Audit & Assuranse 7e Louwers Ch. 3 Solutions PDF

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CHAPTER 03Engagement PlanningLEARNING OBJECTIVESReview CheckpointsMultiple ChoiceExercises, Problems, and Simulations List and describe the required pre-engagement activities that auditors undertake before beginning an audit engagement. 1, 2, 3 27, 41, 52 58, 59, 60 Understand the importance of plan...

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Chapter 03 - Engagement Planning

CHAPTER 03 Engagement Planning LEARNING OBJECTIVES

Review Checkpoints

Multiple Choice

1.

List and describe the required pre-engagement activities that auditors undertake before beginning an audit engagement.

1, 2, 3

27, 41, 52

2.

Understand the importance of planning the audit engagement so that it is conducted in accordance with professional standards.

4, 5, 6, 7, 8, 11, 12

28, 29, 36, 37, 38, 39, 40, 42, 49, 51

3.

Define materiality and explain its importance in the audit planning process.

9, 10

32, 46

4.

List and describe the eight general types of audit procedures for gathering evidence.

13, 14, 15, 16

43, 44, 45, 47, 48, 50

5.

List and discuss matters of planning that auditors should consider related to the client’s computer environment and describe how CAATs can be used to improve the efficiency of the audit process.

17, 18, 19, 20, 21, 22

33, 34, 35

6.

Define what is meant by the proper form and content of audit documentation.

23, 24, 25, 26

30, 31

Exercises, Problems, and Simulations

58, 59, 60

61, 63

53, 54, 55, 56

62, 64

57

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Chapter 03 - Engagement Planning

SOLUTIONS FOR REVIEW CHECKPOINTS 3.1

Auditors can use the following sources of information to help decide whether to accept a new audit client: Financial information prepared by the prospective client such as: Annual reports to shareholders. Interim financial statements. Securities registration statements. Annual report on SEC Form 10-K. Reports to regulatory agencies. Inquiries directed to the prospect’s business associates such as: Banker. Legal counsel. Underwriter. Other persons (e.g., customers, suppliers). Communication with Predecessor auditor, if any, regarding: Integrity of management. Disagreements with management. Analyses such as: Special or unusual risk related to the prospect. Need for special skills (e.g., computer or industry expertise). In addition, auditors can conduct an internals search for relationships that would compromise independence. Also, auditors can search business press articles and stories and legal files on the LexisNexis system or on the Internet for news about chairman of the board, CEO, CFO, and often other highranking officers. Auditors can engage an outside search firm (private investigators) to conduct additional searches for information. Finally, students should always remember that this is a goal-directed search for information. Simply stated, auditors are looking for information about client risk factors—companies accused of fraud, companies under SEC or other regulatory investigation, companies that have changed auditors frequently, and companies showing recent losses.

3.2

Client consent to give information to prospective auditors is required because the Code of Professional Conduct prohibits the predecessor audit firm from revealing confidential information to the prospective audit firm without consent. As you can see, the confidentiality requirement remains intact even when the auditor-client relationship ends. A prospective audit firm should inquire specifically about:    

Management’s integrity. Disagreements the predecessor may have had with management about accounting principles and audit procedures. Communications the predecessor gave the former client about fraud, illegal acts, and internal control recommendations. The predecessor’s understanding about the reasons for the change of auditors (particularly about the predecessor’s termination).

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Chapter 03 - Engagement Planning

3.3

The benefits of an engagement letter include helping to:    

Establish an understanding between client and public accounting firm of the terms of the engagement and the nature of the work. Avoid quarrels and misunderstandings between client and auditor. Avoid disputes over the audit fee. Avoid legal liability assertions based on failure to do work that the CPA may not have contemplated or agreed to do.

A termination letter is a letter from a former public accounting firm (fired or resigned) to a former client specifying terms for future services and the auditors’ understanding of the circumstances related to the termination. 3.4

A planning memorandum summarizes all important overall planning information. The plan is used as a means to document that the audit team is following generally accepted auditing standards. More specifically, an audit plan is a comprehensive list of the specific audit procedures that the audit team needs to perform to gather sufficient appropriate evidence on which to base their opinion on the financial statements. The professional standards require that the auditor plan each audit engagement, including the establishment of an overall strategy for each audit engagement. Specifically, when planning the engagement, the auditor needs to develop and document a plan that describes the nature, timing, and extent of the procedures to be performed to assess the risk of material misstatement at the financial statement and the assertion level. Next, the auditor must carefully plan the nature, timing, and extent of control tests and substantive tests that are designed to mitigate these risks to an acceptable level.

3.5

Auditors usually prepare a planning memorandum that summarizes the preliminary analytical procedures, the materiality assessment, the significant accounts and the relevant assertions about each of the specific accounts. The planning memo also usually includes information about:           

Investigation or review of the prospective or continuing client relationship. Provision of special services or reports and needs for special technical or industry expertise. Staff assignment and timing schedules. The assessed level of inherent risk. The assessed level of control risk. Significant industry or company risks. The nature, timing and extent of testing of each relevant assertion for each significant account and disclosure. Computer system control environment. Utilization of the company’s internal auditors. Identification of unusual accounting principles problems. Schedules of work periods, meeting dates with client personnel, and completion dates.

3.6

Prior to using internal auditors, external auditors should assess the competence and objectivity of the persons whose work the auditor plans to use. In general, the higher the degree of competence and objectivity, the greater the extent to which the auditor can use the work. Stated simply, favorable conclusions about competence and objectivity enable external auditors to accept and use more of the internal auditors’ documentation and work. Importantly, the utilization of internal auditors’ work cannot be a complete substitute for the external auditors’ own procedures and evidence related to accounting judgments and the material financial statement balances.

3.7

Specialists are persons skilled in fields other than accounting and auditing—actuaries, appraisers, attorneys, engineers, and geologists—who are not members of the audit team. When a specialist is engaged, auditors must know about his or her professional qualifications, experience, and reputation. A specialist should be unrelated to the company under audit. Auditors must obtain an understanding of a specialist’s methods and assumptions. Provided some additional auditing work is done on the data used by the specialist, auditors may rely on the specialist’s work in connection with audit decisions.

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Chapter 03 - Engagement Planning

3.8

It is important to remember that skills often reside in the minds of the persons assigned to the job. As a result, it is important to make sure that the team is comprised of the persons that possess the skills that are required to execute the financial statement audit process in an effective and efficient manner. The following positions are normally assigned to a “full service” audit team: Audit engagement partner. Quality assurance (second) audit partner. Audit manager. Senior accountant. Statistical auditing specialist, if needed. Computer auditing specialist, if needed. Industry specialist, if needed. Other specialists, if needed Staff auditors. Tax partner. Tax manager. Tax accountants.

3.9

Information is material if it is likely to influence financial statement users’ decisions. Thus, material information is a synonym for important information. The emphasis is on the financial statement users’ point of view, not the auditors’ or managers’ points of view. Although financial statement users are expected to have a basic knowledge of business and financial statements as well as an understanding of the limitations of the audit process, auditors remain conservative when setting the materiality level. Thus, if it is likely to influence the economic decisions of financial statement users, the information should be considered material.

3.10

On an audit engagement, the audit team uses materiality three ways:

3.11



As a guide to planning substantive procedures (collectively referred to as the audit plan)—directing attention and audit work to those items or accounts that are important, uncertain, or susceptible to errors or frauds.



As a guide to evaluation of the evidence. Auditors use performance materiality (an amount less than materiality for the financial statements as a whole) to make sure that the aggregate of uncorrected and undetected immaterial misstatements does not exceed materiality for the financial statements as a whole. For example, auditors may use an amount less than overall financial statement materiality when auditing particular classes of transactions, account balances, or disclosures.



As a guide for making decisions about the audit report. An account such as inventory can be material in an audit context because of its size or its place in the financial statements. Additionally, inventory’s importance can result from the potential for misstatement or the effect that a misstatement can have on the financial statements. There are two ways to conduct substantive tests: (1) substantive analytical procedures and (2) tests of details. When completing a substantive analytical review to gather evidence, the auditor must develop an independent expectation of what he or she thinks the account balance should be. Once this has been developed, the expectation is compared to the recorded amount. Any significant differences must be investigated and then corroborated with evidential matter to be effective. When applying a substantive test of details, the auditor must seek to understand the account balance and/or economic transactions that comprise the balance to ensure, based on valid and reliable evidence, that the amount was recorded in accordance with the applicable financial reporting framework (e.g., GAAP).

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Chapter 03 - Engagement Planning

The two types of tests (analytical procedures and tests of details) are considered different in terms of effectiveness and efficiency. In general, analytical procedures are seen to be more efficient but less effective, while tests of detail are seen to be more effective but less efficient. Thus, an auditor must take great care in determining the nature of test procedure to specify in the audit plan. Importantly, the professional standards are clear that auditors can gain significant assurance from a well-designed substantive analytical procedure. As a result, some auditing firms encourage the use of analytical procedures whenever possible as a way to be more efficient. 3.12

The four cycles covered in this book, along with the primary accounts that can be identified within each of the cycles are shown as follows: Revenue and collection cycle Acquisition and expenditure cycle Production and conversion cycle Financing and investment cycle X X X X X X

X

X

X X X X X X

X

Inventory Fixed Assets Accumulated Depreciation Accounts Payable Accrued Expenses General Expense

X X

Cost of Goods Sold Depreciation Expense

X

X

X X X X X X X X X 3.13

Cash Accounts Receivable Allowance for Doubtful Accounts Sales Sales Returns Bad Debt Expense

Marketable Securities Bank Loans Long-Term Notes Accrued Interest Capital Stock Retained Earnings Dividends Declared Interest Expense Income Tax Expense

Vouching relates to the examination of documents. Generally, items of financial information are selected from an account recorded in the financial statements, and auditors then go backward through the accounting process to find the source documentation that supports the item selected. Typically, vouching is used to test the existence or the occurrence assertion. Tracing occurs in the opposite direction of vouching. That is, in the process of tracing, auditors select sample items from the source documentation and proceeds forward through the accounting process all the way to its final recording in the financial statements. Typically, tracing is used to test the completeness assertion. Finally, Scanning refers to the auditors scrutinizing documentation for unusual items and events. Scanning is the way auditors exercise their general alertness to unusual items and events in clients’ documentation. In general, scanning is an “eyes-open” approach of looking for anything unusual. The scanning procedure usually does not produce direct evidence itself, but it can raise questions related to other evidence that must be obtained.

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Chapter 03 - Engagement Planning

3.14

Auditors use eight general audit procedures to gather evidence: (1) inspection of records and documents (vouching, tracing, scanning), (2) inspection of tangible assets, (3) observation, (4) inquiry, (5) confirmation, (6) recalculation, (7) reperformance, and (8) analytical procedures. One or more of these procedures may be used no matter what account balance, control procedure, class of transactions, or other information is under audit.

3.15

Five types of general analytical procedures and their sources: Ana l y t i c alPr oc e dur e s So ur c e so fI nf o r ma t i o n 1. Co mpa r i s o nofc ur r e n t y e a ra c c oun tb a l a n c e s Fi na nc i a la c c o unti nf o r ma t i o nf o r t oba l a nc e sofoneo rmor ec o mpa r a b l e c omp a r a b l ep e r i o d( s ) pe r i o ds Ex amp l e :Cur r e nt y e a rCos tofGo o dsS ol d c o mp ar e dt opr e v i o us y e arb a l an c e Co mpa n yb u dg e t sa n df or e c a s t s 2. Co mpa r i s o noft h ec ur r e n t y e a ra c c o u nt ba l a nc e st oa n t i c i pa t e dr e s ul t sf o u ndi nt he Ex amp l e :Cur r e nt y e a rCos tofGo o dsS ol d c o mpa n y ’ sb u dg e t sa n df or e c a s t s c o mp ar e dt ot h ec o mpa ny ’ sb udg e t e d a mou nt 3. Ev a l ua t i o noft her e l a t i o ns h i p sofc ur r e n t y e a r Fi n a nc i a lr e l a t i on s h i p sa mon ga c c oun t si n t hec u r r e n tp e r i od a c c o u ntba l a nc e st oot he rc ur r e n t y e a r ba l a nc e sf o rc o nf o r mi t ywi t hp r e di c t a b l e Ex amp l e :Day s ’S al e si nI nv e nt o r y pa t t e r nsb a s e dont h ec omp a n y ’ se x pe r i e n c e 4. Co mpa r i s o nofc ur r e n t y e a ra c c oun tb a l a n c e s I nd us t r ys t a t i s t i c s a n dfin a nc i a lr e l a t i o ns h i ps( e . g . ,r a t i os )wi t h Ex amp l e :Day s ’S al e si nI nv e nt o r y s i mi l a ri n f or ma t i o nf ort h ei nd us t r yi nwhi c h c o mp ar e dt oi n d us t r yav e r ag e s t h ec o mpa n yo p e r a t e s No nfina n c i a li n f o r ma t i ons u c ha sp h y s i c a l 5. St u d yoft her e l a t i o ns hi p so fc ur r e nt y e a r r od uc t i o ns t a t i s t i c s a c c o u ntba l a nc e swi t hr e l e v a n tn onfina nc i a l p i nf o r ma t i on( e . g . , p h y s i c a lp r o du c t i on Ex amp l e :Da y s ’Sa l e si nI nv e nt or y s t a t i s t i c s ) c o mp ar e dt oun fil l e do r de r s

3.16

Professional standards require that analytic procedures be used during planning and during final evaluation stages of the audit; analytical procedures are optional for use as a substantive audit procedure. Remember, auditors can also use tests of detail.

3.17

Additional planning matters that should be considered about a client’s computerized processing environment include:      

3.18

The extent to which the computer is used in each significant accounting cycle. The complexity of the computer operations used by the entity, including the use of an outside service center. The organizational structure of the computer-processing activities. The availability of data. The possibility that computer-assisted audit techniques could be used to increase the efficiency of audit procedures. The need for specialized skills.

Generally speaking, transactions that are routine and similar in nature are excellent candidates for computerized processing. Computerized processing subjects similar transactions to the same processing instructions. Consequently, computerized processing virtually eliminates the occurrence of random errors normally associated with manual processing; as a result, programming errors (or other similar systematic errors in either the computer hardware or software) will result in all similar transactions being processed incorrectly when those transactions are processed under the same conditions.

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Chapter 03 - Engagement Planning

In addition, with automatic transaction initiation, certain transactions can be initiated or executed automatically by a computerized system without human review. Computer-initiated transactions may include the generation of invoices, checks, shipping orders, and purchase orders. Without a human-readable document indicating the transaction event, the correctness of automatic transactions is difficult to judge. The authorization of these transactions cannot be documented in the same way as those in a manual accounting system, and management’s authorization of these transactions can be implicit in its acceptance of the design of the system. Therefore, authorization can be more difficult to trace to the proper person. Control procedures must be designed into the system to ensure the genuineness and reasonableness of automatic transactions and to prevent or detect erroneous transactions. 3.19

The audit trail (sometimes called management trail because it is used more in daily operations than by auditors) is composed of the source documents, journa...