Chapter 8

Planning the Audit

Acceptance of Clients:
The reputation of an accounting firm and its individual members for the performance
of quality work is an important source of new clients.

Quality work may be difficult for clients to recognize, but clients who are satisfied
that they have received high levels of professional services at reasonable prices are
important contributors to the development of professional reputation.

Competition for clients among CPA firms has intensified. So clients may now choose
the CPA firm that offers the lowest audit fee without considering other matters.

Factors affecting the level of Audit Fee:

a. Size of client (measured by total assets or revenues)

b. Proportion of assets in inventories and receivables
c. Type of audit report (qualified or unqualified)
d. Size of audit firm.

Audit Committee

The audit committee of the board of directors (BOD) is important in selecting auditors
and in maintaining auditor independence.

Members of the audit committee should be outside directors not officers or employees
of the company.

Duties of the audit committee often include:

1. Nominating the independent auditors.

2. Reviewing the plan for the audit and related services.
3. Reviewing the audit results and financial statements.
4. Overseeing the adequacy of the company’s internal control.

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Flowchart of the Planning Phase of the Audit:

• Evaluate and Accept the client

1

• Confirm Audit Arrangements (Engagement Letter)

2

• Assess Inherent Risk

3

• Estimate Reliance on Internal Control

4

• Establish Planning Materiality

5

• Identify Potential Problem Areas

6

• Perform Analytical Procedures

7

• Develop an Audit Strategy

8

• Prepare the Audit Program

9

• Schedule the Audit work

10

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Step 1: Evaluate and Accept the Client
Pre-acceptance Procedures Most Auditors are eager to obtain new clients, but:

a. They should prudent and follow Generally Accepted Auditing Standards

(GAAS) by investigating prospective clients before they are accepted.
 They should discuss the business reputation of a prospective client with
their acquaintances in the business community such as bankers and
attorneys.
 They use private detectives to investigate potential clients. Any
indication of improper conduct by a company or its officers should
cause the auditor to consider rejecting the company as a prospective
client
b. Auditors should determine whether they are qualified to perform each audit.
(auditors must be independent of their clients should they should terminate
any relationships or investments with the client if existed)
c. Auditors should consider whether their clients perceive a conflict of interest.
d. Auditors should determine if they have adequate staff to perform the work and
the expertise to deal with matters such as: specialized industry problems and
complex computer systems.

Continuation of Existing Clients:

The auditor’s evaluation for the client is not a one-time consideration. Clients should
be reevaluated each year to be sure that they continue to meet the accounting firm’s
standards.

Reasons to terminate the relationship with an existing client:

a. Actions that raise questions to the management integrity

b. Numerous disagreements over accounting and auditing matters
c. Slow payment or non-payment of fees.

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Step 2: Confirm Audit Arrangements:
Although not required by professional standards, an engagement letter should be
prepared for all audit engagements to confirm the CPA’s responsibility.

The engagement letters are normally addressed to the audit committee or BOD and
include:

a. A confirmation of the audit engagement for the current year

b. A statement of responsibility for detection of errors and fraud
c. Fee and billing arrangements
d. Other matters, if applicable such as preparation of income tax returns.

Most accounting firms base their bills to their clients on a per diem rate (daily rates).
These rates depend on the experience of the individuals working on the engagement
and the type of work being performed.

 Partners have the highest billing rates and new staff members have the
lowest.
 Work on registration statement requiring knowledge of the SEC rules
may be billed at higher rate than regular audit work.

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Step 3: Assess Inherent Risk
Inherent Risk: is the susceptibility of an account balance to misstatement.

Inherent risk exists at the financial statement level where the financial statements may
be more susceptible to misstatements under certain economic conditions, in certain
industries, or in certain entities.

a. Global Economic Risk

 Fluctuations in foreign exchange rates may increase the cost of a
client’s exports or decrease the cost of competitor’s imports.
 Restrictive international trade agreements may restrict or impose tariffs
on imports or exports.
 Political instability may jeopardize foreign markets.

b. National Economic Risk

 Inflation rates, interest rates and position of the economy in the business
cycle (growth or recession) will affect most clients.
 Changes in these factors will affect the planning of the audit

c. Industry Risk
Industry conditions often determine the environment in which a client
operates. Many risks are generated at the industry level such as:
 Stability of Operations; the more stable the operations the lower the risk
the auditor faces.
 Rate of Technological Change; the slower the rate of technological
change in the industry the lower the risk the auditor faces. While a high
rate technological change increase the risk because of potential
obsolescence of inventory, property and equipment and loss of market
share to competitors.

d. Entity Risk
Each entity has characteristics that affect the risk its financial statements may
be misstated
Characteristics controlled directly by management constitute the control
environment (part of the internal control)
Some characteristics cannot be controlled by management such as:
 Customer characteristics ( a few large customers or many moderate-
sized ones)
 Legal constraints
 Financial viability (Strong or weak financial position)

Generally, an entity with few customers, a contentious legal environment and weak
financial position is considered a high-risk client. The auditor responds to this risk by
assigning more experienced staff to the engagement and increasing the level of
supervision and review.
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Step 4: Anticipated Reliance on Internal Control
During the preliminary planning phase, auditors estimate the reliance they may place
on internal control. This permits them to plan the nature, timing and extent of
substantive tests.

Often auditors base their anticipated reliance on internal control on prior-year

findings.

If controls were found to be reliable and control risk was assessed at low level in the
prior year, the auditor would probably anticipate similar reliance on controls in the
current year. (The auditor still will have to confirm their understanding of internal
control and test it by visiting the client).

The greater the anticipated reliance on internal control (lower control risk), the less
substantive tests the auditor will plan to perform.

Step 5: Preliminary Judgment about Materiality

One commonly used approach is to compute materiality as a percentage of some
financial statement amounts such as income before taxes, revenues, net current assets.

How can the auditor determine income before tax for the year before year end?

 The auditor may obtain copies of interim financial statements (for the six months
of the year) and annualize them to use as a basis for determining year-end
amounts.
 In other situations, prior-year annual financial statements could be used.

The lower the materiality threshold (and tolerable misstatement), the more substantive
tests that must be planned.

Step 6: Potential Problem Areas

a. Probably the best indication of where errors may exist is where they existed in the
previous audit.
- Auditors can identify these potential problem areas by a review of the prior-year
audit working papers or, if the prior-year audit was performed by a predecessor
auditor, a review of that auditor’s working papers.
- The auditors then plan to spend additional time and effort in these areas.

b. Potential problem areas may be created when the client’s financial statements are
affected by a new Financial Accounting Standards Board (FASB) accounting
standard.
- Client personnel may be unaware of the new standard or may not understand its
application.

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- This could cause errors or omissions in the financial statements that the auditor
should anticipate.

c. Auditors should plan for difficult auditing situations. They may encounter
situations that require special knowledge of a non-accounting nature.
- In these instances, the auditor may plan to use specialists such as engineers,
geologists and attorneys. Those specialists preferably should not be related to the
client.
- Identification of areas requiring the use of a specialist and consideration of the
specialist’s qualifications are part of the planning process.

d. The type of the report to be issued may affect the extent of the auditor’s work.
- If a client company has several subsidiary companies, substantially more work
should be planned if the auditor is to report on the financial statements of each
subsidiary company individually rather than on the consolidated financial
statements. (materiality would be lower for the individual subsidiary companies
than for the consolidated ones)

Step 7: Perform Analytical Procedures

The auditor is required to use analytical procedures in the planning and final review
phases of all audits.

The purposes of performing analytical procedures in the planning phase are to:

a. Enhance the auditor’s understanding of the client’s business

b. Direct the auditor’s attention to balances and transactions that are unusual or
unexpected

Unusual or unexpected amounts suggest a higher risk of error, so the auditor will plan
to perform extended audit procedures on these amounts.

One form of analytical procedure is to compare current year amounts with those of the
prior year. (Ratio Analysis, Comparative Analysis)

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Step 8: Development of an Audit Strategy
The first step to develop the audit strategy is to form the audit team

An audit team is formed based on the Identified risk,

Size of the engagement

Personnel availability

The audit team generally consists of:

1. One or more staff auditors, often with 3 years experience or less, who perform
audit procedures as directed by a senior auditor.

2. A Senior or in-charge auditor with 2-6 years experience who performs

difficult audit procedures requiring more subjective judgments and who
supervises and reviews the daily work of the staff auditors. The senior auditor
may have special training or experience in the client’s industry.

3. A manager or a supervisor who may have 4-10 years experience. The manager
is responsible for arranging and requesting staff for each audit, reviewing the
audit work performed by the staff and senior auditor, and billing and
collecting the audit fee.

4. A partner with perhaps more than 10 years experience who has overall and
final responsibility for the audit. The partner reviews the audit work of the
staff, senior and manager, resolves audit problems with the client, and
approves the form of and signs the audit report.

An Engagement Team, composed of the audit team and tax and management
consulting personnel assigned to the client, meets to consider the preliminary planning
information and develop an audit strategy. This strategy identifies the primary risk
areas.

A determination then is made as to whether heavy reliance will be placed on internal

control (referred to as the “lower control risk approach”) or Substantive tests (referred
to as the “primarily substantive approach”)

The audit manager summarizes the results of this meeting in an audit planning
memorandum. This memorandum provides guidance to the audit senior in developing
the audit program.

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Step 9: Prepare Audit Program:
The most important control mechanism in an audit is the audit program.
It should be prepared in writing and outline all of the audit procedures considered
necessary for an auditor to express an opinion on the client’s financial statements.
An audit program that is properly prepared and used provides:
1. The program gives the partner, manager and other members of the audit team
an opportunity to review the proposed scope of the audit before the work is
performed, when there is still time to modify the proposed audit procedures.
2. Guidance to less experienced staff members as specific audit steps to be
performed by each staff person are indicated in the program.
3. Evidence of work performed. As each audit step is performed, the staff person
signs in a space beside that step on the program to indicate that it has been
completed.
4. A means of controlling the time spent on an audit. The audit program includes
the estimated time required to perform each audit step and a space in which
the actual time can be recorded.

The audit program is only a tentative (preliminary) program based on assumptions

about the client’s accounting procedures and controls. When the work begins, if
the conditions are not as anticipated, the auditor should revise the audit program
on the basis of conditions actually found.
The audit program consists of 4 major sections:
a. Account description: states briefly the nature of the items included in the accounts.
b. Evaluation of audit risk: summarizes important controls and includes evaluation of the
component risk.
c. Audit procedures: outlines the specific audit steps to be performed, who should perform
them, and an estimate of the required time.
d. Conclusion: represents the opinion of the staff as to whether the audit objectives have been
accomplished

When preparing the audit program, auditors make use of the audit risk model
AAR = IR*CR*PDR

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Step 10: Scheduling the audit work
The audit work can be segmented in various ways, one of which is to split the work
into the following phases:

Phase I – Planning

Phase II – Interim audit work

Phase III – Year-end audit work

Phase IV – Final audit work

Planning the First Time Audit

When an audit is performed for the first time for a client, additional audit procedures
must be planned. If the client has never been audited, the auditor must:

a. Determine if the entity is auditable. (all necessary financial records are

available)

b. Plan to perform audit procedures on asset and liability account balances of the
beginning of the year. This is necessary because errors in beginning balances
will cause errors in the ending balances of the balance sheet

c. Determine whether the accounting principles employed in the current year are
consistent with those employed in the prior year.

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