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1. Select a Base
a. Its user, size, stability
2. Determine an appropriate percentage
a. Table, rule of thumb, size, qualitative factors
i. Criticalpoints, history, risk
3. Multiply and “adjust”
· Focus of an audit (riskiestaccounts/transactions)
· Materiality and tolerable misstatements
· Planned Level of Audit Risk
· Audit Strategy for different processes
o Assignment of inherent risk
o Assignment of control risk
o Detection riskènature,timing, extent of audit tests
· Audit Staffing (need for specialskiils/expertise)
· Budget & Schedule
· Coordination with client
1. Gain an Understanding of the Client
2. Identify Risk of Material Misstatement. (Inherent Risk) (IR)
3. Evaluate Client’s Internal Controls (not when wetest them)(Control Risk-risk that a material misstatement could get past thecontrols)
4. Develop Audit Plan
b. Set of Audit Programs
· ComplexityèComplexaccounting (pensions, derivatives)
· Uncertaintyè(unusual transactions and/or events or estimates.)
· Incentive (Pressure) è [stock price, profits, borrowmoney, debt covenants]
· Opportunityè[Poor internal controls; the “boss”, complex accounting, unusual transactions,estimates, related party transactions]
· Rationalization (Attitude)è”I am the hero”
1. Ive got to understand the client’s business& business Processes
2. Ive got to identify where risks of materialmisstatement are. (Inherent Risk)
a. Where are they high or low?
3. Ive got to evaluate how well the client’sinternal controls can prevent, or detect and correct material misstatementsthat could occur. (Control Risk)
4. Using what I know, I have to plan an effective,yet efficient Audit.
“Planned Audit Risk”(PAR)
The risk I’m willing to accept “ex ante” of coming to thewrong conclusion about financial statement quality based on my audit.
· Determined by Engagement Risk**
Engagement Risk: The risk to me and my audit firm associatedwith auditing a specific client. What to consider?
· Risk of being sued
· Risk of exposure to the media - loss of reputation,loss of future revenue
· Client Going Concern Risk
· The risk of a material misstatement occurring inan account/transaction/disclosure
· Assessment dependent on Error Risk and FraudRisk.
Error Risk: Risk of material misstatement due to error.
· Focus on evidence of the error triangle: RiskFactors
*Look at people, processes, andaccounting.
Fraud Risk: Risk of material misstatement occurring due tofraud.
· Focus on evidence of the fraud triangle: (RiskFactors)
o Perceived Opportunity*
*Look at management
Risk of material Misstatement not being prevented, detectedand corrected, in a timely manner, by the client’s internal controls.
· Assessment depends on the perceived designeffectiveness.
Design Effectiveness: how good do IC’s look “on paper”?
Detection Risk: (DR)
Risk of material misstatement not being detected by auditprocedures.
Determined by the nature, timing, and extent of audit tests(SCOPE).
· Better Test èLowerDR
· Year end tests èLowerDR
· More tests èLowerDR
Required DetectionRisk (RDR): level of detection risk required on an audit to achieve theplanned level of Audit Risk.
Audit Risk Model:
RDR=PAR/(IR x CR)
PreliminaryAnalytical Procedures: (Required)Analysis of “preliminary” financial information(10 month, 3rd Quarter numbers) performed to help gain anunderstanding of client and identify risk accounts/transactions
1. To understand client’s business & businessprocesses-including financial condition
2. To understand the client’s accounting
3. To identify recent changes/events
4. To identify risky transactions/accounts
5. To identify unexpected things
6. To help assess risk of material misstatement(Inherent Risk) (IR)
· Substantivetests- Any direct tests of assertions viatransactions/accounts/disclosures
o By looking directly at the numbers
o Substantive Analytical Procedures and Test ofDetails
· Assign more experienced/senior level staff
· Assign additional Hours
· Adjust tolerable misstatement
· Bring in an expert
· Review relevant accounting standards
· Larger than normal sample sizes
· Set Overall Planned Audit Risk (AR)
· Determine Materiality and assign tolerablemisstatement to accounts that need it
· Identify the riskiest areas(accounts/transactions with residual risk) and make sure to have plan toaddress them
· Group Related Accounts into Cycles (all shouldbe assigned)
· Determine audit strategy for each cycle (IR and CR)
Compute DR and consider its meaning in terms of sufficient appropriate evidence
Consider whether internal auditors can be used
determine audit schedule, staffing, budget
Material Weakness:is a deficiency in internal controls such that it is reasonably possiblethat a material misstatement will not be detected, or preventedon a timely basis.
· (Severe, could lead to material misstatement)
· Reported to Public
What did SOX do?
1. Shifted regulatory authority from AICPA (ASB) tothe “new” PCAOB (public companies only)
2. New Independence Rules
3. Enhanced Audit Committee Roles è Audit CommitteeIndependent/Competent
4. New Rules regarding internal controls overfinancial reporting (ICFR) (section 404)
Notes Regarding ICFRAudits:
1. Scope is much greater than the internal controlwork performed during F/S audits
2. Report provided opinion regarding effectivenessof ICFR
3. Search for material weaknesses
Control Deficiency:the design or operation of a control does not prevent, or detect on a timelybasis, a misstatement.
· Is it Significant or Material?
o Material Weakness
o Significant Weakness
Types of Reports onICFR:
1. No material weaknessèunqualified Report
2. Material Weakness èAdverse Report
3. Scope Limitation èDisclaimer (no opinion)
Auditing plays a significant role in protecting ourfinancial/capital markets and in protecting the general (investing) public andindividual investors.
What should be the objective of regulation?
1. Integrity of profession- auditing only addsvalue to information if there is integrity
2. Protect the public – the public can’t see“inside” the audit
o GAAS (10 + SAS)
o Code of Professional Conduct (ethics)
o Quality Control Standards
o Independence Standards
o Certification Standards (education, Exam,experience)
o Prohibitions on advertising
o Prohibitions on price competition
o Probibitions on solicitation
o Other barriers to entry
o Domination by a few firms
o Audit failures
1. We have a responsibility to others.
2. We must place others interest above our own
3. We should behave ourselves in a professionalmanner.
1. Rule101: Members must be independent “in appearance”
a) Individual on the engagement team
b) Individual in position to influence engagement
c) Partner/manager providing non-attest services
d) Partner in the same office as engagementpartners
e) The audit firm
f) An entity that can be controlled by the above
g) Spouse (or equivalent), dependent children
h) Close relatives? (siblings, parents,non-dependent children)
1. Rule201: Auditors must follow 10 standards in GAAS
b. Due Professional Care
c. Planning and Supervision
d. Sufficient Evidence
1. Rule202: Auditors (and non auditors) must follow all standards issued by designatedregulatory bodies
1. Rule203: Audit Report and/or representation letter must be consistent with reality(GAAP)!
1. Rule302 – No Contingent Fees ( should this be in the independent section?)
1. Rule501- Discreditable Acts
a. Retention of Client Records
c. Failure To follow GAAS
d. Negligence in preparation of FinancialStatements
e. Cheating on CPA exam
f. Cheating on Taxed (including failure to file areturn)
1. Rule502- Be professional in seeking new clients
a. Advertising and Solicitation
b. No False, misleading, deceptive
c. No Coercion, Over-reaching, Harrassing
1. Rule503- No Commissions or referral fees
1. Rule504- Organizational form and AICPA member designation
Auditors understanding of the entity and its environmentincludes:
· Nature of the entity
· Industry, regulatory, and other externalfactors.
· Objectives, strategies, and related businessrisks.
· Entity performance measures.
· Internal Control
· Large acquisitions, reorganizations, or otherunusual events.
· Significant changes in the industry.
· Significant new products or services.
· New locations.
· Significant changes in the IT environment.
· Operations in areas with unstable economies.
· High degree of complex regulation.
Fraud: refers to an intentional act by one or more amongmanagement, those charged with governance, employees, or third parties,involving the use of deception to obtain an unjust or illegal advantage.
an amount of planning materiality that is allocatedto specific accounts or classes of transactions.
sed to obtain anunderstanding of the entity and its environment, including its internalcontrol. These include inquiries of managementand other, preliminary analytical procedures, and observation andinspection.
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