Audit planning - Steps and Strategy

Sources of knowledge

Following are important sources which provide background knowledg

External client:

• Directors/senior personal
• Internal audit financial
• Visit to premises
• Minutes of meetings
• Documents sent to shareholders and authorities
• Financial budgets
• Management reports
• Charts of accounts
• Job organization ad descriptions

Auditor:

• Predecessor auditors
• Legal advisor
• Industry regulations
• Chamber of commerce
• Govt. data
• Customers
• Bankers
• Suppliers
• Competitors
• Trade journals
• Financial press

Use of knowledge

• To develop overall plan and audit programme
• To assess component of risk
• To determine materiality levels
• To evaluate audit evidence
• To identify related parties and transactions
• To recognize conflicting and unusual circumstances
• To appraise appropriateness and effectiveness to accounting policies
• To provide better service to client

Nature of information

• General economic factors
• Recession / growth
• Interest rates
• Inflation
• Fiscal policy
• Monitory policies
• Foreign currency
• Devaluation / evaluation
• The industry
• Market
• Technology
• Key ratios
• Specific accounting ratios
• Environmental requirements

General economic factors

• Recession / growth
• Interest rates
• Inflation
• Fiscal policy
• Monitory policies
• Foreign currency
• Devaluation / evaluation

Management and ownership

• Corporate structure
• Owners and related parties
• Capital structure
• Organization structure
• Strategic plan
• Operating management
• Audit committee

Business

• Nature of business
• Locations
• Products / services / markets
• Suppliers
• Investors
• Information systems
• Debt structure
• Financial performance

Key ratios

• Trends
• Accounting policies
• Leasing commitments
• Off balance sheet finance

Reporting environment

• Legislation
• Taxation
• Securities
• Users of financial statements

Definition:

The material (working papers) prepared by and for (or obtained and retained by) the auditor relating to the conduct of the audit.

In the form of data stored on paper, film, electronic or other media matters, which are important in providing evidence, must be documented.

To support the audit opinion

To demonstrate that the audit was performed in accordance with ISAs.

Audit Working Papers

assist in the planning and performance of the audit (e.g. in providing information)

facilitate the supervision and review of audit work (e.g. in giving instructors to assistants)

Matters To Consider

Nature of the engagement e.g.

• Private or public sector; and
• Other services undertaken (e.g. taxation, systems advice)

From the auditor’s report (e.g. standardized, “short-form” report in which there is “modified” opinion)

Nature and complexity of the organization and its accounting and internal control systems (e.g. the extent of computerization)

Specific audit methodology (e.g. a risk-based approach) and technology (e.g. computer-assisted audit techniques) used in the course of the audit

Standardization

Extent of schedules, analyses and other documentation prepared by the entity

Needs of direction, supervision and review of tasks assigned to assistants.

STANDARDIZATION

It is common practice for audit firms to use standard pre-printed documentation on audit engagement. For example:

Audit completion, disclosure and other checklists

Internal control questionnaires

Audit programs

Specimen letters – e.g. management representation letters

Documentation Techniques

Narrative notes

Flowcharts

Questionnaires

Checklist

1. Narrative notes – written descriptions require little formal training and are best suited to small, simple systems descriptions or to explain peripheral aspects of larger systems not dealt with by other techniques (e.g. the issue of credit notes)
2. Flowcharts – visual descriptions highlight controls and are easy to understand by a trained use. However, different audit firms and their clients use different types (e.g. documentation flowcharts, information flowcharts and overview flowcharts).

1. questionnaires – internal control questionnaires (ICQs) are designed to indicate which parts of a system are strong or weak and so make a preliminary assessment o the extent to which the auditor seeks to place reliance (if any) on internal controls.

Factors To Consider

The form and extent of this documentation is influenced by such factors as:

Size and complexity of entity

Nature of accounting and internal control systems (e.g. manual or electronic)

Auditors intended reliance on internal controls

Whether prepared by client (e.g. internal audit department) or external auditor

Ease of preparation and / or updating

CONFIDENTIA LITY, SAFE CUSTODY, RETENTATION AND OWNERSHIP

Auditors should maintain the confidentiality and safe custody of working papers.

Confidentiality And Safe Custody

Practical procedures include locked fireproof cabinets or rooms and the use of physical keys and logical passwords.

Electronic documentation may be particularly susceptible to corruption or loss and should be backed up.

Considerations not in the ISA

Legal requirements e.g. accounting records must be maintained for 3 years for private companies and 6 years for other companies in the UK.

General position in law governing the period of time in which actions may be brought in a court of law e.g. 6 years for actions based on contract in the UK.

Requirements for compiling tax returns e.g. assessments may be made 6 years after the period to which they relate.

Likelihood of seeking quotation on a recognized stock exchange – previous 6 years are required to be reported on in UK.

Minimum Period

Audit working papers – 7 years

Recommended by ACCA

Tax files – 7 years and then returned to client (or former client)

Ownership

Working papers are the property of the auditor and clients have no rights to demand access

General Principles

Portions of or extracts from working papers may be made available to the entity at the discretion of the auditor

All documents relating to clients are confidential

A client may require auditor to disclose documents, which belong to the client (only) to a third party.

Standardization Of Documents

Advantages

Disadvantages

Preparation and review is more efficient when audit files and sections and documents within them are presented in systematic manner

A “mechanical” approach may lead to a lack of appreciation of test objectives and the implications of errors and deviations founds

Helps to familiarize junior staff with standard procedure (e.g. attending physical inventory counting and requesting direct confirmations from customers).

Adopting a “standard approach” may stifle initiative and discourage the exercise of professional judgement

Similarly, it facilitates

Standard programs may result in a “bare minimum” attitude.

It provides a means of quality control by requiring a consistent approach to all audits and ensuring that essential procedures not overlooked.

It may be inappropriate to follow set procedures for a particular client (e.g. one with subscription income rather that sales revenue)

CONTENTS FO WORKING PAPERS

Permanent Audit File

Information concerning legal structure of entity (e.g. memorandum and articles of association)

Other documents of continuing importance

• Terms of engagement
• Minutes of important meetings
• Debenture deeds
• Mortgage and charges
• Title deeds and lease agreements
• Agreements and labor contracts
• Profit share and bonus agreements
• Royal agreements

Descriptions of nature and history of client’s business, locations and products

A list of client’s investments (if any)

Organization charts, with extra details for finance department

Main accounting records, showing where kept and of what type (e.g. handwritten, computerized)

Copies of previous financial statements and auditor’s reports thereon

Previous reports to management (detailing weaknesses found in the accounting system)

Client’s other professional adviser

Client’s insurance covers details

Significant ratios and trends

Accounting systems descriptions in flow chart and narrative from

Internal controls evaluation data: questionnaires and checklists

Principals accounting policies.

Current Audit Files

Financial statements being audited (evidenced as having been agreed to accounting records and cross-referenced to supporting schedules)

Overall audit plan (including risk assessments and planning materiality) and audit program

Schedule for each balance sheet item (including comparatives), cross-referenced to documents arising from external verification (e.g. of existence and valuation). For example, confirmation of accounts receivable and attendance at physical inventory counting).

Copies of communications with other auditors, experts, and other third parties

Schedule supporting each significant item in the income statement

Checklist of compliance with statutory and IAS disclosure provision

A record of queries raised during the audit and their clearance, with notes for next year

Schedule of queries not cleared for the manager / partner reviewing the audit

Extracts of minutes of meetings of directors and shareholders (cross-referenced where relevant)

Report of management of material weaknesses in internal controls including client response

Letter of representation received from management

Job administration data

• Partner and staff employed
• Dates audit areas completed time summaries
• Time summaries
• Performance monitored against budget

Working papers of results of tests, evaluation of systems, control weakness and action taken

Schedule of results of audit tests on transactions and balances and conclusions reached (indexed and cross-referred to demonstrate sufficient and evidence)

Completed audit program

Accounts completion checklist.

Risk Assessment

Entity risk assessment is different from auditor’s risk assessment

Entity

The purpose of entity risk assessment is to identify, analysis (priorities) and manage risks that effect entity objectives

Auditor

The purpose of auditor’s risk assessment is to evaluate the likelihood that material misstatement could occur in financial statements

Inherent Risk Assessment

Inherent risk is risk that items will be misstated due to characteristics of those items such as that they are estimates or complex accounts.

Auditor must use their professional judgement to assess inherent risk at two level

1. at the financial statements level
2. at the account balance and class of transaction level

At Financial Statement Level

In developing the overall audit plan the auditor should assess inherent risk at financial statement level. The relevant factors to be considered are

Factors Affecting Client as Whole

FACTORS

EXAMPLES

Directors attitude to risk

Domination of decisions by one person

Industry factors

Declining industry causing going concern problems, rapid changes in consumer demand

Management experience and knowledge

High management turnover, poor reputation of management

Unusual pressure on management

Tight reporting deadlines, undue emphasis on meeting earning projection

Nature of business

High sensitivity to economic factors (inflation, interest rate etc)

At Account Balance And Class Of Transaction Level

In developing audit programme auditor should assess inherent risk at account balance and class of transaction level.

Factors Affecting Individual Accounts Balance Or Transaction

FACTORS

EXAMPLES

Related party transactions

Transactions involving director’s interest

Unusual transaction

Year end transactions or transaction involving high accounts

Accounts prone to misstatement

Provisions and prior period

Complex items

Expert valuations

Competence personnel

Unqualified and untrained staff

Assets desirability

Movable assets such as cash, laptops.

Control Risk Assessment

Control risk is the risk of material misstatement not being prevented or detected by internal controls control risk should be assessed in terms of financial statement assertions.

Presentation and disclosure

Existence or occurrence

Rights and obligations

Completeness

Valuation

Detection Risk

Detection risk is risk that material misstatements not being detected by auditor’s substantive procedures.

The auditor’s inherent and controls risk assessment influences the nature timing and extent of substantive procedures required to reduce detection risk and thereby audit risk. In this regard auditor would consider modification in;

Nature - Change from less effective to more effective t4ests (i.e. direct third party confirmation rather then internal evidence)

Timing - Less reliance on interim testing

Extent – Larger sample size

Inter Relationship Of Components Of Audit Risk

There is an inverse relationship between combined levels of inherent and control risk and detection risk, following table shows how acceptable level of detection risk may vary based on combined assessment of inherent and control risk.

Control Risk Assessment

Inherent risk assessment

Analytical Procedures

Consist of analysis of significant ratios and trends including the resulting investigations of fluctuation and relationships that are inconsistent with often relevant information or which deviate from predictable amounts

Purpose

Analytical procedures used for 3 purposes

1. Planning nature timing and extent of other auditing procedures

2. substantive test about particular assertions

3. overall view in the finance stage of audit

Nature

The ISA states that analytical procedure include consideration of;

a) Comparison with prior period comparable financial information and anticipated results such and budgets forecasts industry information

b) Relation between

- Elements of financial information such as gross profit to sales

- Financial and relevant non-financial information such as payroll to no. of employees

Stage

Auditor should apply analytical procedures at

Planning stage

Substantive tests stage

Overall review stages

Planning Purpose

To assist auditor to

Understand the business and events since last audit.

Identify areas of potential risk

Determine timing nature and extent of other audit procedures.

Possible sources of information about client include

Interim financial statements

Management accounts

Tax returns (sales, income)

Board minutes

Discussions with client at year end

Substantive Test Purpose

To assist auditor to

Obtain corroborative evidence

Test details of transactions

Detect material misstatements in financial statements

Reduce detections risk for financial statements assertions.

Factors

When intending to perform analytical procedures as substantive procedures auditor should consider following factors

FACTORS

EXAMPLE

Comparability

Financial information is comparable when accounting policies are consistent in comparable periods

Objective

Normally to obtain corroborative evidence

Desegregation of information

Breakup of administrative expenses appearing in P & L accounts to get more accurate picture for investigations of unusual fluctuations.

Source of information

Independent sources are more reliable than internal sources

Availability of information

Auditor should have unrestricted access to all relevant information

Relevance of information

Marketing expenses and sales, wages and laborers

Reliability of information

Whether budgets are prepared with due care and skill and are realistic

Knowledge gained during previous audit

Adjustment in prior periods

Significant changes in structure culture and resources.

Extent Of Reliances

The extent of reliance that the auditor place on the results of analytical procedures depends on following factors.

FACTORS

EXAMPLE

Materiality of items

When inventory balances are material does not rely only on analytical procedures

Assessment of inherent and control risk

If it is high, place more reliance on test of details of transactions than on analytical procedures

Other audit procedures

To confirm accounts receivable review subsequent cash receipts

Consistency and accuracy of results

Auditor expect greater consistency in comparing margins than from one period to another than in comparing discretionary expenses such as research and development.

Overall Review Purpose

Is to assist auditor to

Assess the conclusions reached

Highlight areas, which require further investigations

Ensure that financial statements as a whole are consistent with auditors knowledge

Consider in formations necessary for assisting in the planning of subsequent audit

Investigations

When analytical procedures identify

Significant fluctuations

Relationship that are inconsistent with often

Deviation from predicted results.

Auditor should investigate and obtain adequate explanations and appropriate corroborative evidence by

Inquiries of management

Corroborations of management response by comparing them with auditor’s knowledge and other evidence obtained during audit. If explanations can not be given by management or if they are insufficient the auditor must determine which further audit procedures to undertake such as modification of report.

Practical Techniques

Analytical techniques may be

Ratio analysis

Examination of accounts

Trend analysis

Bar graph, Pi chart

Time service analysis

Visual presentations

Reasonableness test e.g. Depreciation = (cost + additions – disposal) x ratio of depreciation

Working Papers

Working papers must contain the completed result of analytical procedures.

They should include:

Summary of comparisons

Summary of significant figures

Details of significant fluctuations

Details of results of investigations

Audit conclusions reached

Information considered necessary for planning subsequent audit

Important Ratio

GP margins

In total

By product

By segments

By months/quantity (if possible)

Expense ratio to sales

Receivable ratios and collection periods

Inventory turnover

Current ratio

Quick ratio

Gearing ratio

Return on capital

Related Items

Payable and purchases

Goods and costs of sales

Assets and depreciation and amortizations

Investment and investment income

Receivable and bad debts

Area Of Investigation

Significant changes during the period

Structure

Culture

Resources