Audit planning procedures include understanding internal control, assess the risks of material misstatements of financial statement and determine materiality.
Accepting a Client and Performing Initial Audit Planning
Understand the Client’s Business and Industry
The objective of the auditor is to plan the audit so that it will be performed in an effective manner. The auditor shall establish an overall audit strategy that sets the scope, timing and direction of the audit, and that guides the development of the audit plan. The objective of planning is to determine the amount and type of evidence and review required to give the auditor assurance that there is no material misstatement of the financial statements. The planning procedures are:
■ perform audit procedures to understand the entity and its environment,including the entity’s internal control; ■ assess the risks of material misstatements of the financial statements; ■ determine materiality; ■ prepare the planning memorandum and audit program, containing the auditor’s response to the identified risks.
This chapter has covered the first three steps in the planning process, with the exception of the internal control considerations.
ISA 315 provides an overview of the procedures that the auditor should follow in order to obtain an understanding sufficient to assess the risks and consider these risks in designing the audit plans. The risk assessment procedures should, at a minimum, be a combination of the following: inquiries of management, analytical procedures, and observation and inspection. In addition to these procedures, the auditor might consider obtaining information from others sources, for example, the entity’s external legal counsel, or externally available data sources, including analysts’ reports, industry journals, government statistics, surveys, texts, financial newspapers, etc. ISA 315 also requires an audit team-wide discussion of the susceptibility of the financial statements to material misstatement. If the client is a continuing one, prior year’s working papers are reviewed and reliance can be placed on the observations from prior periods.
In the client acceptance phase (Phase I of the audit process model), the auditors review material that is readily available about the entity and the entity’s environment (annual reports, public news, and public information databases). However, in the planning phase the auditor’s understanding of the entity and its environment should grow significantly.
As ISA 3152 points out, this understanding is an essential aspect of carrying out an ISA audit. It establishes a frame of reference within which the auditor plans the audit and exercises professional judgement about assessing risks of material misstatement of the financial statements and responding to those risks. ■ procedures to obtain an understanding ISA 315 provides an overview of the procedures that the auditor should follow in order to obtain an understanding sufficient to assess the risks and consider these risks in design- ing the audit plans. The risk assessment procedures should, at a minimum, be a combination of the following:3 ■ Inquiries of management and others within the entity.It is important to have discussions with the client’s management about their objectives and expectations, and plans for achieving these goals.
The discussions may encompass short-term management objectives such as increasing profit, reducing investment in working capital, introducing new product lines, reducing taxes, or reducing selling and distribution expenses. Expectations should be explored concerning the company’s external agents such as customers, suppliers, shareholders, financial institutions, government, etc. However, although management will typically be the most effective and efficient information source, it might be worthwhile to obtain information from others, in order to reduce the potential for bias.
Analyticalprocedures.Thesemayhelptheauditorinidentifyingunusualtransactions or positions. Analytical procedures usually involve a comparison of company results to that of the industry. There are publications of major industry ratios and trends that might be helpful to the auditor doing analytical procedures.
Observation and inspection.
These procedures may cover a broad area,ranging from the observation of an entity’s core activities, the reading of management reports or internal control manuals to the inspection of documents. A visit to, and tour of, the company premises will help the auditor develop a better understanding of the client’s business and operations. Viewing the facilities helps to identify some internal control safeguards. Seeing the production process will help in assessing the inventory movement and the use of fixed assets. Observations of the orderliness, cleanliness, and physical layout of facilities and of the employees’ routine functions and work habits can often tell the auditor more about the client than can be learnt from studying the accounting records.
Knowledge of the physical facilities and plant layout may point to the right questions to ask during the planning phase, or getting the right answers to questions later in the audit. Knowing the layout will assist in planning how many audit staff members will be needed to participate in observing the physical inventory. On the site visit one may see signs of potential problems. Rust on equipment may indicate that plant assets have been idle. Excessive dust on raw materials or finished goods may indi- cate a problem of obsolescence. The auditors can see the physical extent of segregation of duties within the client organisation by observing the number of office employees.
Other information sources
In addition to these procedures, the auditor might consider obtaining information from others sources, for example, the entity’s external legal counsel, or externally available data sources, including analysts’ reports, industry journals, government statistics, surveys, texts, financial newspapers, etc. Professional organisations like the American Institute of Certified Public Accountants (AICPA) distribute industry audit guides and most indus- tries have trade magazines and books describing their business. Most large audit firms also have industry groups following the developments in those industries and creating newsletters on industry-specific items.
Audit team discussion:
Finally, ISA 315 requires a team-wide discussion of the susceptibility of the financial statements to material misstatement.4 An important reason for this requirement is the consideration that the team members collectively have a broader access to people within the organisation and their insights. As they say, the most interesting information may typically be obtained in elevators and on the car park, and, again, there might be a better balance in the team’s insights if the perspectives on the entity are not just confined to those conveyed by top management.
If the client is a continuing one, prior year’s working papers are reviewed and reliance can be placed on the observations from prior periods. The client’s permanent audit file frequently contains information on company history and records of most impor- tant accounting policies in previous years. However, before relying on existing working papers, the auditor needs to make sure that there have been no significant changes in the relevant aspects of the client’s entity or environment.
Understanding the entity and its environment:
ISA 315 distinguishes the following relevant aspects in the understanding of the entity
and its environment:
■ industry, regulatory and other external factors, including the applicable financial reporting framework;
■ nature of the entity, including the entity’s selection and application of accounting policies;
■ the entity’s selection and application of accounting policies, including the reasons for changes the appropriateness for its business and consistency with the applicable finan- cial reporting framework.
■ objectives and strategies, and the related business risks that may result in a material misstatement of the financial statements;
■ measurement and review of the entity’s financial performance.