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AUDITING THEORY Handout #4: Overview of the Financial Statement Audit Process & Pre-Engagement Activities and Procedures

INTRODUCTION

An audit of financial statements generally begins with the financial statements prepared by an entity’s management. Without these financial statements, there would be no audit to perform.

PSAs do not impose responsibilities on management or those charged with governance and do not override laws and regulations that govern their responsibilities. However, an audit in accordance with PSAs is conducted on the premise that management and, where appropriate, those charged with governance have responsibilities that are fundamental to the conduct of the audit.

The audit of the financial statements does not relieve management or those charged with governance of those responsibilities.

OVERVIEW OF THE AUDIT PROCESS The audit process generally includes the following phases:

1. Pre-engagement

Carrying out initial audit activities such as:

Client acceptance and continuance, and

Agreement on the terms of engagement

2. Audit planning

In this phase, the auditor obtains more detailed knowledge about the client’s business and industry in order to understand the transactions and events affecting the financial statements, and to identify potential problems that might be encountered during the audit.

This phase involves the following:

(a)

Obtaining an understanding of the client and its environment;

(b)

Determining the need for experts;

(c)

Establishing materiality and audit risk;

(d)

Assessing the possibility of noncompliance;

(e)

Identifying related parties;

(f)

Performing analytical procedures, and

(g)

The development of the overall audit strategy, detailed audit plan, and preliminary audit programs.

3. Study and evaluation of internal controls

Involves documenting and evaluating the auditor’s understanding of the internal control structure of the client.

The auditor is required to obtain an understanding of the client’s internal control structure. The following steps are

performed in the study and evaluation of internal controls:

(1)

Obtain and document an understanding of internal control.

(2)

Make a preliminary assessment of control risk.

(3)

Determine the auditor’s response to the risk assessment.

(4)

Reassess control risk

(5)

Determine the nature, extent and timing of substantive tests.

4. Substantive testing

Gathering of evidence regarding management’s assertions by performing substantive audit procedures.

Substantive tests are procedures used to detect material misstatements in account balances, classes of transactions and disclosures.

5. Completing the audit

Wrapping-up procedures and review of audit conclusions prior to issuance of the audit report.

This phase involves performing the following:

(1)

Performs final analytical procedures,

(2)

Read minutes of recent board and committee meetings,

(3)

Obtains management representation letters,

(4)

Makes final materiality judgments,

(5)

Summarizes and evaluates the audit findings,

(6)

Reviews the working papers,

(7)

Reviews the financial statement presentation and disclosures for adequacy, and

(8)

Considers subsequent events.

These procedures require the exercise of considerable professional judgement and are generally performed by senior members of the engagement team.

At this stage, the auditor communicates the updated list of findings to management and to those charged with governance.

6. Issuance of the audit report

Preparation and issuance of audit report.

BRIAN CHRISTIAN S. VILLALUZ, CPA LEarning ADvancement Review Center (LEAD) CPA Reviewer in Advanced Financial Accounting & Reporting (AFAR) CPA Reviewer in Financial Accounting & Reporting (FAR)

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PRE-ENGAGEMENT ACTIVITIES AND PROCEDURES The objective of the auditor is to accept or continue an audit engagement only when the basis upon which it is to be performed has been agreed, through:

(a)

Establishing whether the preconditions for an audit are present; and

(b)

Confirming that there is a common understanding between the auditor and management and, where appropriate, those charged with governance of the terms of the audit engagement.

Preconditions for an Audit

In order to establish whether the preconditions for an audit are present, the auditor shall:

(a)

Determine whether the financial reporting framework to be applied in the preparation of the financial statements is

acceptable; and

(b)

Obtain the agreement of management that it acknowledges and understands its responsibility:

(i)

For the preparation of the financial statements in accordance with the applicable financial reporting framework,

including where relevant their fair presentation;

(ii)

For such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error; and

(iii)

To provide the auditor with:

a. Access to all information of which management is aware that is relevant to the preparation of the financial statements such as records, documentation and other matters;

b. Additional information that the auditor may request from management for the purpose of the audit; and

c. Unrestricted access to persons within the entity from whom the auditor determines it necessary to obtain audit evidence.

Limitation on Scope Prior to Audit Engagement Acceptance

If management or those charged with governance impose a limitation on the scope of the auditor’s work in the terms of a proposed audit engagement such that the auditor believes the limitation will result in the auditor disclaiming an opinion on the financial statements, the auditor shall not accept such a limited engagement as an audit engagement, unless required by law or regulation to do so.

Other Factors Affecting Audit Engagement Acceptance

If the preconditions for an audit are not present, the auditor shall discuss the matter with management. Unless required by law or regulation to do so, the auditor shall not accept the proposed audit engagement if the auditor has determined that the financial reporting framework to be applied in the preparation of the financial statements is unacceptable.

A firm shall have a system for deciding whether to accept or reject an audit engagement. In making this decision the firm should consider:

(1)

Its competence;

(2)

Its independence;

(3)

Its ability to serve the client properly, and

(4)

The integrity of the prospective client’s management

Competence

One of the primary considerations before accepting an audit engagement is to determine whether the auditor has the necessary skills and competence to handle the audit engagement.

Competence is acquired through a combination of education, training and experience.

Before accepting an audit engagement, the auditor should obtain a preliminary knowledge of the client’s business and industry to determine whether the auditor has the degree of competence required by the engagement or whether such competence can be obtained before the completion of the audit.

Independence

Essential to the credibility of the auditor’s report is the concept of independence.

Before accepting an audit engagement, the auditor should consider whether there are any threats to the audit team’s independence and objectivity and, if so, whether adequate safeguards can be established.

Ability to serve the client properly

An engagement should not be accepted if there are no enough qualified personnel to perform the audit.

The audit work should be assigned to personnel who have appropriate capabilities, competence and time to perform the audit engagement in accordance with professional standards.

Integrity of management

The firm is required to conduct a background investigation of the prospective client in order to minimize the likelihood of association with clients whose management lacks integrity. This task would involve:

(a)

Making inquiries of appropriate parties such as prospective client’s banker, legal counsel, or underwriter to obtain

information about the reputation of the client.

(b)

Communicating with the predecessor auditor. This communication allows the incoming auditor to obtain information about the client that will be useful in determining whether the engagement will be accepted.

Before the incoming auditor contacts the predecessor auditor, the incoming auditor should obtain client’s permission to communicate with the predecessor auditor. Once permission of the client is obtained, the incoming auditor should inquire into matters that may affect the decision to accept the engagement. This includes questions regarding:

(a)

The predecessor auditor’s understanding as to the reasons for the change of auditors.

(b)

Any disagreement between the predecessor auditor and the client.

(c)

Any facts that might have a bearing on the integrity of the prospective client’s management.

BRIAN CHRISTIAN S. VILLALUZ, CPA LEarning ADvancement Review Center (LEAD) CPA Reviewer in Advanced Financial Accounting & Reporting (AFAR) CPA Reviewer in Financial Accounting & Reporting (FAR)

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Refusal of the prospective client’s management to permit this will raise serious questions as to whether the engagement will be accepted.

Agreement on Audit Engagement Terms The auditor shall agree the terms of the audit engagement with management or those charged with governance. The agreed terms of the audit engagement shall be recorded in an audit engagement letter. This serves as the written contract between the auditor and the client and shall include:

(a)

The objective and scope of the audit of the financial statements;

(b)

The responsibilities of the auditor;

(c)

The responsibilities of management;

(d)

Identification of the applicable financial reporting framework for the preparation of the financial statements;

(e)

The fact that because of the limitations of the audit, there is an unavoidable risk that material misstatements may remain undiscovered; and

(f)

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.

In addition, the auditor may also include the following in the engagement letter:

(a)

Billing arrangements

(b)

Expectations of receiving management representation letter

(c)

Arrangements concerning the involvement of others (i.e., experts, other auditors, internal auditors and other client personnel)

(d)

Request for the client to confirm the terms of the engagement.

Importance of the engagement letter

It is in the interest of both the auditor and the client that the auditor sends engagement letter in order to:

(a)

Avoid misunderstandings with respect to the engagement.

(b)

Document and confirm the auditor’s acceptance of the appointment.

RECURRING AUDITS The auditor does not normally send new engagement letter every year. However, the following factors may cause the auditor to send

a new engagement letter:

(a)

Any indication that the client misunderstands the objective and scope of the audit.

(b)

Any revised or special terms of the engagement.

(c)

A recent change of senior management, board of directors or ownership.

(d)

A significant change in the nature or size of the client’s business.

(e)

Legal requirements and other government agencies’ pronouncements.

AUDITS OF COMPONENTS

When the auditor of a parent entity is also the auditor of its subsidiary, branch or division (component), the auditor should consider the following factors in making a decision of whether to send a separate letter to the component:

(a)

Who appoints the auditor of the component;

(b)

Whether a separate audit report is to be issued on the component;

(c)

Legal requirements;

(d)

The extent of any work performed by other auditor;

(e)

Degree of ownership by parent;

(f)

Degree of independence of the component’s management.

Acceptance of a Change in the Terms of the Audit Engagement

The auditor shall not agree to a change in the terms of the audit engagement where there is no reasonable justification for doing so.

If, prior to completing the audit engagement, the auditor is requested to change the audit engagement to an engagement that conveys a lower level of assurance, the auditor shall determine whether there is reasonable justification for doing so.

If the terms of the audit engagement are changed, the auditor and management shall agree on and record the new terms of the engagement in an engagement letter or other suitable form of written agreement.

If the auditor is unable to agree to a change of the terms of the audit engagement and is not permitted by management to continue the original audit engagement, the auditor shall:

(a)

Withdraw from the audit engagement where possible under applicable law or regulation; and

(b)

Determine whether there is any obligation, either contractual or otherwise, to report the circumstances to other parties, such as those charged with governance, owners or regulators.

DISCUSSION QUESTIONS:

PRE-ENGAGEMENT ACTIVITIES & PROCEDURES

1. The auditor may accept or continue an audit engagement only when the basis upon which it is to be performed has been agreed,

 

through

I.

Establishing whether the preconditions for an audit are present.

II.

Confirming that there is a common understanding between the auditor and management and, where appropriate, those charged with governance of the terms of the audit engagement.

A.

I only

B.

II only

C.

Both I and II

D.

Neither I nor II

BRIAN CHRISTIAN S. VILLALUZ, CPA LEarning ADvancement Review Center (LEAD) CPA Reviewer in Advanced Financial Accounting & Reporting (AFAR) CPA Reviewer in Financial Accounting & Reporting (FAR)

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2.

An audit is conducted on the premise that management and, where appropriate, those charged with governance, have acknowledged and understand that they have responsibilities that are fundamental to the conduct of an audit in accordance with PSAs. Which of the following is not one of those responsibilities?

A. The preparation of financial statements in accordance with relevant pronouncements issued by the AASC.

B. The establishment and maintenance of an adequate internal control system that is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error.

C. To provide the auditor with access to all information that is relevant to the preparation of financial statements such as records, documentation, and other matters.

D. To provide the auditor with unrestricted access to persons within the entity from which the auditor determines it necessary to obtain audit evidence.

3. Which of the following is not one of the reasons why auditors should perform preliminary engagement activities?

A. To ensure that the auditor maintains the necessary independence and ability to perform the engagement.

B. To help ensure that there are no issues with management integrity that may affect the auditor’s willingness to continue the engagement.

C. To ensure that there is no misunderstanding with the client as to the terms of the engagement.

D. To ensure that sufficient appropriate evidence will be obtained to support the auditor’s opinion on the financial statements.

4. Which of the following is not normally performed in the pre-engagement phase?

A. Deciding whether to accept or reject an audit engagement.

B. Inquiring from predecessor auditor.

C. Preparing an engagement letter.

D. Making a preliminary estimate of materiality.

5. Before accepting an engagement to audit a new client, a CPA is required to obtain

A. A preliminary understanding of the prospective client’s industry and business.

B. The prospective client’s signature to the engagement letter.

C. An understanding of the prospective client’s control environment.

D. A representation letter from the prospective client.

6. In making a decision to accept or continue with a client, the auditor should consider

 

A

B

C

D

Its competence Its independence Its ability to serve the client properly The integrity of client’s management

Yes

Yes

Yes

Yes

Yes

No

Yes

No

Yes

Yes

Yes

No

Yes

Yes

No

Yes

7. Which of the following most likely would cause an auditor to decline a new audit engagement?

A. Concluding that the entity’s management probably lacks integrity.

B. An inability to perform preliminary analytical procedures before assessing control risk.

C. An inadequate understanding of the entity’s internal control.

D. The close proximity to the end of the entity’s reporting period.

8. Prior to the acceptance of an audit engagement with a client who has terminated the services of the predecessor auditor, the CPA should

A. Contact the predecessor auditor without advising the prospective client and request a complete report of the circumstance leading to the termination with the understanding that all information disclosed will be kept confidential.

B. Accept the engagement without contacting the predecessor auditor since the CPA can include audit procedures to verify the reason given by the client for the termination.

C. Not communicate with the predecessor auditor because this would in effect be asking the auditor to violate the confidential relationship between the auditor and the client.

D. Advise the client of the intention to contact the predecessor auditor and request permission for the contact.

9. The purpose of the requirement in having communication between the predecessor and successor auditor is to

A. Allow the predecessor to disclose information which would otherwise be confidential.

B. Help the successor auditor evaluate whether to accept the engagement or not.

C. Help the client by facilitating the change of auditors.

D. Ensure the predecessor collects all unpaid fees prior to a change in auditor.

10. What information should an incoming auditor obtain during the inquiry of the predecessor auditor prior to acceptance of the audit?

I. Facts that bear on the integrity of management.

II. Whether statistical or non-statistical sampling was used to gather evidence.

III. Disagreement with management concerning auditing procedures.

IV. The effect of the client’s internal audit function on the scope of the independent auditor’s examination

A. I and II

B. I and III

C. I and IV

D. III and IV

BRIAN CHRISTIAN S. VILLALUZ, CPA LEarning ADvancement Review Center (LEAD) CPA Reviewer in Advanced Financial Accounting & Reporting (AFAR) CPA Reviewer in Financial Accounting & Reporting (FAR)

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11. A successor auditor requested permission to communicate with the predecessor auditor and review certain portions of the predecessor auditor’s working papers. The prospective client’s refusal to permit this will bear directly on the successor auditor’s decision concerning the

A. Adequacy of the preplanned audit program

B. Ability to establish consistency in application of accounting principles between periods.

C. Apparent scope limitation.

D. Integrity of the management

12. A predecessor auditor withdrew from the engagement after discovering that a client’s financial statements are materially misstated that it would not revise. If asked by the successor auditor about the termination of the engagement, the predecessor auditor should

A. Suggest that the successor auditor should obtain the client’s consent to discuss the reasons.

B. Suggest that the successor auditor ask the client.

C. Indicate there was a misunderstanding.

D. State that the audit revealed material misstatement that the client would not revise.

13. Which of the following factors most likely would influence an auditor’s determination of the auditability of the entity’s financial statements?

A. The complexity of the accounting system

B. The existence of related party transactions

C. The adequacy of the accounting records

D. The operating effectiveness of control procedures

TERMS OF ENGAGEMENT

14. According to PSA 210, the auditor and the client should agree on the terms of engagement. The agreed terms would need to

be recorded in a(n)

A. Memorandum to be placed in the permanent section of the auditing working papers.

B. Engagement letter

C. Client representation letter

D. Comfort letter

15. Which of the following is (are) valid reasons why an auditor sends to his client an engagement letter?

 

A

B

C

D

To avoid misunderstanding with respect to engagement To confirm the auditor’s acceptance of the appointment To document the objective and scope of the audit

Yes

Yes

No

Yes

Yes

No

Yes

Yes

Yes

Yes

Yes

No

16. An engagement letter should ordinarily include information on the objectives of the engagement and

 

CPA’s responsibilities

Client’s responsibilities

Limitation of engagement

A.

Yes

Yes

Yes

B.

Yes

No

Yes

C.

Yes

No

No

D.

No

No

No

17. An engagement letter would not normally include

A. Billing arrangement

B. Arrangement concerning client’s assistance

C. Details of the procedure that will be performed

D. Expectation of receiving a representation letter from management

18. If an auditor believes that an understanding with the client has not been established, he or she should ordinarily

A. Perform the audit with increased professional skepticism.

B. Decline to accept or perform the audit.

C. Assess the control risk at the maximum level and perform a primarily substantive audit.

D. Modify the scope of the audit to reflect an increased risk of material misstatement due to fraud.

19. In which of the following situations would the auditor be unlikely to send a new engagement letter to a continuing client?

A. A change in terms of the engagement.

B. A significant change in the nature or size of the client’s business.

C. A recent change of client management.

D. A recent change in the partner and/or staff in the audit engagement.

20. When the auditor of a parent entity is also the auditor of its component (i.e., subsidiary, branch or division), which of the following factors would least likely influence the auditor’s decision to send separate letter to a component of a parent?

A. Geographical location of the component.

B. Legal requirements

C. Degree of ownership by parent

D. Degree of independence of component’s management

BRIAN CHRISTIAN S. VILLALUZ, CPA LEarning ADvancement Review Center (LEAD) CPA Reviewer in Advanced Financial Accounting & Reporting (AFAR) CPA Reviewer in Financial Accounting & Reporting (FAR)

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21. The auditor shall not agree to a request from the entity to change the terms of the audit engagement or to change the audit engagement to an engagement that conveys a lower level of assurance when there is no reasonable justification for doing so. Which of the following may be considered reasonable justifications for the change in the audit engagement?

I. A change in circumstances affecting the need for the service.

II. A misunderstanding as to the nature of an audit as originally requested.

III. A restriction on the scope of the engagement, whether imposed by management or caused by other circumstances.

A. I and II only

B. I and III only

C. II and III only

D. I, II, and III

22. If the auditor is unable to agree to a change of the engagement and is not permitted to continue the original engagement, the auditor should

A. Insist on continuing the original engagement

B. Express a qualified opinion

C. Express an adverse opinion

D. Withdraw from the engagement

-END-

BRIAN CHRISTIAN S. VILLALUZ, CPA LEarning ADvancement Review Center (LEAD) CPA Reviewer in Advanced Financial Accounting & Reporting (AFAR) CPA Reviewer in Financial Accounting & Reporting (FAR)

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