Phases of audit planning

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Auditing I Week 7

• Phases of audit planning
• Desired level of assurance
• Impact of materiality
• Impact of audit risk on planning
• Engagement Letter
• Analytical procedures

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Phases of audit planning

• If any task is to be completed effectively and
  efficiently it must be planned.
• ISA 300
• The auditor should plan the audit so that the
  engagement will be performed in and effective
  manner.
• Benefits
• Attention is devoted to important areas.
• Potential problems are identified and resolved.
• Work is performed in an efficient, effective and
  timely manner.
• Assists in proper assignment of work to
  assistants.
• Coordinates the work of other auditors and
  experts.

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Audit Planning

• Planning has two stages
• Audit strategy development OVERALL AUDIT PLAN
• Audit programme design.

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Audit strategy development

• Scope and conduct of the audit.
• How much evidence.
• What evidence.
• How should this be done.
• And when should it be done.
• Audit strategy
• Desired level of audit risk.
• Materiality levels.
• Assessment of inherent and internal control risk.

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Considerations in developing and audit strategy

• ISA 300
• Knowledge of the business.
• Understanding of the accounting and internal
  control systems.
• Risk and materiality.
• Nature timing and extent of the procedures.
• Coordination, direction, supervision and review.
• Other matters.

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Considerations in developing and audit strategy

• Audit strategy depends on
• General economic factors and industry conditions.
• Level of assurance (level of confidence in
  opinion).
• Materiality.
• Likelihood of material errors being present.
• Appropriate segments into which audit can be
  divided to facilitate conduct of the work.
• Availability and sources of evidence.
• Likely impact of IT.
• Availability of suitable staff and if applicable
  other experts.

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Audit programme design

• The operational aspect.
• Sets out detailed procedures to be performed
• For each auditable area.
• Whether interim/final work.
• Type of test.
• Size of sample.
• Instructions for audit staff to follow.
• Allows for working papers to be prepared and
  cross referenced to other evidence.
• Allows staff to sign off the work.
• Assists with review of work.

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Desired level of assurance

• Auditors are required under CA 1985 to state an
  opinion.
• Therefore they need to give reasonable assurance
  that the financial statements are true and fair.
• And as such they want to be reasonably confident
  that the financial statements are not materially
  misstated and their opinion is correct.

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Desired level of assurance

• ISA 200 Objective and General Principles
• Poor attempt to define reasonable assurance. A
  better definition is
• The desired level of assurance is the
  subjectively determined level of confidence that
  the auditor wants to have about the fair
  presentation of the financial statements after
  the audit is completed. The higher the level of
  assurance attained, the more confident the
  auditor is that the financial statements contain
  no material misstatements
• Arens and Loebbecke (1980)
• (see page 208 of PSH)

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Levels of assurance

• Level of assurance is the complement of the
  desired level of risk.
• E.g. 95 confident prepared to accept 5 risk.
• High levels of assurance
• Where large numbers of users are likely to rely
  on the accounts (Note Caparo case limited this
  exposure).
• Or when a takeover is contemplated.
• Or there is a going concern issue.

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Impact of materiality

• Objective
• The auditor establishes an acceptable materiality
  level judgement is required.
• The amount (quantity) and the nature (quality) of
  misstatements needs to be considered.
• Need to consider overall materiality and account
  level materiality (tolerable error).
• Materiality must not be viewed as a fixed
  monetary amount.
• Needs to be re-evaluated throughout the audit.

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Impact of materiality

• The auditor needs to consider
• Possibility of small amounts that accumulate into
  a large amount.
• Also consider the classes of transactions,
  account balances and disclosures.
• E.g. for disclosure of directors emoluments and
  related party transactions - materiality is
  irrelevant.

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Factors to be considered when accepting a
tolerable error rate.

• Significance of the account balance e.g. cash.
• The size of the account balance.
• The auditability of the account.
• Relative significance of over/under statement of
  the account balance e.g. overstated debtors and
  understated liabilities.
• The smaller the tolerable error the more
  evidence/testing is required.

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Impact of audit risk on planning

• The risk that the auditor gives an inappropriate
  opinion when the financial statements are
  materially misstated.
• Some degree of audit risk is unavoidable.
• ISA 400 Risk assessments and internal control.
• Components
• Inherent risk (IR)
• Control risk (CR)
• Detection risk (DR)

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Impact of audit risk on planning

• Audit firms focus is on an efficient,
  cost-effective audit and therefore they adopt a
  risk-based approach.
• Risk like materiality is ascertained at the
  overall level and the FSA level.
• Objective of risk-based auditing is
• To achieve maximum effectiveness and efficiency.
• To avoid under/over auditing.

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Relationships of Risk

• Inherent and Control Risk
• Risk of material error being present in the
  Unaudited financial statements
• Plus the risk of failing to detect material error
  
• Audit Risk (IRCR)DR
• Inherent and control risk are beyond the direct
  control of the auditor, therefore detection risk
  should be adjusted to achieve the desired level
  of audit risk.

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Relationships of Risk

• The audit risk model assigns probability and is
  therefore
• AR IR x CR x DR
• However this model is not without its critics
• Each event has to be independent of each other.

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Audit Risk,Materiality Planning

• There is an inverse relationship between
  materiality and the level of audit risk.
• The higher the materiality level the lower the
  level of audit risk.
• The lower the materiality level the higher the
  level of audit risk.

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Audit Risk, Materiality Planning

• Audits must be planned to ensure that
• Inherent risk is properly assessed.
• Internal control risk is properly evaluated.
• Sufficient appropriate substantive procedures are
  performed so that detection risk and therefore
  audit risk is reduced to an acceptable level.
• Hence in order to reduce the audit risk to an
  acceptable level, the auditor must carefully
  plane the nature, timing and extent of audit
  procedures.
• Lower materiality, higher audit risk and more
  substantive testing required.

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Analytical procedures

• Its Meaning
• . By which meaningful relationships and trends
  in both financial and non-financial data may be
  analysed, actual data may be compared with
  budgeted or forecast data, and the data of an
  entity may be compared with that of similar
  entities and industry averages.
• PSH page 228

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Analytical procedures

• Examples include
• Ratios, percentages, trends and comparative
  analysis e.g.
• Comparison of payroll costs on a monthly basis
  taking into account wage increases starters,
  leavers etc.
• Comparison of sales seasonality year on year.
• Comparison of aged debtors on monthly basis and
  calculation of debtor days.
• Gross profit comparison year on year.

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Analytical procedures

• AP is considered to be highly efficient and
  effective but it is limited by
• The quality of the underlying data.
• The accuracy of relationships.
• Relevant availability of information.
• Information that is comparable.
• Auditors knowledge of the business.

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Analytical procedures

• Used at 3 stages of the audit
• Planning
• Liquidity
• Solvency
• Profitability
• Substantive tests
• Final review

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Analytical procedures

• Key features
• Investigation
• Explanation
• Corroboration
• Prediction
• Plausible explanations may not always be the
  case!
• For example.

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Analytical procedures

• We sold more cola in June because it was very
  hot
• After investigation , explanation and
  corroboration it could be
• we recorded more cola sales in June because a
  large batch of invoices was posted twice in
  error!

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Analytical procedures

• At the final review stageAnalytical review at
  this stage is required in forming an overall
  conclusion
• As to whether the financial statements as a whole
  are consistent with the auditors knowledge of
  the business.
• The review may also identify the need for further
  substantive procedures.

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Analytical procedures

• Ratio analysis is particularly useful in testing
  the consistency of the inter-relationships of
  amounts disclosed in the financial statements.
• It is usual to compare ratios calculated at this
  stage with those of the preliminary analytical
  review
• Kim Smith Examiner ACCA

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Analytical procedures

• At the final review stage
• The auditor should tabulate the information
  contained in the financial statements.
• Identify any discrepancies between the financial
  statements and the auditors knowledge of the
  industry.
• The business and the results of earlier years.
• Confirmation by the auditor that there are no
  unexplained discrepancies should be recorded as
  the conclusion to the review.

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Analytical procedures

• Audit firms may find it useful to record
  appropriate key ratios and performance indicators
  specific to each client within their permanent
  files each year.
• As part of their knowledge of the business for
  use in future audits.
• This record will often be of more value and use
  than just calculating standard ratios, during
  each audit.
• Which may not be particularly meaningful for some
  clients.
• Andrew Skaife, Compliance Officer, Monitoring
  Unit, ACCA

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The Engagement Letter

• This is a letter sent by the auditor
• Setting out the terms of the engagement
• Forming the basis of a contract.
• Hence avoiding any misunderstandings.

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The Engagement Letter

• The contents should be
• Ideally agreed prior to the audit.
• Should be reviewed annually.

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The Engagement Letter

• The letter addresses
• The responsibilities of the directors.
• The responsibilities of the auditors.
• The scope of the audit.
• Description of audit procedures.
• Other services potentially being offered.
• The billing method for fees.
• The applicable law.
• And agreement of terms.