TOPIC 7: AUDIT PLANNING

References: Chapter 5,6,7 & 11

AUD390 2011

Engagement letter Planning activities Understanding the client’s business &

industry Fundamental concepts of materiality &

audit risk Relationship between materiality value

& evidence Preparation of audit programme Determination of audit objectives Analytical procedures - planning,

fieldwork & completion stageAUD390 2011

Procedures carried out before accepting a new client or continuing with an existing client include:obtaining and reviewing available financial information

regarding the clientmaking inquiries of third parties such as solicitors

and bankerscommunicating with previous auditorevaluating the firm’s independence and ability to serve

the client, including technical skills and knowledge of industry and personnel

ensuring accepting engagement will not violate the Code of Ethics.

6-5

To ensure the interests of shareholders, the incoming auditor and existing auditor are protected. It allows the existing auditor to advise the prospective auditor of any professional matters they should be aware of before accepting the engagement.

After accepting the appointment, it requires that the auditor and entity to agrees on terms of engagement.

The agreed terms of the engagement shall be recorded in an engagement letter.

EL is from the auditor to the client, document the arrangements made with the client and clarify matters that may be misunderstood.

Contents:the objectives and scope of the auditthe responsibilities of the auditorthe responsibilities of management identification of the applicable financial reporting

frameworkthe form and contents of any reports, and a statement

that there may be circumstances in which a report may differ from its expected form and content.

Refer Exhibit 6.1(pp.236)

Definition: involves general strategy and detail approach for the expected nature, timing and extent of an audit

Reasons for Audit PlanningTo enable the auditor to obtain sufficient

competent evidence for the circumstances

To help keep audit costs reasonableTo avoid misunderstandings with the

client

AUD390 AUDITING DIA

1. Understanding the entity and its environment

2. Understanding internal controls3. Assessing risks of material misstatement4. Developing responses to assessed risks5. Performing tests of controls6. Performing substantive procedures7. Completion and review.

Source: Gay & Simnet (2012, pp. 241-243)

The three phases of the audit—planning, interim and final—are normally related to the major stages.

The first four stages: the planning phase of the audit.The evidence gathering phase, performing tests of controls and substantive procedures: the interim phase (before year end) or final phase (after year end).Some substantive tests (e.g. counting inventory) are usually best done at balance date others: engagement completion

Audit Risk :Risk that the auditor gives an

inappropriate opinion when the FS are materially misstated

Risk that the auditor delivers an incorrect audit opinion – an opinion which states that the account presents a true & fair view while in reality they do not

AUD390 AUDITING DIA

INHERENT RISK

Risk that the accounts may contain misstatements

DETECTION RISK

CONTROL RISK

Derived from the characteristics of the enterprise & of its components

Risk that internal controls will not prevent or detect material errors

Risk that the auditor may fail to detect misstatements

INHERENT RISK (IR)Risk related to the characteristics of the

business that may cause material FSFactors used in assessing inherent risks

Nature of client’s business Integrity of management Client motivation Client’s knowledge of accounting

standards Results of previous audit

AUD390 AUDITING DIA

Susceptibility of defalcation Nature of client’s inventory &

technological developmentE.g.

External factors such as technological development might make a particular product obsolete

IR is high if no internal control system & IR is low if internal control exist

AUD390 AUDITING DIA

CONTROL RISK (CR)› Risk that the client’s internal control will

not prevent or detect material errors or misstatements in the account balance

› Control risk exist due to the inherent limitation of internal control system & inadequacy of the segregation of duties such as human error, faulty judgment

› CR high if internal control system is not effective & CR low if internal controls system is effective

AUD390 AUDITING DIA

DETECTION RISK (DR)Risk that any remaining material

misstatements after assessing IR & CR will not be detected by auditor

Risk that the auditor’s substantive procedures & review FS will not detect material errors misstatements

DR high if the auditors are not competent & due care & DR low if the auditors are competent & exercise due care

AUD390 AUDITING DIA

Definition: a study of relationship between elements of financial information expected to conform to a predictable pattern based on the auditor’s knowledge of the business relationship between financial and non financial information

AUD390 AUDITING DIA

Types of data, ratios, etc Comparison withFinancial Data (Account balances, budgets, etc)

Corresponding period, budget & forecasts

Non Financial Data (Production, employment statistics)

Entries in accounting records, other financial data

Ratios & Percentage Preceding period, budget & forecast, industry statistics

Types of analytical procedures:1. Compare client data & industry data2. Compare client data with similar prior-

period data3. Compare client data client-determined

expected results4. Compare client data & auditor-

determined expected results5. Compare client data with expected

results, using non financial data

AUD390 AUDITING DIA

Common financial ratios1. Short-term Debt-Paying Ability

E.g. Cash ratio, quick ratio & current ratio2. Liquidity Activity Ratios

E.g. Accounts receivable turnover, Days to collect receivables, Inventory turnover, Days to sell inventory

3. Ability to meet Long-term Debt Obligations E.g. Debt to equity, Times interest earned

4. Profitability Ratios E.g. Earnings per share, Gross profit margin, Profit

margin, Return on assets, Return on common equity

AUD390 AUDITING DIA

AUD390 AUDITING DIA

STAGES PLANNING DETAILED TEST REVIEW FSTIMING Before the FS are

availableStart after client had submitted FS with supporting schedules

Carry out overall review of FS when most of audit testing are completed

PURPOSES 1.To understand the client’s industry & business2.To assess going concern3.To indicate possible misstatement4.To reduced detailed tests

1. To ensure completeness, accuracy & validity of information contain in the FS2.To obtain sufficient audit evidence by reducing the work done through substantive tests

1.To update auditor’s knowledge of client’s business2.To ensure the FS are not materially misstated3.To corroborate conclusions form during the audit

SOURCES OF INFORMATIONS

Interim FS, Management reports, Budget & forecasts, Internal audit report

Annual FS, Accounting & other records, Management reports, Internal audit reports

Drafted audited FS

EXAMPLES Calculate key ratios for client and compare against industry’s ratios

Reasonable test on EPF contribution account

Gearing ratio