit Documentation Arrangement and Indexing
A Lead Schedule is a summary of the accounts or components in an account group
Indexing
Cross-Referencing
Heading
Signatures and Initials
Dates of Audit Work
Audit Marks and Explanations
