5-1

The Phases of an Audit That Relate

to Audit Planning
Client acceptance
and continuance

Establish the terms

Chapter Five of the engagement

Audit Planning and Types of Audit Tests Preplanning

Assess risks and

establish materiality

Plan the audit

Prospective Client Acceptance Continuing Client Retention

1. Obtain and review financial information. Evaluate client

2. Inquire of third parties. retention periodically

3. Communicate with the predecessor

auditor.
Near audit completion
4. Consider unusual business or audit risks. or after a significant
5. Determine if the firm is independent. event

6. Determine if the firm has the necessary

skills and knowledge.
7. Determine if acceptance violates any Conflicts over
applicable regulatory or ethical accounting & auditing Dispute over fees
requirements. issues
 5-2

Establish Terms of the Engagement The Engagement Letter

The engagement letter formalizes the arrangement reached
The terms of the engagement, which are documented in
between the auditor and the client.
the engagement letter, should include the objectives of
the engagement, managements responsibilities, the In addition to the items mentioned in the
auditors responsibilities, and the limitations of the sample engagement letter in Exhibit 5-1 in
engagement. the textbook, the engagement letter may
include:
In establishing the terms of the Arrangements for use of experts or
engagement, three topics
must be discussed:
internal auditors.
1. The engagement letter Any limitations of liability of the auditor
2. The internal auditors or client.
3. Those charged with
governance.
Additional services to be provided.
Arrangements regarding other services.

Internal Auditors

Internal
Auditors
 5-3

Those Charged with Governance Preplanning

Board of
Determine the Audit
Directors Engagement Team
Requirements

Assess
Audit Committee
Independence

Assess Risks and Establish

Planning the Audit
Materiality
When planning the audit, the auditor should be guided by the
Use audit results of the risk assessment procedures performed to gain
risk model an understanding of the entity.

Additional steps:
Assess a preliminary level of control risk
by account and assertion.

Restrict risk at
Achieve Consider the possibility of non-compliance Lets look at each
acceptable (illegal) acts. of these steps.
account
level of audit Identify related parties.
balance level
risk Conduct preliminary analytical
procedures.
You may want to review the detailed discussion in Develop an overall audit strategy and
Chapter 3 of the process used to assess the clients prepare an audit plan.
business risks and to establish materiality. Consider additional value-added services.
 5-4

Assess a Preliminary Level for Control Assess the Possibility of Non-compliance

Risk by Account and Assertion (Illegal) Acts

Control risk is the risk that material misstatements will not be Non-
prevented or detected by internal controls. compliance
Acts
A preliminary
assessment of Materially Not materially
control risk is affecting the affecting the
necessary for the financial financial
auditor to plan the statements statement
The presence of complex
nature, timing, information technology may Be aware may have
and extent of require the use of an IT
Obtain evidence of
compliance
occurred;
investigate if
testing. specialist. brought to attention

Assess the Possibility of Non-compliance

Identify Related Parties
Acts
Some examples from IAS 24
Related Party Disclosure
Parents and subsidiaries.
Significant influence.
Joint control.
Associate entity.
Joint venture.
Management.
Close family of the
principal owners & management.
Other parties that can have
significant influence.
How to Identify Related Parties in
Addition to Request Management
Review contracts and
agreements.
Review bank and legal
confirmations.
Review transactions with major
customers, suppliers, borrowers,
and lenders.
Review large, unusual, or
non-recurring transactions
especially at year end.
Review minutes of meetings of
boards and management.
 5-5

Conduct Preliminary Analytical

Develop an Overall Audit Strategy
Procedures
To identify
To understand the
financial statement
Complete other planning
clients business
and transactions
accounts likely to Scope steps.
contain errors
Compile knowledge about the
clients business objectives
Timing and strategies, business risks,
audit risks, and controls.
By understanding the clients business and Document effects of identified
identifying where errors are likely to occur, the Direction risks and controls on planned
auditor can allocate more resources to investigate audit procedures.
necessary accounts.

Consider Additional Value-Added

Prepare Audit Plan
Services

The audit plan addresses in

Nature more detail the matters
Tax Planning
IT Internal
identified in the audit strategy. Consultancy Reporting

Timing An audit plan contains the

nature, timing and extent of Risk Benchmarkin Electronic
Assessment g Commerce
specific audit procedures.
Extent
 5-6

Types of Audit Tests Tests of Controls

Used to obtain an understanding of

Risk Assessment
the entity and its environment,
Procedures including internal controls. Inquiry Inspection
Performed to obtain audit evidence
about the operating effectiveness of
Tests of Controls controls in preventing, detecting and
Observation
correcting material misstatements.

Detect material misstatements in a Walk

Substantive Reperformance
transaction class, account balance,
and disclosure component of the
Through
Procedures
financial statements.

Tests of Controls Substantive Procedures

Tests of Analytical
Details Procedures

Obtains evidence
Tests for errors about particular
or fraud in assertions related to
individual account balances or
transactions classes of
transactions
 5-7

Dual Purpose Tests Purposes of Analytical Procedures

Preliminary Used as risk assessment procedure to
assist the auditor to better understand the
Tests of Substantive Analytical business and to plan the nature, timing,

Controls Tests Procedures and extent of audit procedures.

Substantive Used to obtain evidence about particular

Analytical assertions related to account balances or
classes of transactions.
Dual Procedures
Purpose
Test Final Used as an overall review of the financial
Analytical information in the final review stage of the
audit.
Procedures

Substantive Analytical Procedures

Purposes of Analytical Procedures
Decision Process

Trend Analysis

Ratio
Analysis

Reasonableness
Analysis
 5-8

The Investigation of Differences for

Define a Tolerable Difference Planning and Final Analytical Procedures
The size of the tolerable difference depends on: Preliminary Final
The significance of the account. Analytical Analytical
Procedures Procedures
The desired degree of reliance on the substantive Differences Differences
analytical procedures.
The level of disaggregation in the amount being tested.
The precision of the expectation. Corroboratin Corroboratin
g evidence g evidence is
not required required

Filling the Assurance Bucket

Audit
Testing
Hierarchy
 5-9

Accounts Payable Example of Filling the

Assurance Buckets for Each Assertion
Short-Term Liquidity Ratios

Current
Ratio

Quick Ratio

Operating
Cash Flow
Ratio

Activity Ratios Profitability Ratios

Days
Receivables Outstanding Gross Profit
Profit Margin
Turnover in Accounts Percentage
Receivable

Days of
Inventory Return on Return on
Inventory on
Turnover Assets Equity
Hand
 5-10

Coverage Ratios

Debt to
Equity

Times
Interest
Earned