Assessing auditability

Has the adequacy of the accounting records been assessed for proper:

32. Descriptions of transactions to permit the appropriate financial statement classification?

33. Information about transactions to permit the recording of appropriate monetary amounts?

34. Recording of transactions in the appropriate accounting period?

Have the following factors regarding the integrity of management been considered in planning the audit:

35. Responses to previous inquiries of local attorneys, bankers, and other business leaders regarding PM's standing in the community?

36. PM's credit rating?

37. Have inquiries of a sample of PM's customers regarding PM's credit-granting policies been made?

V. Assessing risk

38. Has detection risk been appropriately restricted to determine how much inherent risk can be accepted?

39. Has consideration been given to permitting PM's internal auditors to make the assessment of inherent risk and evaluations of significant accounting estimates?

If control risk is assessed at below the maximum level

40. Is the audit fee high enough to handle any likely litigation?

41. Have specific internal control activities that are likely to prevent or detect material misstatements in those assertions been identified?

If control risk is assessed at the maximum level for some or all assertions 42. Is the scope of substantive testing appropriately decreased?

43. Have tests of controls to evaluate the design and operation of such activities been performed?

VI. Illegal acts

Have the following matters been considered in assessing the risk that PM has not complied with laws and regulations that have a direct and material effect on the financial statements:

44. PM's policy relative to the prevention of illegal acts?

45. PM's understanding of the requirements of law and regulations pertinent to its business?

46. Obtaining management's written assurance that no employees have committed any illegal acts of any type?

VII. Analytical procedures

In planning the audit, have analytical procedures been used that focus on:

47. Enhancing an understanding of PM's business and the transactions and events of the year under audit?

48. Identifying areas that may represent specific risks relevant to the audit?

49. Evaluating the overall financial statement presentation?

VIII. Audit strategies and the audit program

50. Has the program been developed for the engagement and approved by the engagement partner?

The following are inappropriate points:

6. The client should not be asked to approve the sampling method.

10. Although discussions with management, the board of directors, and the audit committee will be held on fraud, the details at the assertion level for each account will not ordinarily be discussed. The professional standards do require that members of the audit team discuss the potential for material misstatement due to fraud either during planning or in conjunction with the information-gathering procedures related to fraud subsequent to planning.

12. The controller and audit committee should not approve the time budget.

18. There is ordinarily no reason to restrict an engagement to CPAs.

19. A review of the predecessor auditor's working papers might be appropriate—not the successor (Larkin CPA).

24. SAS do not provide guidance on PM's operations.

31. Engagement personnel should have no investments in PM stock.

37. Customers are not ordinarily consulted concerning credit-granting policies.

38. Inherent and control risk are more conventionally assessed so as to determine the appropriate level of detection risk.

39. Internal auditors do not make judgment about the assessment of inherent risk and evaluation of estimates.

40. Such a litigation concern is not appropriate in this document.

42. One does not expect a decrease in the scope of substantive testing when control risk is assessed at the maximum level.

43. Tests of controls are not ordinarily performed when a plan exists to assess control risk at the maximum level.

46. Management need not attempt to determine whether employees have committed illegal acts of any type.

49. Evaluating overall financial statement presentation is not ordinarily an objective of analytical procedures.

Learning Objective: 06-03 Explain the auditors' responsibilities when planning an audit.

Source: AICPA

Topic: Planning the Audit

75. Engagement letters are used by most auditors in performing professional services.

a. Describe the purpose of an engagement letter.

b. List four items that are normally included in an engagement letter.

a. The purpose of an engagement letter is to establish a written contract between the auditors and the client. Thus, the letter tends to prevent misunderstandings between those two parties.

b. Items that are normally included in an engagement letter include (only four required):

 Name of the entity and statements to be examined.

 Scope of services.

 Description of responsibility for detecting fraud.

 Obligations of the client's staff to prepare schedules.

 Fee or method of determining fee.

 Provision for client's acceptance signature.

 Management's obligation to conclude about the materiality of misstatements not recorded.

AACSB: Analytic AICPA BB: Industry AICPA FN: Measurement Bloom's: Understand Difficulty: Medium

Learning Objective: 06-03 Explain the auditors' responsibilities when planning an audit.

Topic: Planning the Audit

76. As a part of the planning process, the auditors often prepare an audit plan, an audit program, and a time budget.

a. Describe an audit plan and explain its purpose.

b. Describe an audit program and explain its purpose.

c. Describe a time budget and explain its purpose.

a. The audit plan is an overview of the engagement, outlining the nature and characteristics of the client and its environment and the overall audit strategy. The audit plan documents the major considerations in planning the engagement.

b. The audit program is a detailed listing of audit procedures to be performed in the engagement. It is a tool for scheduling and controlling the work.

c. The time budget includes an estimate of the time required for each audit task. It serves as a basis for the fee estimate, controls the audit work, and may be used to evaluate performance by the audit staff.

AACSB: Analytic AICPA BB: Industry AICPA FN: Measurement Bloom's: Understand Difficulty: Medium

Learning Objective: 06-03 Explain the auditors' responsibilities when planning an audit.

Topic: Planning the Audit

77. Auditors perform various tasks in planning an audit engagement. Provide an overall description of how each task is performed and its purpose.

a. Obtain an understanding of the client's business.

b. Assess audit risk and materiality for the engagement.

c. Assess fraud risk.

d. Assess the risk of material misstatement of assertions about financial statement accounts and classes of transactions.

a. The auditors obtain an understanding of the client's business through procedures such as inquiry of client personnel, observing client operations, studying AICPA Audit and

Accounting Guides and Industry Risk Alerts and other industry publications, and reviewing prior annual reports, SEC filings, tax returns, and interim financial statements. An

understanding of the client's business is necessary to the evaluation of the appropriateness of the client's transactions, accounting principles used, and the estimates and assumptions embodied in the financial statements. In addition, it provides part of the information to assess the risks of material misstatement.

b. Materiality for planning purposes is the auditors' preliminary estimate of the smallest amount of misstatement that would affect the decisions of reasonable users of the financial statements. The auditors use judgment to determine the amount of planning materiality, usually based on some rule of thumb. Audit risk is the possibility that the auditors will fail to modify the opinion on financial statements that are materially misstated. The auditors assess this risk by considering characteristics of management, operations, and the engagement.

Audit risk and materiality determine the overall scope of the engagement. The lower the amount of planning materiality, the more extensive the scope of the audit. The higher the risk of misstatement of the financial statements, the more extensive the scope of the audit.

c. The auditors are required to assess fraud risk on every audit. This assessment is based on information derived from (1) the discussion among the audit staff about the risk of fraud, (2) inquiries of management, the audit committee, internal auditors and others, (3) the results of risk assessment analytical procedures, and consideration of fraud risk factors. If the auditors identify fraud risks they may respond with (1) an overall response to the way the audit is conducted, or (2) a response specifically to address the identified risk. In all audits they must include responses to further address the risk of management override of internal control.

d. The auditors assess the risk of material misstatement (composed of inherent risk and control risk) for each significant assertion about financial statement accounts and classes of assertions by considering the information about the client and its environment including internal control, and the nature of the account. These risk assessments are used to determine the nature, timing, and extent of the substantive procedures that will reduce the detection risk to the appropriate level.

AACSB: Analytic AICPA BB: Industry AICPA FN: Measurement AICPA FN: Risk Analysis Bloom's: Apply Difficulty: Hard

Learning Objective: 06-04 Describe the nature of the risk assessment procedures that auditors use to obtain an understanding of the client and its environment.

Learning Objective: 06-05 Describe the manner in which an audit is affected by the auditors' assessment of audit risk and materiality.

Learning Objective: 06-06 Describe how the auditors address fraud risk.

Learning Objective: 06-07 Discuss how the auditors design further audit procedures in response to the assessed risks of material misstatement.

Topic: Assessing Risks and Designing Audit Procedures Topic: Understanding Client and Environment

78. Many auditors take an approach to assessing the risk of material misstatement by beginning with an assessment of business risks.

a. Define business risks.

b. Why have auditors found it effective to take the approach of assessing business risks?

c. Identify a business risk and explain how it might affect the auditor's audit procedures.

a. Business risks are those that threaten management's ability to achieve the organization's objectives.

b. Auditors have found this approach effective because significant business risks often create related risks of material misstatement (inherent risks) that the auditors should address in designing their audit procedures.

c. Students may provide a number of examples. The textbook provides the following:

Assume that the auditors have identified as a significant business risk and audit risk that sales personnel, informally or through written side agreements, may be modifying the terms of contracts with customers which may affect the amount of revenue that should be recognized.

The auditors must design tests that are focused on determining whether such modifications of terms have been made, perhaps by obtaining tailored confirmations from customers about the existence of such side agreements.

AACSB: Analytic AICPA BB: Industry AICPA FN: Measurement Bloom's: Understand Difficulty: Medium

Learning Objective: 06-01 Describe the major steps in the audit process.

Topic: Audit Process