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chapter 8

audit planning

analytical procedures

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Test no 2

• Internal Controls are effective / ineffective• Extensive substantive tests• Limited substantive tests• Tests of Controls v. Substantive Tests• If DR – Low extensive Substantive Tests• If CR – high we don’t Test Controls• Definition of Audit Risk

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• Indirect – my brother• Nondependent• Does it impair independence Yes or No• You memorized scenarios

– Answer the question that was asked

• Material is not 5%• What am I trying to say when

– A mother lives in her son’s house– Steve is a partner in the engagement office

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#1 2.90 variance of POP B > POP A

#3 3.03 sample variance less than planning

#5 2.24 compare ;X to Critical Value

#7 close relative

#8 3.15 101-1 part A

#13 3.47 primary beneficiary

#14 2.03 foreseen party

#20 2.97 SEC Act issuer in an IPO

#24 3.00 PDR low => extensive subst tests

#25 2.56 V&T project

#27 1.97 Acc Rec project

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Enron

Related Party Transactions

No one could explain how Enron actually made money

Incredibly complicated business structure

“What we are looking at here is an example of superbly complex financial reports. They didn’t have to lie. All they had to do was to obfuscate it with sheer complexity,”

John Dingell, U.S. Congressman Michigan

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Obtain engagement

Analytical procedures

Understand the client

Internal controls AU-c 315

Assess RoMM

Tests of controls if RoMM < 1.00

Substantive tests of transactions AU-c 500

Substantive Analytical procedures

Substantive tests of details of balances

Reporting AU-c 700

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RoMMAAR = IR CR PDR

transactions balances

analytical procedures (planning)

substantive tests of transactions

substantive analytical procedures

tests of details of balances

tests of controls

environmental client auditor

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Jonathan

What is the definition of audit risk?

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AU-C Section 200

The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated.

Audit risk is a function of the Risk of Material Misstatement and Detection Risk

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Yu

What is the definition of control risk?

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The risk that a misstatement that could occur in an assertion about a class of transaction, account balance, or disclosure and that could be material, either individually or

when aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely basis by the entity’s internal control.

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Stages of the Audit Accepting the engagement

client acceptance

1) integrity of management

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Client Acceptance page 79-80

• Why the client needs an audit• New client investigation• Competency, industry knowledge• Communicate with predecessor auditor• Risks

– Intended users of the financial statements

• Independence• Engagement Letter

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AICPA

February 1997

84Statementon AuditingStandards

Communications between Predecessor and Successor Auditors

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Lauren

what issues need to be discussed with the predecessor auditor ?

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• Integrity of senior management• Disputes with the client over accounting principles• Disputes with the client over audit procedures• Disputes with the client over fees

page 80

Communications with Predecessor Auditor

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Giselle

who is responsible for initiating the communication between the successor auditor and the predecessor auditor ?

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AICPA Code of Professional Conduct

Rule 301 – Confidential Client Information

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Michael

Do we care about the nature of the client’s business?

Do we care about the reasons they are having their financial statements audited?

Do we care who is going to rely on the audited financial statements?

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RISK RISK RISK

identify the users of the financial statements

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Elizabeth W

How does the AICPA’s Code of Professional Conduct define the Ethical Principle “Objectivity and Independence?”

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Objectivity and Independence

A member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. A member in public practice should be independent in fact and appearance when providing auditing and other attest services.

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Jennifer

Does this effect our decision whether to accept the engagement ?

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Eric

When an accounting firm considers a new client, “who” needs to be independent?

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independence

memo to partners and staff

Partners in the engagement office

Everyone in the engagement office

Everyone in the firm

Consulting and tax employees or just auditors

must consider spouses & dependents

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Ellen

How might the financial investments of non-dependent, close relatives affect the firm’s decision whether to accept a new client ?

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Brenda

If a non-dependent, close relative is employed by a potential client, what issues does the audit firm need to consider in their decision whether to accept the client?

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Anyone on the engagement team

Anyone in position to influence the engagement

All partners in the engage partner’s office

Close relatives (including immediate family): parent, sibling or nondependent child, spouse, dependents

Holding a key position with the client

Holding a financial interest in the client that is material to the relative (covered member must know)

Holding a financial interest that enables the relative to exercise significant influence over the client

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Key positions

– positions that allow significant influence over the client’s, accounting, financial or operating policies

– positions subject to significant internal accounting controls

– positions that are an element of significant internal accounting controls

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Phases of the Audit Accepting the engagement

Engagement Letter page 82

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Understand the Client’s Business

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Ryan M

what is the objective of AU-c 315?

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AU-C Section 315

The objective of the auditor is to identify and assess the risk of material misstatement, whether due to fraud or error, at the financial statement and relevant assertion levels through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risk of material misstatement.

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Many litigation cases result from the auditor’s failure to fully understand the nature of transactions in the client’s industry.

ZZZZ Best

ESM

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RISK of Material Misstatement

Declines in economic conditions

Information technology

Expansion

Accounting COMPLEXITY of JUDGMENTS

Accounting COMPLEXITY of ESTIMATES

COMPLEX financial instruments

Page 134/135

Related Party transactions

Complex transactions

Nonroutine transactions

JudgmentChapter 9

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Steffan

how does the Auditor’s Responsibility Paragraph in the independent auditor’s report describe the auditor’s responsibility to detect material misstatements?

Does the auditor’s responsibility differ for misstatements that are the result of an error or a fraud?

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Auditor’s Responsibility Paragraphstandard unmodified opinion

Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with

auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.

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Suiting

what is the overall objective of the indepent auditor?

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Overall ObjectiveAU-C 200

…obtain reasonable assurance about whether the financial statements as a whole are free of material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are presented fairly, in accordance with an applicable financial reporting framework.

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Related Parties --- RISK p. 86

.. an affiliated company, principal owner of the client company, or any other party with which the client deals, where one of the parties can influence the management or operating policies of the other.

investors are concerned that the terms of the transaction may not reflect “arms length” bargaining. There is risk that the transaction may not be valued at the same amount as a transaction with a non-related party.

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Related Parties --- RISK p 77 Enron

Enron - Andy Fastow

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Related Parties --- RISK

Essentially a related party is one that can exert significant influence over another party.

Related parties are frequently involved in fraudulent transactions because they can conceal problems that the auditor would likely detect if the transactions occurred between unrelated parties.

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RELATED PARTIES SECTION R36 Sources: ARB 43, Chapter 1A; FASB Statement 57; FASB Statement 109

Summary

Financial statements shall include disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. The nature of certain common control relationships shall be disclosed if the nature of those relationships could significantly affect the reporting enterprise. The reporting of certain related party transactions is specified in other sections.

-------------------- Introduction

.101 Examples of transactions between related parties include transactions between (a) a parent company and its subsidiaries; (b) subsidiaries of a common parent; (c) an enterprise and trusts for the benefit of employees , such as pension and profit-sharing trusts that are managed by or under the trusteeship of the enterprise's management; (d)

an enterprise and its principal owners, management, or members of their immediate families; and (e)affiliates. Transactions between related parties commonly occur in the normal course of business. Some examples of common types of transactions with related parties are: sales, purchases, and transfers of realty and personal property; services received or furnished, for example, accounting, management, engineering, and legal services; use of property and equipment by lease or otherwise; borrowings and lendings; guarantees; maintenance of bank balances as compensating balances for the benefit of another; intercompany billings based on allocations of common costs; and filings of consolidated tax returns. Transactions between related parties are considered to be related party transactions even though they may not be given accounting recognition. For example, an enterprise may receive services from a related party without charge and not record receipt of the services. [FAS57, 1] Disclosures

.102 Financial statements shall include disclosures of material related party

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AU Section 334

Related Parties (Supersedes Statement on Auditing Standards No. 6, AICPA, Professional Standards, vol. 1, AU sec. 335.01ÄÄ.19)

Source: SAS No. 45. See section 9334 for interpretations of this section. Effective for periods ended after September 30, 1983, unless otherwise indicated. .01 This section provides guidance on procedures that should be considered by the auditor when he is performing an audit of financial statements in accordance with

generally accepted auditing standards to identify related party relationships and transactions and to satisfy himself concerning the required financial statement accounting and disclosure. The procedures set forth in this section should not be considered all-inclusive. Also, not all of them may be required in every audit.

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Catherine

what is Client Business Risk?

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Box at the Bottom of PAGE 89

increased emphasis on

how the client manages risk

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Analytical Procedures

Pages 93-102

Look at Figure 6 on page 94

Go to links on web page

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Analytical Procedures

Reasonableness tests

evaluations of financial information by a study of plausible relationships among financial and nonfinancial data …

….involving comparisons of recorded amounts … to expectations developed by the auditor.

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Dev

at which stages of the audit are Analytical Procedures required ?

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Analytical Procedures

planning phase

• testing phase (as substantive tests)completion phase (as an overall

review)

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Nicho

why do we perform analytical procedures during the planning stage ?

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Analytical Procedures

During the Planning Phase

Understand the client’s business & industry

Assess going concern

Indicate possible misstatements (attention directing)

Reduce detailed tests

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Analytical Procedures in the planning phase

• understand the client’s industry and business

• to identify potential misstatements

• attention directing

• design audit procedures that reduce the risk we might fail to detect a material misstatement

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Steps in performing Analytical Procedures

Develop expectationsDefine significant difference (what is reasonable)

Compare our predictions with recorded amount

Investigate Significant differences

DOCUMENT the above steps

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