Summary of Last Week

Assurance
2015-16
Week 3

Todays Topics

Client acceptance
Audit planning procedures and business risk
Audit risk model
Materiality (possibly contd next week)
Ruhnke & Schmidt (2014) (possibly contd next
week)

Client Acceptance Procedures

1. Evaluate the clients background and reasons for

the audit.
2. Determine whether the auditor is able to meet
the ethical and competence requirements
regarding the client.
3. Determine need for other professionals.
4. Communicate with predecessor auditor.
5. Prepare client proposal.
6. Select staff to perform the audit.
7. Obtain an engagement letter.

The Auditor in the News

What are ethics?

Resolving ethical dilemmas
The importance of ethical conduct for the
audit profession
IESBA Code of Ethics
Independence

Audit Process Model

Phase I Client acceptance (today)

Phase II Audit planning (today & week 4)

Phase III Testing and evidence (week 4)
Phase IV Evaluation and reporting (week 5)

1. Evaluate the Clients Background and Reasons for the Audit

Sources of Information for Client Evaluation

Illustration 5.2

Client Acceptance
(Acceptance of and by the client)
Chapter 5

1. Evaluate the Clients Background and Reasons for the Audit

Evaluate Governance, IC, and Risks

Changes in management, organizational structure and activities of

the client
Current government regulations
Current business developments
Current or impending financial difficulties or accounting problems
Susceptibility of the entitys f/s to material misstatement due to
error or fraud (ISA 240 and ISA 315)
Existence of related parties (ISA 550)
New or closed premises and plant facilities
Recent or impending changes in technology, types of products or
services and production or distribution methods
Changes in the accounting system and the system of internal
control.

1. Evaluate the Clients Background and Reasons for the Audit

Three Major Influences on Engagement Continuance

Client Acceptance Procedures

1. Evaluate the clients background and

reasons for the audit.
2. Determine whether the auditor is able
to meet the ethical and competence
requirements regarding the client.
3. Determine need for other professionals.
4. Communicate with predecessor auditor.
5. Prepare client proposal.
6. Select staff to perform the audit.
7. Obtain an engagement letter.

2. Ethical and Competence Requirements

The audit team should meet ethics requirements

(also see previous week lecture).
Litigation with the client jeopardizes
independence.

Audit team must have a degree of technical

training and proficiency required in the
circumstances.
Partner rotation is generally required
(US every 5 years, EU every 7 years).

Illustration 5.3

2. Ethical and Competence Requirements

Specific Competencies

Review existing partner and staff competencies:

knowledge of relevant industries or subject matters;

experience with relevant regulatory or reporting requirements;
ability to complete the engagement within the reporting
deadline;
individuals meeting the criteria and eligibility requirements
to perform engagement quality control review are available.

Client Acceptance Procedures

1. Evaluate the clients background and reasons for

the audit.
2. Determine whether the auditor is able to meet
the ethical and competence requirements
regarding the client.
3. Determine need for other professionals.
4. Communicate with predecessor auditor.
5. Prepare client proposal.
Acceptance by
6. Select staff to perform the audit.
the client
7. Obtain an engagement letter.

Client Acceptance Procedures

1. Evaluate the clients background and reasons for

the audit.
2. Determine whether the auditor is able to meet
the ethical and competence requirements
regarding the client.
3. Determine need for other professionals.
4. Communicate with predecessor auditor.
5. Prepare client proposal.
6. Select staff to perform the audit.
7. Obtain an engagement letter.

Major Proposal Components

5. Prepare Client Proposal

How the audit firm can (continue to/further)

add value
Audit team
Audit approach
Detailed fee proposal
Issue of low balling

Client Acceptance Procedures

1. Evaluate the clients background and reasons for

the audit.
2. Determine whether the auditor is able to meet
the ethical and competence requirements
regarding the client.
3. Determine need for other professionals.
4. Communicate with predecessor auditor.
5. Prepare client proposal.
6. Select staff to perform the audit.
7. Obtain an engagement letter.

Client Acceptance Procedures

1. Evaluate the clients background and reasons for

the audit.
2. Determine whether the auditor is able to meet
the ethical and competence requirements
regarding the client.
3. Determine need for other professionals.
4. Communicate with predecessor auditor.
5. Prepare client proposal.
6. Select staff to perform the audit.
7. Obtain an engagement letter.

Audit Process Model

7. Obtain an Engagement Letter

Components

a. The objective of the audit

b. The responsibilities of the auditor
c. The responsibilities of management
d. The applicable financial reporting framework
e. Reference to the expected form and content of
any reports to be issued by the auditor and a
statement
that there may be circumstances in which a
report may differ from its expected form and
content.

Audit Planning: Overall Objective

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.

Inquiries of Management and

Personnel
- Objectives? (profit, investment,
product)
- Expectations? (customers,
suppliers, product, shareholders,
banks, government)
Business operations?
(market, locations);
Investments

Phase I Client acceptance

Phase II Audit planning

Phase III Testing and evidence
Phase IV Evaluation and judgment

Audit Planning
Chapter 6

Procedures to Understand the Entity

and Assess Risks (ISA 315.6)

Audit Planning: Procedures

1. Perform audit procedures to understand

the entity and its environment, including
the entitys internal control;
2. assess the risks of material
misstatements of the financial
statements;
3. determine materiality; and
4. prepare the planning memorandum and
audit program, containing the auditors
response to the identified risks.

Today

Inquiries of management and personnel

Analytical procedures
Observation and inspection

Next
week

(Preliminary) Analytical Procedures

Comparison of client ratios to prior year, industry

or competitor benchmarks to gain understanding
of companys performance

Preliminary tests can reveal unusual changes in ratios.

Purposes of preliminary analytical procedures:

Assess the entitys ability to continue as a going

concern.
Indicate the presence of possible misstatements in the
financial statements.
Reduce detailed audit tests.

Examples of Preliminary Analytical Procedures

Inspection and Observation

Observe core activities

Read management reports
View facilities
Inventory
Fixed assets
Employee work habits
Etc.

Understanding the Entity and its Environment

Understand clients
business and
industry
Assess client
business risk
Assess risk of
material
misstatements

Industry, regulatory and other

external factors
Nature of the entity

Objectives and strategies

Measurement and performance

Client business risk is the risk that the client will

fail to achieve its objectives.

1. Identify risks by developing an understanding of the company

environment, including relevant controls that relate to the risks.
2. Relate the identified risks to what could go wrong in managements
assertions about completeness, existence, valuation, occurrence and
measurement of transactions or assertions about rights, obligations,
presentation and disclosure.
3. Determine whether the risks are of a magnitude that could result in a
material misstatement of the financial statements.
4. Consider the likelihood that the risks will result in a material misstatement
of the financial statements and their impact on classes of transactions,
account balances and disclosures.

The Audit Risk Model

All this is finally related to the Audit Risk Model

Audit Risk Model

AR = (IR, ICR, DR)

AR

= Audit Risk

CR

= Control Risk

IR

DR

= Inherent Risk
= Detection Risk

RMM = Risk of Material Misstatement

Client Business Risks result from significant conditions,

events, circumstances or actions that could adversely
affect the entitys ability to achieve its objectives and
execute its strategies, e.g.,
Operations in regions that are economically unstable.
Operations exposed to volatile markets.
High degree of complex regulation.
Going concern and liquidity issues including loss of
significant customers.
Constraints on the availability of capital and credit.
Changes in the industry in which the entity operates.

Audit Risk Model

Understanding BR RMM

Four tasks:

Client Business Risk

Audit Risk

Audit risk is the risk that the auditor expresses

an inappropriate audit opinion when the
financial statements are materially misstated.
AR = (IR, CR, DR)

Major Purposes:

Help the auditor identify the potential for

misstatements where they are most likely to
occur.
Help the auditor determine the amount and type
of audit testing that needs to be performed.
Force the auditor to consider each of the
component risks in context and to document each
decision made.

Factors Affecting Assessed Audit Risk

The degree to which external users rely on the

statements.
The likelihood that a client will have financial
difficulties after the audit report is issued.
The auditors evaluation of managements
integrity.

Risk of Material Misstatement: Inherent Risk

Inherent risk is the susceptibility of an account

balance or class of transactions to
misstatements that could be material,
individually or when aggregated with
misstatements in other balances or classes,
assuming that there were no related internal
controls.

Factors Affecting Inherent Risk

Risk of Material Misstatement: Control Risk

AR = (IR, CR, DR)

Nature of the clients business

Results of previous audits
Related parties
Nonroutine transactions
Judgment required to correctly record account
balances and transactions
Makeup of the population
Factors related to fraudulent financial reporting
Factors related to misappropriation of assets

Detection Risk

Relationship between IR, CR and DR

Components of Audit Risk

Interrelationship of the Components

of Audit Risk

Significant Risk

Detection risk is the risk that an auditors

substantive procedures will not detect a
misstatement that exists in an account balance
or class of transactions that could be material,
individually or when aggregated with
misstatements in other balances or classes.

Control risk is the risk that a misstatement that

could occur in an account balance or class
of transactions and that could be material
individually or when aggregated with
misstatements in other balances or classes will
not be prevented or detected and corrected on a
timely basis by accounting and internal control
systems.
AR = (IR, CR, DR)

AR = (IR, CR, DR)

Illustration of Differing Evidence Among Cycles

A
B
C
D

Inventory and
warehousing
cycle

Payroll and
personnel
cycle

Inherent
risk

High

Low

High

Low

Audit risk

Low

Low

Detection risk

Low

High

Control
risk

Significant risk An identified and assessed risk

of material misstatement that in the auditors
judgment requires special audit consideration
Significant risks generally relate to judgmental
matters and significant non-routine transactions
like accounting estimates or revenue recognition
and for assumptions about the effects of future
events (e.g. fair value) than for ordinary
transactions.

Is a Risk is Significant?

Risk of fraud?
Likelihood of occurrence?
Related to recent significant economic, accounting or other
developments?
Complexity of transactions causing risk?
Involving significant transactions with related parties?
Degree of subjectivity in the measurement of financial
information related to the risk?
Involving significant transactions outside the normal course of
business for the entity?

Goal of Materiality

Determine the extent of audit procedures to

be performed.
Provide a threshold at which either the client
must adjust its financial statements or the
auditor will issue an opinion other than
unqualified.

What is Materiality? (ISA 320.2)

Materiality

Example: Apple

Net income after tax: 37 billion

10 million = 0,03% of net income
Far below materiality

Misstatements, including omissions, are

considered to be material if they, individually or
in the aggregate, could reasonably be expected to
influence the economic decisions of users taken
on the basis of the financial statements.
Judgments about materiality are made in light of
surrounding circumstances, and are affected by
the size or nature of a misstatement, or a
combination of both.

Factors Affecting Judgement About

Materiality

Materiality is a relative rather than an

absolute concept.
Bases are needed for evaluating materiality.

But what if misstatement arose due to fraud?

Is $ 10 million material?

Some Quantitative Bases of Materiality

(Size)
Apple Inc.
$2.5-5 billion

$3.7-7.3 billion
$4.2-8.3 billion
$1-4.1 billion

$0.8-3.4 billion

But: Standards say you should not rely on

quantitative considerations alone!

$1.2-6 billion

Qualitative Factors (Nature)

Qualitative factors also affect materiality.

Important to understand clients business!

Quantitative amounts may be adjusted lower

for qualitative factors, such as
Close to violating loan covenants
Changing trend
Meeting earnings forecasts
Indicative of fraud
Complex accounting rules

Guidelines in Determining Materiality

Accounting and auditing standards do not
provide specific materiality guidelines to
practitioners.
Professional judgment is to be used at all
times in setting and applying materiality
guidelines.

The Relationship between Materiality,

Audit Risk and Audit Evidence (ISA 320)

There is an inverse relationship between materiality

and the level of audit risk.
E.g., 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 increasing
the amount of audit testing, more specifically, either:

Reducing the assessed risk of material misstatement,

where this is possible, and supporting the reduced level by
carrying out extended or additional tests of control; or
Reducing detection risk by modifying the nature, timing
and extent of planned substantive procedures.
(Ruhnke & Schmidt, 2014)

Dependent Variable: Audit Adjustments

Independent Variables: Risk Factors

Inherent risk factors:

management
competence and
integrity (QUALITY)
clients economic
position (LOSS;
ALTMANZ)
management
incentives
(REMUNERATION)

Number of audit adjustments

Magnitude of audit adjustments, scaled by the
client-specific planning materiality

(Ruhnke & Schmidt, 2014)

Main Results (Models 4-5)

(Ruhnke & Schmidt, 2014)

Control risk factors:

controls conducted by
management (ELC)
controls by internal
audit (INTAUDIT)
overall ICS assessment
by auditor (ICS)
presence of an audit
committee
(AUDCOMM)

(Ruhnke & Schmidt, 2014)

Summary of Todays Lecture

Client acceptance
Audit planning procedures and business risk
Audit risk model
Materiality
Ruhnke & Schmidt (2014)

Main Results (Models 1-3)

(Ruhnke & Schmidt, 2014)

Next Week

Internal control and control risk

Auditors response to risk
Tests of controls
Substantive procedures

Audit evidence
Trompeter & Wright (2010)

Thanks for your attention!

Questions?