ALDERSGATE COLLEGE APPLIED AUDITING

SCHOOL OF BUSINESS AND ACCOUNTANCY

MODULE 2 AUDIT PLANNING

OBJECTIVES

After studying this module, students are expected to:

1. Know the nature and objectives of audit planning
2. Describe the considerations in audit planning
3. Explain the basics of audit planning
4. Describe the work involved in audit planning

LEARNING FOCUS

PSA 200, "Objective and General Principles Governing the Audit of Financial Statements", paragraph 6 requires
that:

"The auditor should plan and perform the audit with an attitude of professional
skepticism recognizing that circumstances may exist which cause the financial
statements to be materially misstated. For example, the auditor would ordinarily expect
to find evidence to support management representations and not assume they are
necessarily correct"

The auditor-in-charge must develop a "plan of action" to organize, coordinate* and schedule activities of the audit
staff. An audit plan is normally drafted prior to starting the work at the client's offices.

PSA 300, “Planning' establishes standards and provides guidance on planning an audit of financial statements.

Purposes

The main reasons why the auditor should properly plan audit engagements are:
1. to enable the auditor to obtain sufficient competent evidence for the circumstances,
2. to help keep audit costs reasonable, and
3. to avoid misunderstandings with the client.

On the over-all, good planning facilitates quality work at reasonable cost and at the same time helps maintain
good relations with the client.

Audit Planning Considerations

Matters to be considered by the auditor in developing the overall audit plan include:
1. Knowledge of the Bus iness
2. Understanding of the Accounting and Internal Control System
3. Assessment of Risk and Materiality
4. Application of Analytical Procedures
5. Coordination, Direction, Supervision and Review
6. Other matters, such as assessment of the going concern assumption, related parties, nature and timing
of reports and other communications with the entity.

Discussion:

1. Knowledge of the Business

This section discusses what is meant by knowledge of the business, why it is important to the auditor and to
members of the audit staff working on an engagement, why it is relevant to all phases of an audit and how the
auditor obtains and uses the knowledge.
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According to PSA 315, Understanding the Entity and Its Environment and Assessing the Risks of Material
Misstatement, the auditor should obtain an understanding of the entity and its environment, including its internal
control, sufficient to identify and assess the risks of material misstatement of the financial statements whether
due to fraud or error, and sufficient to design and perform further audit procedures. For example, such
knowledge is used by the auditor in assessing inherent and control risks and in determining the nature, v timing,
and extent of audit procedures.

The auditor's level of knowledge for an engagement would include a general knowledge of the economy and the
industry within which the entity operates, and a more particular knowledge of how the entity operates. The level
of knowledge required by the auditor would, however, ordinarily be less
than that possessed by management.

Obtaining the Knowledge

Prior to accepting an engagement, the auditor would obtain a preliminary knowledge of the industry and of the
ownership, management and operations of the entity to be audited, and would consider whether a level of
knowledge of the business adequate to perform the audit can be obtained.

Following acceptance of the engagement, further and more detailed information would be obtained. To the extent
practicable, the auditor would obtain the required knowledge at the start of the engagement. As the audit
progresses, that information would be assessed and updated and more information would be obtained.

Obtaining the required knowledge of the business is a continuous and cumulative process of gathering and
assessing the information and relating the resulting knowledge to audit evidence and information at all stages of
the audit. For example, although information is gathered at the planning stage, it is ordinarily refined and added
to in later stages of the audit as the auditor and assistants learn more about the business.

The auditor should obtain an understanding of the nature of the entity. The nature of an entity refers to the
entity's operations, its ownership and governance, the types of investments that it is making and plans to make*
the way that the entity is structured and how it is financed. An understanding of the nature of an entity enables
the auditor to understand the classes of transactions, account balances, and disclosures to be expected in the
financial statements.

For continuing engagements, the auditor would update and reevaluate information gathered previously, including
information in the prior year's working papers. The auditor would also perform procedures designed to identify
significant changes that have taken place since the last audit.

The auditor can obtain knowledge of the industry and the entity from a number of sources. For example:
 Previous experience with the entity and its industry.
 Discussion with people with the entity (for example, directors and senior operating personnel).
 Discussion with internal audit personnel and review of internal audit reports.
 Discussion with other auditors and with legal and other advisors who have provided services to the
entity or within the industry.
 Discussion with knowledgeable people outside the entity (for example, industry regulators, customers
and suppliers, competitors).
 Publications related to the industry (for example, government statistics, surveys, texts, trade journals,
reports prepared by banks and securities dealers, financial newspapers).
 Legislation and regulations that significantly affect the entity*
 Visits to the entity's premises and plant facilities.
 Documents produced by the entity (for example, minutes of meetings, material sent to shareholders or
filed with regulatory authorities, promotional literature, prior years' annual and financial reports, budgets,
internal management repeats, interim financial reports, management policy manual, manuals of
accounting and internal control systems, chart of accounts, job descriptions, marketing and sales plans).
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The auditor's understanding of the entity and its environment consists of an understanding of the following
aspects:
1. Industry, regulatory, and other external factors, including the applicable financial reporting framework.
2. Nature of the entity, including the entity's selection and application of
3. accounting policies.
4. Objectives and strategies and the related business risks that may result in a material misstatement of
the financial statements.
5. Measurement and review of the entity's financial performance.
6. Internal control.

Appendix 1 contains examples of matters that the auditor may consider in obtaining an understanding of the
entity and its environment relating to categories (a) through (d) above. Appendix 2 contains a detailed
explanation of the internal control components.

The nature, timing, and extent of the risk assessment procedures performed depend on the circumstances of the
engagement such as the size and complexity of the entity and the auditor's experience with it. In addition,
identifying significant changes in any of the above aspects of the entity from prior periods is particularly important
in gaining a sufficient understanding of the entity to identify and assess risks of material misstatement.

Understanding the Entity and Its Environment

Appendix 1 of PSA 315 provides additional guidance on matters the auditor may consider when obtaining an
understanding of the industry, regulatory, and other external factors that affect the entity, including the applicable
financial reporting framework; the nature of the entity; objectives and strategies and related business risks; and
measurement and review of the entity's financial performance. The examples provided cover a broad range of
matters applicable to many engagements; however, not all matters are relevant to every engagement and the list
of examples is not necessarily complete.

Industry, Regulatory and Other External Factors, including the Applicable Financial Reporting
Framework

Examples of matters an auditor may consider include the following:

 Industry conditions
 The market and competition, including demand, capacity, and price competition
 Cyclical or seasonal activity
 Product technology relating to the entity's products
 Energy supply and cost

 Regulatory environment
 Accounting principles and industry specific practices
 Regulatory framework for a regulated industry
 Legislation and regulation that significantly affect the entity's operations
 Regulatory requirements
 Direct supervisory activities
 Taxation (corporate and other)
 Government policies currently affecting the conduct of the entity's business
 Monetary, including foreign exchange controls
 Fiscal
 Financial incentives (for example, government aid programs)
 Tariffs, trade restrictions
 Environmental requirements affecting the industry and the entity's business
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 Other external factors currently affecting the entity's business

 General level of economic activity (for example, recession, growth)
 Interest rates and availability of financing
 Inflation, currency revaluation

Nature of the Entity

Examples of matters an auditor may consider include the following:

 Business Operations

 Nature of revenue sources (for example, manufacturer, wholesaler, banking, insurance or other
financial services, import/export trading, utility, transportation, and technology products and
services)
 Products or services and markets (for example, major customers and contracts, terms of payment,
profit margins, market share, competitors, exports, pricing policies, reputation of products,
warranties, order book, trends, marketing strategy and objectives, manufacturing processes)
 Conduct of operations (for example, stages and methods of production, business segments,
delivery or products and services, details of declining or expanding operations)
 Alliances, joint ventures, and outsourcing activities
 Involvement in electronic commerce, including internet sales and marketing activities
 Geographic dispersion and industry segmentation
 Location of production facilities, warehouses, and offices
 Key customers
 Important suppliers of goods and services (for example, long-term contracts, stability of supply,
terms of payment, imports, methods of delivery such as "just-in-time")
 Employment (for example, by location, supply, wage levels, union contracts, pension and other post
employment benefits, share option or incentive bonus arrangements, and government regulation
related to employment matters)
 Research and development activities and expenditures
 Transactions with related parties

 Investments
 Acquisitions, mergers or disposals of business activities (planned or recently executed)
 Investments and dispositions of securities and loans
 Capital investment activities, including investments in plant and equipment and technology, and any
recent or planned changes
 Investments in non-consolidated entities, including partnerships, joint ventures and special-purpose
entities

 Financing
 Group structure - major subsidiaries and associated entities, including consolidated and non
consolidated structures
 Debt structure, including covenants, restrictions, guarantees, and off-balance-sheet financing
arrangements
 Leasing of property, plant or equipment for use in the business
 Beneficial owners (local, foreign, business reputation and experience)
 Related parties
 Use of derivative financial instruments

 Financial Reporting
 Accounting principles and industry specific practices
 Revenue recognition practices
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 Accounting for fair values

 Inventories (for example, locations, quantities)
 Foreign currency assets, liabilities and transactions
 Industry-specific significant categories (for example, loans and investments for banks, accounts
receivable and inventory for manufacturers, research and development for pharmaceuticals)
 Accounting for unusual or complex transactions including those in controversial or emerging areas
(for example, accounting for share-based compensation)
 Financial statement presentation and disclosure

Objectives and Strategies and Related Business Risks

Examples of matters an auditor may consider include the following:

 Existence of objectives (i.e. how the entity addresses industry, regulatory and other external factors)
relating to, for example, the following:
 Industry developments (a potential related business risk might be, for example, that the entity does
not have the personnel or expertise to deal with the changes in the industry)
 New products and services (a potential related business risk might be, for example, that there is
increased product liability)
 Expansion of the business (a potential related business risk might be, for example, that the demand
has not been accurately estimated)
 New accounting requirements (a potential related business risk might be, for example, incomplete
or improper implementation, or increased costs)
 Regulatory requirements (a potential related business risk might be, for example, that there is
increased legal exposure)
 Current and prospective financing requirements (a potential related business risk might be, for
example, the loss of financing due to the entity's inability to meet requirements)
 Use of IT (a potential related business risk might be, for example, that systems and processes are
incompatible)

 Effects of implementing a strategy, particularly any effects that will lead to new accounting requirements
(a potential related business risk might be, for example, incomplete or improper implementation)

Measurement and Review of the Entity's Financial Performance

Examples of matters an auditor may consider include the following:

 Key ratios and operating statistics

 Key performance indicators
 Employee performance measures and incentive compensation policies
 Trends
 Use of forecasts, budgets and variance analysis
 Analyst reports and credit rating reports
 Competitor analysis
 Period-on-period financial performance (revenue growth, profitability, leverage)

Using the Knowledge

Obtaining an understanding of the entity and its environment is an essential aspect of performing an audit in
accordance with PSAs. In particular, that understanding establishes a frame of reference within which the auditor
plans the audit and exercises professional judgment about assessing risks of material misstatement of the
financial statements and responding to those risks throughout the audit, for example when:
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 Establishing materiality and evaluating whether the judgment about materiality remains appropriate as
the audit progresses;
 Considering the appropriateness of the selection and application of accounting policies, and the
adequacy of financial statement disclosures;
 Identifying areas where special audit consideration may be necessary, for example, related party
transactions, the appropriateness of management's use of the going concern assumption, or
considering the business purpose of transactions;
 Developing expectations for use when performing analytical procedures;
 Designing and performing further audit procedures to reduce audit risk to an acceptably low level; and
 Evaluating the sufficiency and appropriateness of audit evidence obtained, such as the appropriateness
of assumptions and of management's oral and written representations.

The auditor should ensure that assistants assigned to an audit engagement obtain sufficient knowledge of the
business to enable them to carry out the audit work delegated to them. The auditor would also ensure they
understand the need to be alert for additional information and the need to share that information with the auditor
and other assistants.

To make effective use of knowledge about the business, the auditor should consider how it affects the financial
statements taken as a whole and whether the assertions in the financial statements are consistent with the
auditor's knowledge of the business.

2. Understanding the Accounting and Internal Control System

The information system relevant to financial reporting objectives, which includes the accounting system, consists
of the procedures and records established to initiate, record, process, and report entity transactions (as well as
events and conditions) and to maintain accountability for the related assets, liabilities, and equity.

The auditor should obtain an understanding of the information system, including the related business processes,
relevant to financial reporting, including the following areas:

 The classes of transactions in the entity's operations that are significant to the financial statements.
 The procedures, within both IT and manual systems, by which those transactions are initiated, recorded,
processed and reported in the financial statements.
 The related accounting records, whether electronic or manual, supporting information, and specific
accounts in the financial statements, in respect of initiating, recording, processing and reporting
transactions.
 How the information system captures events and conditions, other than classes of transactions, that are
significant to the financial statements.
 The financial reporting process used to prepare the entity's financial statements, including significant
accounting estimates and disclosures.

In obtaining this understanding, the auditor considers the procedures used to transfer information from
transaction processing systems to general ledger or financial reporting systems. The auditor also understands
the entity's procedures to capture information relevant to financial reporting for events and conditions other than
transactions, such as the depreciation and amortization of assets and changes in the recoverability of accounts
receivables.

When obtaining an understanding of the accounting and internal control systems to plan the audit, the auditor
obtains knowledge of the design of the accounting and internal control systems, arid their operation. For
example, an auditor may perform a "walk-through" test that is tracing a few transactions through the accounting
system. When the transactions selected are typical of those transactions that pass through the system, this
procedure may be treated as part of the tests of control. The nature and extent of walk-through tests performed
by the auditor are such that they alone would not provide sufficient appropriate audit evidence to support a
control risk assessment which is less than high.
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The nature, timing, and extent of the risk assessment procedures performed by the auditor to obtain an
understanding of the accounting and internal control system will vary with, among other things:

 The size and complexity of the entity and of its computer system.
 Materiality considerations.
 The type of internal controls involved.
 The nature of the entity's documentation of specific internal controls.
 The auditor's assessment of inherent risk.

Ordinarily, the auditor's understanding of the accounting and internal control systems significant to the audit is
obtained through previous experience with the entity and is supplemented by:

1. inquiries of appropriate management, supervisory, and other personnel at various organizational levels
within the entity, together with reference to documentation, such as procedures manuals, job
descriptions and flow charts;
2. inspection of documents and records produced by the accounting and internal control systems; and
3. observation of the entity's activities and operations, including observation of the organization of
computer operations, management personnel and the nature of transaction processing.

Accounting and Reporting Systems

The auditor should obtain an understanding of the entity's selection and application of accounting policies and
consider whether they are appropriate for its business and consistent with the applicable financial reporting
framework and accounting policies used in the relevant industry. The understanding encompasses the methods
the entity uses to account for significant and unusual transactions; the effect of significant policies in controversial
or emerging areas for which there is a lack of authoritative guidance or consensus; and changes in the entity's
accounting policies. The auditor also identifies financial reporting standards and regulations that are new to the
entity and considers when and how the entity will adopt such requirements. Where the entity has changed its
selection of or method of applying significant accounting policy, the auditor considers the reasons for the change
and whether it is appropriate and consistent with the requirements of the applicable financial reporting
framework.

The auditor should obtain an understanding of the accounting system sufficient to identify and understand:

1. major classes of transactions in the entity's operations;

2. how such transactions are initiated;
3. significant accounting records, supporting documents and accounts in the financial statements; and
4. the accounting and financial reporting process, from the initiation of significant transactions and other
events to their inclusion in the financial statements.

A tour of the plant and offices of the client affords the auditor an opportunity to observe at firsthand what types of
internal documentation are used to record activities such as receiving raw materials, transferring materials into
production, and shipping finished goods to customers. This documentation is essential to the auditor's study and
evaluation of internal control. In going through the offices of the client, the auditor will also learn the location of
various accounting records.

Understanding the Client s Internal Control

The auditor should obtain an understanding of internal control relevant to the audit The auditor uses the
understanding of internal control to identify types potential misstatements, consider factors that affect the risks of
material misstatement, and design the nature, timing, and extent of further audit procedures.

Internal control is the process designed and effected by those charged with governance, management, and other
personnel to provide reasonable assurance about the achievement of the entity's objectives with regard to
reliability of financial reporting, effectiveness and efficiency of operations and compliance with applicable laws
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and regulations. It follows that internal control is designed and implemented to address identified business risks
that threaten the achievement of any of these objectives.

Internal control, as discussed in PSA 315, consists of the following components:

1. The control environment

2. The entity's risk assessment process
3. The information system, including the related business processes, relevant to financial reporting, and
communication
4. Control activities
5. Monitoring of controls

Appendix 2 of PSA 315 contains a detailed discussion of the internal control components.

The primary objective of the study and evaluation of internal control is to determine if the auditor can place
reliance on the system of internal control. The reliance of the auditor on the internal control refers only to specific
controls and not on the system in its entirety.

The nature, timing and extent of the audit work to be performed on a particular engagement depend largely upon
the effectiveness of the client's system of internal control in preventing material errors in the financial statements.
Before auditors can evaluate the effectiveness of the system, they need to obtain a knowledge and
understanding of how it works.

Sources of information about the client's system includes interviews with client personnel, audit working papers
from prior year's engagements, plant tours and the client's procedures manuals. In gathering information about a
system, it is often useful to study the sequence of procedures used in processing major categories of
transactions.

A working knowledge of the client's system of internal control is needed throughout the audit. Consequently, the
auditor should prepare a working paper fully describing his understanding of the system. The description of the
system of internal control is usually prepared in the form of a written narrative, flowcharts, or a questionnaire.

The auditor then, evaluates the system of internal control on a preliminary basis to identify the significant
strengths and weaknesses in the system.

Figure 2.1 presents the Methodology for the Study and Evaluation of Internal Accounting Control

Depth of Understanding of Internal Control

Obtaining an understanding of internal control involves evaluating the design of a control and determining
whether it has been implemented.

Evaluating the design of a control involves considering whether the control, individually or in combination with
other controls, is capable of effectively preventing, or detecting and correcting, material misstatements. Further
explanation is contained in the discussion of each internal control component below. Implementation of a control
means that the control exists and that the entity is using it. The auditor considers the design of a control in
determining whether to consider its implementation. An improperly designed control may represent a material
weakness1 in the entity's internal control and the auditor considers whether to communicate this to those charged
with governance and management as required by paragraph 120 of PAS 315.

Risk assessment procedures to obtain audit evidence about the design and implementation of relevant controls
may include inquiring of entity personnel, observing the application of specific controls, inspecting documents
and reports, and tracing transactions through the information system relevant to financial reporting. Inquiry alone
is not sufficient to evaluate the design of a control relevant to an audit and to determine whether it has been
implemented.
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Figure 2.1 Methodology for the Study and Evaluation of Internal Accounting System

Obtaining an understanding of an entity’s controls is not sufficient to serve as testing the operating effectiveness
of controls, unless there is some automation that provides for the consistent application of the operation of the
control (manual and automated elements of internal control relevant to the audit are further described below). For
example, obtaining audit evidence about the implementation of a manually operated control at a point in time
does not provide audit evidence about the operating effectiveness of the control at other times during the period
under audit. However, IT enables an entity to process large volumes of data consistently and enhances the
entity's ability to monitor the performance of control activities and to achieve effective segregation of duties by
implementing security controls in applications, databases, and operating systems. Therefore, because of the
inherent consistency of IT processing, performing audit procedures to determine whether an automated control
has been implemented may serve as a test of that control's operating effectiveness, depending on the auditor's
assessment and testing of controls such as those over program changes. Tests of the operating effectiveness of
controls are further described in PSA 330.

3. Assessment of Risk and Materiality

Obtaining an understanding of the entity and its environment, including its internal control, is a continuous,
dynamic process of gathering, updating and analyzing information throughout the audit. As described in PSA
500, audit procedures to obtain an understanding are referred to as "risk assessment procedures" because some
of the information obtained by performing such procedures may be used by the auditor as audit evidence to
support assessments of the risks of material misstatement. In addition, in performing risk assessment
procedures, the auditor may obtain audit evidence about classes of transactions, account balances, or
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disclosures and related assertions and about the operating effectiveness of controls, even though such audit
procedures were not specifically planned as substantive procedures or as tests of controls. The auditor also may
choose to perform substantive procedures or tests of controls concurrently with risk assessment procedures
because it is efficient to do so.

a. Materiality

The auditor should consider materiality and its relationship with audit risk when conducting an audit.
According to PAS 1 Presentation of Financial Statements "omissions or misstatements of items are material if
they could, individually or collectively, influence the economic decisions of users taken on the basis of the
financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the
surrounding circumstances. The size or nature of the item, or a combination of both, could be determining
factors."

The objective of an audit of financial statements is to enable the auditor to express an opinion whether the
financial statements are prepared, in all material respects, in accordance with an identified financial reporting
framework. The assessment of what is material is a matter of professional judgment.

In designing the audit plan, the auditor establishes an acceptable materiality level so as to detect quantitatively
material misstatements. However, both the amount (quantity) and nature (quality) of misstatements need to be
considered. Examples of qualitative misstatements would be the inadequate or improper description of an
accounting policy when it is likely that a user of the financial statements would be misled by the description, and
failure to disclose the breach of regulatory requirements when it is likely that the consequent imposition of
regulatory restrictions will significantly impair operating capability.

The auditor needs to consider the possibility of misstatements of relatively small amounts that, cumulatively,
could have a material effect on the financial statements. For example, an error in a month end procedure could
be an indication of a potential material misstatement if that error is repeated each month.

Materiality should be considered by the auditor when:

1. determining the nature, timing, and extent of audit procedures; and

2. evaluating the effect of misstatements.

b. Audit Risk

Audit Risk refers to the possibility that the auditors fail to appropriately modify their opinion on financial
statements that are materially misstated. Since an audit involves gathering evidence for each material financial
statement assertion, audit risk can also be examined at that level For each financial statement account, audit risk
consists of the possibility that:

1. a material misstatement in an assertion about the account has occurred, and

2. the auditors do not detect the misstatement

The risk of occurrence of a material misstatement may be separated into two components, inherent risk and
control risk. The risk that auditors will not detect the misstatement is called detection risk.

Inherent risk. The susceptibility of a financial statement assertion to a material misstatement, assuming
there are no related internal controls.

Control risk. The risk that a material misstatement could occur in a financial statement assertion and
not be prevented or detected by the client's internal controls.

Detection risk. The risk that the audit procedures will not detect a material misstatement that exists in a
financial statement assertion.
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c. Relationship between Materiality and Audit Risk

When planning the audit, the auditor considers what would make the financial statements materially misstated.
The auditor's assessment of materiality, related to specific account balances and classes of transactions, helps
the auditor decide such questions as what items to examine and whether to use sampling and analytical
procedures. This enables the auditor to select audit procedures that, in combination, can be expected to reduce
audit risk to an acceptably low level.

There is an inverse relationship between materiality and the level of audit risk, that is, the higher the materiality
level, the lower the audit risk and vice versa. The auditor takes the inverse relationship between materiality and
audit risk into account when determining the nature, timing and extent of audit procedures. For example, if, after
planning for specific audit procedures, the auditor determines that the acceptable materiality level is lower, audit
risk is increased. The auditor would compensate for this by either:

1. reducing the assessed level of control risk, where this is possible, and supporting the reduced level by
carrying out extended or additional tests of control; or
2. reducing detection risk by modifying the nature, timing, and extent of planned substantive procedures.

d. Business Risk

The auditor should obtain an understanding of the entity's objectives and strategies, and the related business
risks that may result in material misstatement of the financial statements. The entity conducts its business in the
context of industry, regulatory and other internal and external factors. To respond to these factors, the entity's
management or those charged with governance define objectives, which are the overall plans for the entity.
Strategies are the operational approaches by which management intends to achieve its objectives. Business
risks result from significant conditions, events, circumstances, actions or inactions that could adversely affect the
entity's ability to achieve its objectives and execute its strategies, or through the setting of inappropriate
objectives and strategies. Just as the external environment changes, the conduct of the entity's business is also
dynamic and the entity's strategies and objectives change over time.

Business risk is broader than the risk of material misstatement of the financial statements, though it includes the
latter. Business risk particularly may arise from change or complexity, though a failure to recognize the need for
change may also give rise to risk. Change may arise, for example, from the development of new products that
may fail; from an inadequate market, even if successfully developed; or from flaws that may result in liabilities
and reputational risk. An understanding of business risks increases the likelihood of identifying risks of material
misstatement. However, the auditor does not have a responsibility to identify or assess all business risks.

Most business risks will eventually have financial consequences and, therefore, an effect on the financial
statements. However, not all business risks give rise to risks of material misstatement. A business risk may have
an immediate consequence for the risk of misstatement for classes of transactions, account balances, and
disclosures at the assertion level or the financial statements as a whole. For example, the business risk arising
from a contracting customer base due to industry consolidation may increase the risk of misstatement associated
with the valuation of receivables. However, the same risk, particularly in combination with a contracting economy,
may also have a longer-term consequence, which the auditor considers when assessing the appropriateness of
the going concern assumption. The auditor's consideration of whether a business risk may result in material
misstatement is, therefore, made in light of the entity's circumstances. Examples of conditions and events that
may indicate risks of material misstatement are given in Appendix 3 of PSA 315.

4. Application of Analytical Procedures

Analytical Procedures

Analytical procedures may be helpful in identifying the existence of unusual transactions or events, and amounts,
ratios, and trends that might indicate matters that have financial statement and audit implications. In performing
analytical procedures as risk assessment procedures, the auditor develops expectations about plausible
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relationships that are reasonably expected to exist. When comparison of those expectations with recorded
amounts or ratios developed from recorded amounts yields unusual or unexpected relationships, the auditor
considers those results in identifying risks of material misstatement. However, when such analytical procedures
use data aggregated at a high level (which is often the situation), the results of those analytical procedures only
provide a broad initial indication about whether a material misstatement may exist. Accordingly, the auditor
considers the results of such analytical procedures along with other information gathered in identifying the risks
of material misstatement. See PSA 520, "Analytical Procedures" for additional guidance on the use of analytical
procedures.

Analytical procedures consist of evaluations of financial information made by a study of plausible relationships
among financial and non- financial data. They are used for the following purposes:

1. To assist the auditor in planning the nature, timing and extent of other auditing procedures
2. As a substantive test to obtain evidential matter about particular assertions related to account balances
or classes of transactions
3. As an overall review of the financial information in the final review stage of the audit

In addition, in some cases, analytical procedures can be more effective than tests of details for achieving
particular substantive testing objectives.

Analytical procedures involve the audit comparisons of recorded amounts, or ratios developed from recorded
amounts, to expectations developed by the auditor. The auditor develops such expectations by identifying and
using plausible relationships that are reasonably expected to exist based on the auditor's understanding of the
client and of the industry in which the client operates.

Examples of sources of information for developing expectations follow:

1. Financial information for comparable prior period(s) giving consideration to known changes.
2. Anticipated results - for example budgets or forecasts.
3. Relationships among elements of financial information within the period.
4. Information regarding the industry in which the client operates - for example, gross margin information.
5. Relationships of financial information with relevant non-financial information.

Analytical Procedures in Planning the Audit

The purpose of applying analytical procedures in planning the audit is to assist in planning the nature, time, and
extent of auditing procedures that will be used to obtain evidential matter for specific account balances or classes
of transactions. By identifying such things as the existence of unusual transactions and events, and amounts
ratios and trends, matters that have financial statement and audit planning ramifications might be brought to light.
Likewise, relevant non-financial information such as number of employees, area of selling space, volume of
goods produced may also contribute to the accomplishment of the purpose of the analytical procedures.

When used for planning purposes, analytical procedures assist the auditors in planning the nature, timing, extent
of audit procedures that will be used for the specific accounts. The approach used is one of obtaining an
understanding of the client's business and transactions, and identifying areas that may represent higher risks.
The auditors will then plan a more thorough investigation of these potential problem areas, and perform a more
effective audit. SAS 56 (AU 329), "Analytical Procedures," requires the auditors to perform analytical procedures
as a part of the planning process for every audit.

5. Coordination, Direction, Supervision, and Review

a. Establishment of an Engagement or Audit Team

An audit team consists of people with different levels of expertise and experience. The team usually is composed
of an engagement partner, a manager, at least one senior, and one or more staff auditors. In determining the
number of people who will be assigned to an engagement, an auditor normally considers the audit's size and
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complexity, the availability and experience of personnel, the necessity for special expertise, the opportunity to
train personnel, and the continuity and rotation of personnel. The audit team assembled for a larger engagement
typically is larger than that needed for a smaller engagement. An engagement involving an entity in a regulated
industry, such as banking, also requires that the major members of the audit team have necessary knowledge
and experience in that industry.

The members of the engagement team should discuss the susceptibility of the entity's financial statements to
material misstatements.

The objective of this discussion is for members of the engagement team to gain a better understanding of the
potential for material misstatements of the financial statements resulting from fraud or error in the specific areas
assigned to them, and to understand how the results of the audit procedures that they perform may affect other
aspects of the audit including the decisions about the nature, timing, and extent of further audit procedures.

The discussion provides an opportunity for more experienced engagement team members, including the
engagement partner, to share their insights based on their knowledge of the entity, and for the team members to
exchange information about the business risks2 to which the entity is subject and about how and where the
financial statements might be susceptible to material misstatement. As required by PSA 240, particular emphasis
is given to the susceptibility of the entity's financial statements to material misstatement due to fraud. The
discussion also addresses application of the applicable financial reporting framework to the entity's facts and
circumstances.

Professional judgment is used to determine which members of the engagement team are included in the
discussion, how and when it occurs, and the extent of the discussion. The key members of the engagement team
are ordinarily involved in the discussion; however, it is not necessary for all team members to have a
comprehensive knowledge of all aspects of the audit. The extent of the discussion is influenced by the roles,
experience, and information needs of the engagement team members. In a multi-location audit, for example,
there may be multiple discussions that involve the key members of the engagement team in each significant
location. Another factor to consider in planning the discussions is whether to include experts assigned to the
engagement team. For example, the auditor may determine that including a professional possessing specialist
information technology (IT) or other skills is needed on the engagement team and therefore includes that
individual in the discussion.

b. Consideration of Work Performed by Other Auditors/Parties

1. Predecessor Auditor

The successor auditor's examination may be greatly facilitated by consulting with the predecessor auditors and
reviewing the predecessor's working papers. Communication with the predecessor auditors can provide the
successor CPA with background information about the client, details about the client's system of internal control,
and evidence as to the account balances at the beginning of the year under audit.

Auditors are ethically prohibited from disclosing confidential information obtained in the course of an audit without
the consent of the client. The successor auditor should therefore obtain the client's consent before making
inquiries from the predecessor auditors.

If the auditor is unable to obtain cooperation from the preceding auditors, or if he feels that the work done by the
preceding auditors does not meet the requirements of generally accepted auditing standards, he may have to
treat the audit of the new client, previously audited by other accountants, just as he would the first audit of a
client who has never been audited before.

2. Other CPAs

When a portion of the client (e.g., subsidiary in a distant city) is audited by another CPA firm, efforts may be
coordinated. For example, if the accounts of the subsidiary are to be consolidated with the overall enterprise, and
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if that subsidiary is audited by another CPA firm, the auditors must coordinate timing of necessary reports and
procedures to be performed.

3. Specialists

CPAs may lack the qualifications necessary to perform certain technical tasks relating to the audit. A specialist
brings unique knowledge and judgment in a field other than accounting and auditing. An auditor might decide to
have an art appraiser place values on works of art, a mineralogist determine the physical characteristics of
mineral reserves, or an actuary provide data related to a group's life expectancy. Effective planning involves
arranging for the appropriate use of specialists both inside and outside of the client organization.

4. Use of Client's Staff

The auditors should obtain an understanding with the client as to the extent to which the client's staff, including
the internal auditors, can help prepare for the audit. The client's staff should have the accounting records up-to-
date when the auditors arrive. In addition, many audit working papers can be prepared for the auditors by the
client's staff, thus reducing the cost of the audit and freeing the auditors from routine work. The auditors may set
up the columnar headings for such working papers and give instructions to the client's staff as to the information
to be gathered. These working papers should bear the label Prepared by Client, or PBC, and also the initials of
the auditor who verifies the work performed by the client's staff. Working papers prepared by the client should
never be accepted at face value; such papers must be reviewed and tested by the auditors.

Among the tasks that may be assigned to the client's employees are the preparation of a trial balance of the
general ledger, preparation of an aged trial balance of accounts receivable, analyses of accounts receivable
written off, lists of property additions and retirements during the year, and analyses of various revenue and
expense accounts. Many of these "working papers" may be in the form of computer spreadsheets and other
computerized data files.

5. Internal Auditors

Internal auditors can affect the audit in two ways. First, they can enhance internal control. For example, if internal
auditors determined that bank reconciliations "were properly prepared and all cash receipts were deposited, the
entity's controls would enhance the reliability of the accounting records. In such cases, independent auditors
would be able to reduce the extent of substantive testing. In deciding whether to reduce the amount of testing for
specific assertions because of work performed by internal auditors, the independent auditor should consider (1)
the materiality of the amount, (2) the risk of misstatement, and (3) the degree of subjectivity involved in
evaluating the accumulated audit evidence. As these factors increase, the auditor is less likely to rely on the
internal auditor's work.

The second way internal auditors affect an audit is by assisting independent auditors in performing specific audit
procedures. For example, an internal auditor may observe client personnel taking the inventory.

6. Other Critical Matters in Engagement Planning

a. Assessment of Going Concern Assumption

Auditing standards require auditors to evaluate whether substantial doubt exists about an entity's ability to
continue as a going concern, based on procedures planned and performed to obtain evidence about the
management assertions embodied in the financial statements. That is, an auditor is not required to design
specific procedures to evaluate whether an entity is a going concern. But when information obtained during the
audit raises substantial doubt about the entity's ability to continue in operation for a year following the date of the
financial statements being audited, the auditor should add a paragraph calling attention to the fact that the
statements have been prepared assuming that the entity will continue as a going concern.
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b. Identification of Related Parties

Transactions with related parties are important to auditors because they will be disclosed in the financial
statements if they are material. Generally accepted accounting principles require disclosure of the nature of the
related party relationship; a description of transactions, including peso amounts; and amounts due from and to
related parties. Most auditors assess inherent risk as high for related parties and related party transactions, both
because of the accounting disclosure requirements and the lack of independence between the parties involved in
the transactions.

A related party is defined as an affiliated company, a 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. A related party transaction is any transaction between the client and a related party. Common examples
include sales or purchase transactions between a parent company and its subsidiary, exchanges of equipment
between two companies owned by the same person, and loans to officers. A less common example is the
exercise of significant management influence on an audit client by its most important customer.

Because material related party transactions must be disclosed, it is important that all related parties be identified
and included in the permanent files early in the engagement. Finding undisclosed related party transactions is
thereby enhanced. Common ways of identifying related parties include inquiry of management, review of SEC
filings, and examination of shareholders' listings to identify principal shareholders.

c. Client's Legal Obligations

Pertinent current-year information that auditors should review includes (1) minutes of directors' and shareholders'
meetings, (2) changes to articles of incorporation or bylaws, and (3) any significant contracts executed during the
year. By reading the minutes, an auditor will obtain information about significant events that have or will have an
impact on the client. For example, an auditor should be alert to the following:

 Major contracts or agreements, including merger and acquisition agreements, debt agreements,
compensation agreements, and asset purchase agreements
 Information about current situations and future business plans
 Authorization of dividends

For new clients for which historical information relating to these matters is unavailable, the auditor should review
information relating to prior years. For example, instead of reading only the changes to the articles of
incorporation and bylaws, the auditor should read the articles of incorporation and bylaws since the inception of
the entity, making appropriate summaries for the permanent file. The auditor should also read ail contracts
having an impact on the current year.

Planning the Audit Work

At the end of the planning phase, an auditor prepares the initial audit program, assigns personnel to the
engagement and schedules the work. To facilitate planning and controlling time, an auditor prepares a time
budget so that the time spent during the audit can be compared on a regular basis with that budgeted.

Complete the Initial Audit Program

Considering materiality, risk of misstatement, and the relative cost of performing audit procedures, auditors
determine the procedures to test the assertions embodied in the financial statements. The audit program is a list
of audit procedures to be performed so that the auditor will have evidence as a basis for expressing an opinion
on the financial statements. For example, an auditor might include the following two steps in the initial audit
program to test the existence of sales:

1. For a sample of entries in the sales journal, compare data in the sales journal to the approved customer
order, the sales order, the shipping document, and the sales invoice.
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2. Confirm a sample of accounts receivable at year-end.

Auditing standards require that a written audit program be prepared as a part of each engagement.

An audit program is a set of audit procedures specifically designed for each audit. The program which includes
both substantive tests and tests of controls will enable the auditor to express an opinion on the financial
statements taken as a whole.

On initial engagements, the audit program typically will develop in three stages:
(1) the broad phases of the program can be outlined at the time of engagement;
(2) other details of the program can be identified after the review of internal control structure and
accounting procedures has begun; and
(3) procedures on specific phases of the audit can be further challenged arid revised as the work
progresses.

On recurring engagements, the program for the preceding audit should be studied before preparing the program
for the current audit. The program for the current audit should reflect modifications or are required by the
experience gained in the business, internal control or accounting methods of the client.

PSA 300, "Planning" also provides the following as far as development of audit program is concerned.

In planning his examination, the auditor should consider the nature, extent, and timing of work to be performed
and should prepare a written audit program (or a set of written audit program). An audit program aids in
instructing assistants in the work to be done. It should set forth to reasonable detail the audit procedures that the
auditor believes are necessary to accomplish the objectives of the examination. The form of the audit program
and the extent of its detail will vary. In developing the program the auditor should be guided by the results of the
planning considerations and procedures. As the examination progresses, changed conditions or unexpected
results of audit procedures applied may make it necessary to modify planned audit procedures.

In preparing the audit program, the auditor, having to understanding of the accounting system and related
internal control, may wish to rely on certain controls in determining the nature, timing, and extent of required
auditing procedures. The auditor may conclude that relying on certain internal controls is an effective and
efficient way to conduct his audit. However, the auditor may decide not to rely on internal controls when there are
other more efficient ways of obtaining sufficient appropriate audit evidence. The auditor should also consider the
timing of the procedures, the coordination of any assistance expected from the client, the availability of
assistance, and the involvement of other auditors or experts.

The auditor normally has flexibility in deciding when to perform audit procedures, as very few of them have to be
carried out within specific time limits. For example, procedure carried out on transactions can be performed at
any time after the transactions have been recorded. On the other hand, the auditor may have no discretion as to
timing, for example, when observing the taking of inventories by client personnel.

Prepare a Time Budget

A time budget is an estimate of the total hours an audit is expected to take. It is based on the information
obtained in the first major step in the audit that is, obtaining an understanding of the client. It takes into
consideration such things as:

1. the client's size as indicated by its gross assets, sales, number of employees
2. location of client facilities
3. the anticipated accounting and auditing problems
4. the competence and experience of staff available.

The total time must be allocated by the preparation of work schedules indicating who is to do what and how long
it should take. Thus, total hours are budgeted by major categories and may be scheduled on a weekly basis.
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Time budget also serves as the basis for estimating fees. It is also an important tool to communicate to the audit
staff those areas the manager or partner believes are critical and require more time. Furthermore, a time budget
is used to measure the, efficiency of the staff and to determine at each stage of the engagement whether the
work is progressing at a satisfactory rate. An illustration of an Audit Budget and Time Summary is shown in
Figure 2.2.

Total Actual Weekly Hours

Budgeted (by date)
Hours
// // //
Total hours:
Partner
Manager
Senior
Staff
Hours by type of work:
General
Supervision
Preparation of audit program
Trial balances and adjusting entries
Permanent file
Financial statement comparisons
Transactions subsequent to year-end
Preparation of reports
Sales and collections cycle
Study and evaluation of internal control
Tests of control – sales
Substantive tests – sales
Tests of controls – collections

Figure 2.2 Portion of an Audit Budget and Time Summary

For repeat engagement, the development of time budgets is facilitated by reference to the preceding year's
detailed time records.

Managing time is an important consideration because billing is often based on the amount of time charged to the
engagement. Indeed, the most costly element of an engagement is the auditor's time. Time budgets can motivate
staff to perform efficiently, and one criterion by which audit personnel are evaluated is their ability to complete
assignments within the allotted time. (However, placing too much emphasis on time management can lower the
quality of the audit.)

A special concern in auditing has been the "underreporting of time." in which a staff member reports only a
fraction of the actual time spent performing a particular audit procedure. Some auditors take work home,
complete it in the evening, and do not charge that time. Staff members may feel that they will look bad if they
cannot complete a procedure within an allocated time, or they may want to impress their supervisor by finishing
(of appearing to finish) below budgeted time. However, such practices can create several problems, both for the
firm and for the following year's audit team. If the firm bases its charges on staff hours worked, underreporting
causes the firm to lose revenue to which it is entitled. Underreporting also creates an unrealistic basis for the
following year s time budget. In addition, if completing an assignment requires staff members to work additional
hours for which they are not compensated, they may experience burnout.

The development of time budgets is facilitated in repeat engagements by reference to the preceding year's
detailed time records. Sometimes time budgets prove quite unattainable because the client's records are not in
satisfactory condition, or because of other special circumstances that arise. Even when time estimates are
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exceeded, there can be no compromise with qualitative standards in the performance of the field work. The CPA
firm's professional reputation and its legal liability to clients and third parties do not permit any shortcutting or
omission of audit procedures to meet a predetermined time estimate.

Assign Personnel to the Engagement

Assigning the appropriate staff to the engagement is important to meet generally accepted auditing standards
and to promote audit efficiency.

Staff must, therefore, be assigned with that standard in mind. On larger engagements, there are likely to be one
or more partners and staff at several experience levels doing the audit. Specialists in such technical areas as
statistical sampling and computer auditing may also be assigned. On smaller audits there may be only one m two
staff members.

A major consideration affecting staffing is the need for continuity from year to year. An inexperienced staff
assistant is likely to become the most experienced nonpartner on the engagement within a few years. Continuity
helps the CPA firm maintain familiarity with the technical requirements and closer interpersonal relations with
client personnel.

Another consideration is that the persons assigned be familiar with the client's industry.

To illustrate the importance of assigning appropriate staff to engagements, consider a computer manufacturing
client with extensive inventory of computers and computer parts. Inherent risk for inventory has been assessed
as high. It is essential for the staff person doing the inventory portion of the audit to be experienced in auditing
inventory. In addition, he or she should have a good understanding of the computer manufacturing industry.

Schedule the Work

Audit work that can always be performed during the interim period includes the consideration of internal control,
issuance of management letter, and substantive tests of transactions that have occurred to the interim date.

Interim tests of certain financial statement balances, such as accounts receivable, may also be performed, but
this results in additional risk that must be controlled by the auditors. Significant errors or irregularities could arise
in these accounts during the remaining period between the time that the interim test was performed and the
balance sheet date. Thus, to rely on the interim test of a significant account balance, the auditors must perform
additional tots of the account during the remaining period.

Performing audit work during the interim period has numerous advantages in addition to facilitating the timely
release of the audited financial statements. The independent auditors may be able to assess internal control
more effectively by observing and testing controls at various times throughout the year. Also, they can give early
consideration to accounting problems. Another advantage is that interim auditing creates a more uniform work
load for CPA firms. With a large client, such as San Miguel Corporation, the auditors may have office space
within the client's buildings and perform auditing procedures throughout the entire year.

Performance of substantive tests of details of balances and other analytical procedures are scheduled near at,
and after year-end. Consideration should be given to such factors as:

1. Deadline for submitting final audit report and filing of income tax returns
2. Ability of the client's staff to submit required schedules
3. Other audit clients
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Posttest

1. Define the following terms:

a. audit risk
b. inherent risk
c. control [Link]
d. detection risk

2. How does audit planning assist in assessing inherent risk?

3. Name three sources of business and industry information.

4. What is the audit risk model?

a. How can an auditor use the audit risk model?

5. Describe the relationship between detection risk and evidence accumulation.

6. Analytical procedures consist of evaluations of financial information made by a study of plausible

relationships among both financial and nonfinancial data. They range from simple comparisons to the
use of complex models involving many relationships and elements of data. They involve comparisons of
recorded amounts, or ratios developed from recorded amounts, to expectations developed by the
auditors.

Required:
a. Describe the broad purpose of analytical procedures.
b. Identify the sources of information from which an auditor develops expectations.
c. Describe the factors that influence an auditor's consideration of the reliability of data for purposes of
achieving audit objectives.
(AICPA Adapted)
7. The following questions deal with materiality. Choose the best response.

A. Which one of the following statements is correct concerning the concept of materiality?
a. Materiality is determined by reference to guidelines established by the AICPA.
b. Materiality depends only on the peso amount of an item relative to other items in the financial
statements.
c. Materiality depends on the nature of an item rather than peso amount 1
d. Materiality is a matter of professional judgment.

B. The concept of materiality will be at least important to the CPA in determining the
a. scope of his audit of specific accounts.'
b. specific transactions that should be reviewed.*
c. effects of audit exceptions upon his opinion. *
d. effects of his direct financial interest in a client upon his independence.

8. The following questions concern materiality and risk. Choose the best response.

A. Edison Corporation has a few large accounts receivable that total PI.400, 000. Victor Corporation
has a great number of small accounts receivable that also total PI, 400,000. The importance of an
error in any one account is, therefore, greater for Edison than for Victor. This is an example of the
auditor's concept of:
a. materiality.
b. comparative analysis.
c. reasonable assurance.
d. relative risk.
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B. Which of the following elements ultimately determines the specific auditing procedures that are
necessary in the circumstances to afford a reasonable basis for an opinion?
a. Auditor judgment
b. Materiality
c. Relative risk
d. Reasonable assurance

C. Which of the following best describes the element of relative risk that underlies the application of
generally accepted auditing standards, particularly the standards of field work and reporting?
a. Cash audit work may have to be carried out in a more conclusive manner than inventoryaudit
work.
b. Intercompany transactions^^ usually subject to less detailed scrutiny than arm's-length
transactions with outside parties.
c. Inventories may require more attention on an engagement for a public utility.
d. The scope of the examination need not be expanded if errors that arouse suspicion of fraud
are of relatively insignificant amounts.

9. The following questions deal with materiality and risk, and their effect on audit reports. Choose the best
response.

A. A major customer of an audit client suffers a fire just prior to completion of year-end field work. The
audit client believes that this event could have a significant direct effect on the financial statements.
The auditor should:
a. advise management to disclose the event in notes to the financial statements.
b. disclose the event in the auditor's report.
c. withhold submission of the auditor's report until the extent of the direct effect on the financial
statements is known.
d. advise management to adjust the financial statements.

B. Late in December, Tech Products Company sold its marketable securities that had appreciated in
value and then repurchased them the same day. The sale and purchase transactions resulted in a
large gain. Without the gain the company would have reported a loss for the year. Which of the
following statements with respect to the auditor is correct?
a. If the sale and repurchase are disclosed, an unqualified opinion should be rendered.
b. The repurchase transaction is a sham and the auditor should insist upon a reversal or issue an
adverse opinion.
c. The auditor should withdraw from the engagement and refuse to be associated with the
company.
d. A disclaimer of opinion should be issued.

C. A material change in an accounting estimate

a. requires a consistency modification in the auditor's report and disclosure in the financial
statements.
b. requires a consistency modification in the auditor's report but does not require disclosure in the
financial statements.
c. affects comparability and may require disclosure in a note to the financial statements but does
not require a consistency modification in the auditor's report,
d. involves the acceptability of the generally acceptable accounting principles used.
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10. Below are an auditor's planned audit risk and assessment of inherent risk and control risk for five
situations.

Situation Planned Audit Assessed Assessed

Risk Inherent Risk Control Risk
1 1% 20% 20%
2 1 100 50
3 4 20 20
4 5 100 50
5 5 100 100

Required:
a. Determine the detection risk that can be allowed for each situation.
b. Rank the five situations, based on the amount of audit evidence that will be needed. You may
assume that all other factors that may affect audit evidence accumulation are the same.

11. Audit risk and materiality should be considered when planning and performing an audit in accordance
with GAAS. Both audit risk and materiality should also be considered in determining the nature, timing,
and extent of auditing procedures and in evaluating the results of those procedures.

Required:
A.
a. Define audit risk.
b. Describe is components of inherent risk, control risk, and detection risk.
c. Explain how these components are interrelated.

B.
a. Define materiality.
b. Discuss the factors affecting its determination.

12. Last year you were assigned to minor parts of the audit of the sales and collections cycle for Patrick
Corporation. This year you have been assigned significant responsibility in the audit of the sales and
collections cycle. You recall that last year, the credit manager, Josie Tan, treated you as if you were one
of the clerks. In fact, you had to call her "Ms. Tan" when you went to ask her several questions. This
year, she has become very friendly. Josie, as she now wants you to call her, has just invited you to join
her for dinner at a very exclusive private club in town. You were called away before you could give Josie
a reply, but she did indicate to you that last year she took your predecessor to such a dinner.

Required:
How do you respond to Josie?