5 6 8 9ppts

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The Phases of an Audit That Relate to Audit Planning Chapter 5

Audit Planning and Types of Audit Tests
Client acceptance and continuance
LO# 1
Establish the terms of the engagement
Preplanning
Assess risks and establish materiality
Plan the audit

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
5-2
LO# 1
LO# 1
Prospective Client Acceptance

1. Obtain and review financial information. 2. Inquire of third parties. 3. Communicate with the predecessor auditor. 4. Consider unusual business or audit risks. 5. Determine if the firm is independent. 6. Determine if the firm has the necessary skills and knowledge. 7. Determine if acceptance violates any applicable regulatory agency requirements or the Code of Professional Conduct.
5-3
Continuing Client Retention

Evaluate client retention periodically
Near audit completion or after a significant event
Conflicts over accounting & auditing issues
Dispute over fees
5-4
Establish Terms of the Engagement
LO# 2
LO# 3
The Engagement Letter

The engagement letter formalizes the arrangement reached between the auditor and the client. In addition to the items mentioned in the sample engagement letter in Exhibit 5-1 in the textbook, the engagement letter may include:
The terms of the engagement, which are documented in the engagement letter, should include the objectives of the engagement, managements responsibilities, the auditors responsibilities, and the limitations of the engagement.
In establishing the terms of the engagement, three topics must be discussed: 1.The engagement letter; 2.The internal auditors; 3.The audit committee.
Arrangements for use of specialists or

internal auditors.
Any limitations of liability of the auditor

or client.
5-5
Additional services to be provided. Arrangements regarding other services.
5-6
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LO# 4
LO# 4
Internal Auditors
1
Internal Auditors
5-7
5-8
LO# 5
LO# 6
The Audit Committee

Subcommittee of the board of directors
Section 301 of Sarbanes-Oxley Act requires the following for audit committee members of publicly held companies:
Preliminary Engagement Activities

Determine the Audit Engagement Team Requirements
Member of board of directors and independent. Directly responsible for overseeing work of any
registered public accounting firm employed by the company.
No specific requirements for privately held companies
Must preapprove all audit and nonaudit services

provided by its auditors.
Must establish procedures to follow for complaints. Must have authority to engage independent counsel.
5-9
Assess Compliance with Ethical Requirements, Including Independence

5-10
LO# 6
LO# 7
Preliminary Engagement Activities

Assess Risks
Planning the Audit

The auditor will develop an overall audit strategy for conducting the audit. This will help the auditor to determine what resources are needed to perform the engagement. An audit plan is more detailed than the audit strategy.
Use audit risk model
Establish Materiality
Restrict risk at account balance level
Achieve acceptable level of audit risk
Basically, the audit plan should consider how to conduct the engagement in an effective and efficient manner.
You may want to review the detailed discussion in Chapter 3 of the process used to assess the clients business risks and to establish materiality.
5-11
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LO# 7
LO# 7
Planning the Audit

When preparing the audit plan, the auditor should be guided by the results of the risk assessment procedures performed to gain an understanding of the entity. Additional steps:
Specialists
A major consideration is planning the audit is the need for specialist (AU 336). The use of an IT specialist is a significant aspect of most audit engagements.
Assess the need for specialist. Assess the possibility of illegal acts. Identify related parties. Conduct preliminary analytical
procedures.
Lets look at each of these steps.
Consider additional value-added

services.
The presence of complex information technology may require the use of an IT specialist.
5-13 5-14
Document Audit Strategy and Plan and Prepare Audit Programs
LO# 7
LO# 7
Illegal Acts
Illegal Acts
Direct & Material
Consider laws & regulations as part of audit
Illegal Acts
Material & Indirect

Be aware may have occurred; investigate if brought to attention
5-15 5-16
LO# 7
LO# 7
Related Parties
Some examples from FASB No. 57, Related Party Disclosure How to Identify Related Parties
Preliminary Analytical Procedures

To understand the clients business and transactions To identify financial statement accounts likely to contain errors
Affiliates of the enterprise. Entities using equity method to

account for investments.
Review board minutes. Review conflict-of-interest

statements.
Trusts for benefit of employees. Principal owners of enterprise. Management. Immediate families of the
principal owners & management.
Review transactions with major

customers, suppliers, borrowers, and lenders.
Review large, unusual, or

nonrecurring transactions especially at year end.
Other parties that can have

significant influence.
Review loan agreements for

guarantees.
5-17
By understanding the clients business and identifying where errors are likely to occur, the auditor can allocate more resources to investigate necessary accounts.
5-18
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LO# 7
LO# 7
Additional Value-Added Services

Tax Planning System Design and Integration Internal Reporting
Document Audit Strategy and Plan

Document overall audit strategy and audit plan, which involves documenting the decisions about
A U
Nature
The auditor documents how the client is managing its risk (via internal control processes) and the effects of the risks and controls on the planned audit procedures.
Risk Assessment
Benchmarking
Electronic Commerce
D I T
Timing
Auditors ensure they have addressed the risks they identified by documenting the linkage from the clients business, objectives, and strategy to the audit plan. The auditors preliminary decision concerning control risk determines the level of control testing, which in turn affects the auditors substantive tests of the account balances and transactions.
5-20
Auditors who audit public companies are limited in the types of consulting services that they can offer their audit clients.
5-19
T E S T S
Extent
LO# 8
LO# 8
Types of Audit Tests

Risk Assessment Procedures
Used to obtain an understanding of the entity and its environment, including internal controls.
Tests of Controls
Inquiry Observation Walk Through
Inspection
Tests of Controls
Directed toward the evaluation of the effectiveness of the design and implementation of internal controls. Detect material misstatements in a transaction class, account balance, and disclosure component of the financial statements.
5-21
Substantive Procedures
Reperformance
5-22
LO# 8
LO# 8
Tests of Controls
Tests of Details Analytical Procedures
Tests for errors or fraud in individual transactions
Obtains evidential matter about particular assertions related to account balances or classes of transactions
5-24
5-23
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LO# 8
LO# 9
Dual Purpose Tests

Tests of Controls Substantive Tests
Purposes of Analytical Procedures

Preliminary Analytical Procedures Substantive Analytical Procedures Final Analytical Procedures
5-25
Used to assist the auditor to better understand the business and to plan the nature, timing, and extent of audit procedures.
Dual Purpose Test
Used to obtain evidential matter about particular assertions related to account balances or classes of transactions.
Used as an overall review of the financial information in the final review stage of the audit.
5-26
LO# 9
Types of Analytical Procedures

Trend Analysis
Substantive Analytical Procedures Decision Process
LO# 9
Ratio Analysis Reasonableness Analysis
5-27
5-28
LO# 9
LO# 9
Develop an Expectation
Developing an expectation is the first step in the decision process for the amount or account balance. This is the most important step in performing analytical procedures. Auditing standards require the auditor to have an expectation whenever analytical procedures are used. An expectation can be developing using a variety of information sources such as:
Define a Tolerable Difference

The size of the tolerable difference depends on
the significance of the account, the desired degree of reliance on the substantive
analytical procedures,
Financial and operating data

Budgets and forecasts Industry publications Competitor information Managements analyses Analysts reports.
5-29
the level of disaggregation in the amount being tested, and the precision of the expectation.
5-30
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LO# 9
LO# 9
Compare and Investigate

Compare the expectation to the recorded amount and investigate any differences greater than the tolerable difference.
Investigate Differences for Planning and Final Analytical Procedures

Preliminary Analytical Procedures Differences Final Analytical Procedures Differences
Corroborating evidence is not required
Corroborating evidence is required
5-31
5-32
LO# 10
LO# 10
Audit Testing Hierarchy
Filling the Assurance Bucket
5-33
5-34
LO# 10
LO# 11
Example of Filling the Assurance Buckets for Each Assertion (Accounts Payable)
Short-Term Liquidity Ratios

Current Ratio
Quick Ratio
Operating Cash Flow Ratio

5-35 5-36
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LO# 11
LO# 11
Activity Ratios
Receivables Turnover Days Outstanding in Accounts Receivable
Profitability Ratios
Gross Profit Percentage Profit Margin
Inventory Turnover
Days of Inventory on Hand

5-37
Return on Assets
Return on Equity
5-38
LO# 11
Coverage Ratios
Debt to Equity
End of Chapter 5
Times Interest Earned
5-39
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LO# 1
Internal Control Chapter 6

Internal Control in a Financial Statement Audit
Internal control plays an important role in how management meets its stewardship or agency responsibilities. Management has the responsibility to maintain controls that provides reasonable assurance that adequate control exists over the entitys assets and records. Proper internal control not only ensures that assets and records are safeguarded but also creates an environment in which efficiency and effectiveness are encouraged and monitored. Management also needs a control system that generates reliable information for decision making. The auditor needs assurance about the reliability of the data generated by the information system in terms of how it affects the fairness of the financial statements and how well the assets and records of the entity are safeguarded.
McGraw-Hill/Irwin
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-2
LO# 1
LO# 2
Internal Control
The auditor uses risk assessment procedures to obtain an understanding of the entitys internal control and uses this understanding to identify the types of potential misstatements, ascertain factors that affect the risk of material misstatement, and design tests of controls and substantive procedures. The auditors understanding of the internal control is a major factor in determining the overall audit strategy. The auditors responsibilities for internal control are discussed under two major topics: (1) obtaining an understanding of internal control and (2) assessing control risk.
Reliability of Financial Reporting
Internal Control
Objectives
Effectiveness & Efficiency of Operations
Compliance with Laws & Regulations
6-3
6-4
LO# 3
LO# 3
Controls Relevant to the Audit

Objectives
Controls Relevant to the Audit

Objectives
Generally, internal controls pertaining to the preparation of financial statements for external purposes are relevant to an audit.
6-5
Controls relating to operations and compliance objectives may be relevant when they relate to data the auditor uses to apply auditing procedures.
6-6
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LO# 4
LO# 4
Components of Internal Control

Control Environment Entitys Risk Assessment Process
Information System and Related Business Processes Relevant to Financial Reporting & Communication
Control Procedures
Monitoring of Controls
6-7
6-8
LO# 4
The Effect of Information Technology on Internal Control
LO# 5
6-9
6-10
LO# 6
LO# 6
Planning an Audit Strategy
Planning an Audit Strategy
Audit Risk Model

AR = IR CR DR
In applying the audit risk model, the auditor must assess control risk. The figure on the next slide presents a flowchart of the auditors decision process when considering internal control in planning an audit.
6-11 6-12
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LO# 6
LO# 6
Substantive Strategy
After obtaining an understanding of internal control, an auditor may choose to follow a substantive strategy and set control risk at the maximum for some or all assertions because of one or all of the following factors:
Controls are assessed as ineffective.
Reliance Strategy
Obtain Understanding of Internal Control Plan to Rely on Internal Control and Assess Control Risk Below Maximum
6-14
Controls do not pertain to an assertion.
Testing the effectiveness of controls is inefficient.
6-13
LO# 6
LO# 6
Assertions
Occurrence Completeness Authorization Accuracy Cutoff Classification
6-15
Assertions
6-16
LO# 6
Assertions
Obtain an Understanding of Internal Control
LO# 7
The auditor should obtain an understanding of each of the five components of internal control in order to plan the audit. This knowledge is used to:
Identify types of potential misstatements Design tests of controls and substantive procedures
6-17 6-18
Pinpoint the factors that affect the risk of material misstatement
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LO# 7
Control Environment
The Entitys Risk Assessment Process
LO# 7
The risk assessment process should consider external and internal events and circumstances that may arise and adversely affect the entitys ability to initiate, record, process and report financial data consistent with the assertions of management in the financial statements.
Client business risk can arise or change due to the following circumstances:
Changes in the operating environment Corporate restructuring
6-19
New personnel Rapid growth New technology New accounting pronouncements Expanded international growth
New or revamped information systems
New business models, products, or activities

6-20
Information Systems and Communication

1. Identify and record all valid transactions.
LO# 7
LO# 7
Control Activities
Control activities are the policies and procedures that help ensure that managements directives are carried out. Those control procedures that are relevant to the audit include
An effective accounting system gives appropriate consideration to establishing methods and records that will
2. Describe on a timely basis the transactions in sufficient detail to permit proper classification of transactions for financial reporting. 3. Measure the value of transactions in a manner that permits recording their proper monetary value in the financial statements. 4. Determine the time period in which transactions occurred to permit recording of transactions in the proper accounting period. 5. Properly present the transactions and related disclosures in the financial statements.
6-21
Performance reviews
Information processing
Physical controls
Segregation of duties
6-22
LO# 7
LO# 7
Monitoring of Controls
Monitoring of controls is a process that assesses the quality of internal control performance over time.
An effective internal audit function has clear lines of authority and reporting, qualified personnel, and adequate resources to enable these personnel to carry out their assigned duties.
6-23
The Effect of Entity Size on Internal Control

While the basic concepts of the five components should be present in all entities, they are likely to be less formal in a small or midsize entity than in a large entity.
Internal Auditors
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LO# 7
LO# 7
The Limitations of an Entitys Internal Control

Management Override of Internal Control Human Errors or Mistakes
Factors Contributing to Fraud
Collusion
6-25 6-26
LO# 8
LO# 9
Documenting the Understanding of Internal Control

Procedure Manuals and Organizational Charts Narrative Description
Assessing Control Risk

Identify specific controls that will be relied upon. Perform tests of controls
Internal Control Questionnaires
Flowcharts
Conclude on the achieved level of control risk.

6-27 6-28
LO# 10
LO# 10
Documenting the Assessed Level of Control Risk

The auditors assessment of control risk and the basis for the achieved level can be documented using a structured working paper, an internal control questionnaire, or a memorandum.
Lets look at an example from EarthWear Clothiers to see how the control risk for two accounts that differ in terms of their nature, size and complexity is documented.
6-29
Documenting the Assessed Level of Control Risk
6-30
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LO# 11
LO# 12
Timing of Audit Procedures

Interim
Year End
Lets look at the EarthWear Clothiers example again to see the timing of their audit procedures.
6-31 6-32
LO# 12
LO# 12
Timing of Audit Procedures
Interim Audit Procedures

Interim Tests of Controls
1. Assertion being tested not significant 2. Control has been effective in prior audits 3. Efficient use of staff time
Interim Substantive Procedures
1. Assertion probably has low control risk 2. May increase the risk of material misstatements 3. Still requires some year end testing
6-33
6-34
LO# 13
LO# 13
Auditing Accounting Applications Processed by Service Organizations

In some instances, a client may have some or all of its accounting transactions processed by an outside service organization. Because the clients transactions are subjected to the controls of the service organization, one of the auditors concerns is the It is not uncommon for service internal control system in organizations to have an auditor place at the service issue one of two types of organization. reports on their operations.
6-35
Auditing Accounting Applications Processed by Service Organizations

Report #1 Describes the service organizations controls and assesses whether they are suitably designed to achieve specified internal control objectives.
An auditor may reduce control risk below the maximum only on the basis of a service auditors report that includes tests of the controls.
Report #2 Goes further by testing whether the controls provide reasonable assurance that the related control objectives were achieved during the period.
6-36
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LO# 14
LO# 14
Communication of Internal ControlRelated Matters

Reportable Conditions
Significant deficiencies in the design or operation of internal control that could adversely affect the organizations ability to initiate, record, process, and report financial data consistent with managements assertions.
Examples of Reportable Conditions
Material Weakness
A material weakness is a significant deficiency, or combination of significant deficiency that results in more than a remote likelihood that a material misstatement of the financial statements will not be prevented or detected.
6-37
6-38
Types of Controls in an IT Environment

General Controls Application Controls
LO# 15
LO# 15
1. Data center & network operations 2. System software acquisition, change and maintenance 3. Access security 4. Application system acquisition, development, and maintenance
1. 2. 3. 4. 5.
Data capture controls Data validation controls Processing controls Output controls Error controls
6-39
6-40
LO# 15
LO# 15
6-41
6-42
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LO# 16
Flowcharting Symbols
End of Chapter 6
6-43
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Introduction Chapter 8
Audit Sampling: An Overview and Application to Tests of Controls
Auditing standards recognize and permit both statistical and nonstatistical methods of audit sampling. Two technological advances have reduced the number of times auditors need to apply sampling techniques to gather audit evidence: 1 Development of well-controlled, automated accounting systems. 2 Advent of powerful PC audit software to download and examine client data
McGraw-Hill/Irwin
8-2
Introduction
However, technology will never eliminate the need for auditors to rely on sampling to some degree because:
1. Many control processes require human involvement. 2. Many testing procedures require the auditor to physically examine an asset. 3. In many cases auditors are required to obtain and examine evidence from third parties.
Definitions and Key Concepts

On the following screens we will define:
1.Sampling 1.Sampling Risk 2.Confidence 2.Confidence Level 3.Tolerable 3.Tolerable and Expected Error 4.Audit 4.Audit Sampling
8-3
8-4
LO# 1
LO# 2
Audit Sampling
Audit sampling is the application of an audit procedure to less than 100 percent of the items within an account balance or class of transactions for the purpose of evaluating some characteristic of the balance or class.
Sampling Risk
Sampling risk is the element of uncertainty that enters into the auditors conclusions anytime sampling is used. There are two types of sampling risk.
Risk of incorrect rejection (Type I) in a test of internal controls, it is the risk that the sample supports a conclusion that the control is not operating effectively when, in fact, it is operating effectively. Risk of incorrect acceptance (Type II) in a test of internal controls, it is the risk that the sample supports a conclusion that the control is operating effectively when, in fact, it is not operating effectively.
8-5 8-6
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LO# 2
LO# 2
Sampling Risk
Three Important Factors in Determining Sample Size
Confidence Level
Confidence level is the complement of sampling risk.
The auditor may set sampling risk for a particular sampling application at 5 percent which percent, results in a confidence level of 95 percent percent.
8-8
1.The 1. The desired level of assurance in the results (or confidence level), 2.Acceptable 2. Acceptable defect rate (or tolerable error), and 3.The 3. The historical defect rate (or estimated error).
8-7
LO# 2
LO# 3
Tolerable and Expected Error

Once the desired confidence level is established, the sample size is determine largely by how much the tolerable error exceeds expected error. Precision, Precision, at the planning stage of audit sampling, is the difference between the expected and tolerable deviation rates.
Audit Evidence To Sample or Not?

Relationship between Evidence Types and Audit Sampling Audit Sampling Type of Evidence Commonly Used Inspection of tangible assets Yes Inspection of records or documents Yes Reperformance Yes Recalculation Yes Confirmation Yes Analytical procedures No Scanning No Inquiry No Observation No
8-10
Auditing Standards refer to Precision as the Allowance for sampling risk
8-9
LO# 3
LO# 3

Inspection of tangible assets. Auditors typically attend the clients year-end inventory count. When there are a large number of items in inventory, the auditor will select a sample to physically inspect and count. Inspection of records or documents. Certain controls
may require the matching of documents. The procedure may take place many times a day. The auditor may gather evidence on the effectiveness of the control by testing a sample of the document packages.

Reperformance. To comply with rule 404 of the Sarbanes-Oxley Act, publicly traded clients must document and test controls over important assertions for significant accounts. The auditor may reperform a sample of the tests performed by the client. Confirmation. Rather than confirm all customer account receivable balances, the auditor may select a sample of customers.
8-11
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LO# 3
LO# 3
Testing All Items with a Particular Characteristic

When an account or class of transactions is made up of a few large items, the auditor may examine all the items in the account or class of transaction. When a small number of large transactions make up a relatively large percent of an account or class of transactions, auditors will typically test all the transactions greater than a particular dollar amount.
Testing Only One or a Few Items

Highly automated information systems process transactions consistently unless the system or programs are changed.
The auditor may test the general controls over the system and any program changes, but test only a few transactions processed by the IT system.
8-13
8-14
LO# 4
Types of Audit Sampling

Auditing standards recognize and permit both statistical and nonstatistical methods of audit sampling. In nonstatistical (or judgmental) sampling, the auditor does not use statistical techniques to determine sample size, select the sample items, or measure sampling risk. Statistical sampling uses the laws of probability to compute sample size and evaluate results. The auditor is able to use the most efficient sample size and quantify sampling risk.
Types of Audit Sampling

Advantages of statistical sampling 1. Design an efficient sample. 2. Measure the sufficiency of evidence obtained. 3. Quantify sampling risk.
LO# 4
Disadvantages of statistical sampling 1. Training auditors in proper use. 2. Time to design and conduct sampling application. 3. Lack of consistent application across audit teams.
8-15
8-16
LO# 4
LO# 4
Statistical Sampling Techniques

1.Attribute Sampling. 2.Monetary-Unit Sampling. 3.Classical Variables Sampling.
Attribute Sampling
Used to estimate the proportion of a population that possess a specified characteristic. The most common use of attribute sampling is for tests of controls.
Yes, I know. We are planning a test of that control using attribute sampling.
Our clients controls require that all checks have two independent signatures.
8-17
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LO# 4
LO# 4
Monetary-Unit Sampling
Monetary-unit sampling uses attribute sampling theory to estimate the dollar amount of misstatement for a class of transactions or an account balance. This technique is used extensively because it has a number of advantages over classical variables sampling.
Classical Variables Sampling

Auditors sometimes use variables sampling to estimate the dollar value of a class of transactions or account balance. It is more frequently used to determine whether an account is materially misstated.
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LO#
LO# 5, 6, & 7
Attribute Sampling Applied to Tests of Controls

In conducting a statistical sample for a test of controls auditing standards require the auditor to properly plan, perform, and evaluate the sampling application and to adequately document each phase of the sampling application.
Plan Perform Evaluate
5, 6, & 7
Planning
Planning
1. Determine the test objectives. 2. Define the population characteristics. Define the sampling population. Define the sampling unit. Define the control deviation conditions. 3. Determine the sample size, using the following inputs: The desired confidence level or risk of incorrect acceptance. The tolerable deviation rate. The expected population deviation rate.
Document
The objective of attribute sampling when used for tests of controls is to evaluate the operating effectiveness of the internal control.
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8-22
LO# 5, 6, & 7
LO# 5, 6, & 7
Planning
Planning
2. Define the population characteristics. Define the sampling population. Define the sampling unit. Define the control deviation conditions. 3. Determine the sample size, using the following inputs: The desired confidence level or risk of incorrect acceptance. The tolerable deviation rate. The expected population deviation rate.
Planning
Planning
All or a subset of the items that constitute the class of transactions make up the sampling population.
Each sampling unit makes up one item in the population. The sampling unit should be defined in relation to the specific control being tested.
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LO# 5, 6, & 7
LO# 5, 6, & 7
Planning
Planning
Planning
Planning
3. Determine the sample size, using the following inputs: The desired confidence level or risk of incorrect acceptance. The tolerable deviation rate. The expected population deviation rate.
A deviation is a departure from adequate performance of the internal control.
The confidence level is the desired level of assurance that the sample results will support a conclusion that the control is functioning effectively. Generally, when the auditor has decided to rely on controls, the confidence level is set at 90% or 95%. The means the auditor is willing to accept a 10% or 5% risk of accepting the control as effective when it is not.
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LO# 5, 6, & 7
LO# 5, 6, & 7
Planning
Planning
Planning
Planning
The tolerable deviation rate is the maximum deviation rate from a prescribed control that the auditor is willing to accept and still consider the control effective.
Suggested Tolerable Deviation Rates for Assessed Levels of Control Risk

Planned Assessed Level of Control Risk Low Moderate Slightly below maximum Maximum
8-27
Tolerable Deviation Rate 35% 610% 1120% Omit test

8-28
LO# 5, 6, & 7
LO#
Planning
Planning
Planning
Planning
5, 6, & 7
The expected population deviation rate is the rate the auditor expects to exist in the population. The larger the expected population deviation rate, the larger the sample size must be, all else equal.
Assume a desired confidence level of 95%, and a large population, the effect of the expected population deviation rate on sample size is shown below:
Expecte d Popula tion Deviation Rate 1.0% 1.5% 2.0% 3.0% Sample Size 93 124 181
Sam ple size too large to be cost-effective.
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LO#
LO# 5, 6, & 7
Population Size: Attributes Sampling

Population size is not an important factor in determining sample size for attributes sampling. The population size has little or no effect on the sample size, unless the population is relatively small, say less than 500 items.
Factor Desired confidence level Tolerable deviation rate Expected population deviation rate Population size
5, 6, & 7
Performance
Performance and Evaluation
4. Select sample items. Random-Number Selection. Systematic Selection. 5. Perform the Audit Procedures. Voided documents. Unused or inapplicable documents Inability to examine a sample item. Stopping the test before completion. 6. Calculate the Sample Deviation and Upper Deviation Rates 7. Draw Final Conclusions
Examples Change in Effect on Factor Sample Lower Decrease Direct Higher Increase Lower Increase Inverse Higher Decrease Lower Decrease Direct Higher Increase Decreases sample size only when population is small (fewer than 500 items) Relationship to Sample Size
Every item in the population has the same probability of being selected as every other sampling unit in the population.
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8-31
LO# 5, 6, & 7
LO# 5, 6, & 7
Performance
4. Select sample items. Random-Number Selection. Systematic Selection. 5. Perform the Audit Procedures. Voided documents. Unused or inapplicable documents Inability to examine a sample item. Stopping the test before completion. 6. Calculate the Sample Deviation and Upper Deviation Rates 7. Draw Final Conclusions
Performance
5. Perform the Audit Procedures. Voided documents. Unused or inapplicable documents Inability to examine a sample item. Stopping the test before completion. 6. Calculate the Sample Deviation and Upper Deviation Rates 7. Draw Final Conclusions
The auditor determines the sampling interval by dividing the population by the sample size. A starting number is randomly selected in the first interval and every nth item is 8-33 selected thereafter.
For example, assume a sales invoice should not be prepared unless there is a related shipping document. If the shipping document is present, there is evidence the control is working properly. If the shipping document is not present a control deviation exist.
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LO# 5, 6, & 7
LO# 5, 6, & 7
Performance
Performance
Unless the auditor finds something unusual about either of these items, they should be replaced with a new sample item.
If the auditor is unable to examine a document or to use an alternative procedure to test the control, the sample item is a deviation for purposes of evaluating the sample results.
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LO# 5, 6, & 7
LO# 5, 6, & 7
Performance
Evaluation
Evaluation
6. Calculate the Sample Deviation and Upper Deviation Rates 7. Draw Final Conclusions
If a large number of deviations are detected early in the tests of controls, the auditor should consider stopping the test, as soon as it is clear that the results of the test will not support the planned assessed level of control risk.
8-37
After completing the audit procedures, the auditor summarizes the deviations for each control tested and evaluates the results. For example, if the auditor discovered two deviations in a sample of 50, the deviation rate in the sample would be 4% (2 50). The upper deviation rate is the sum of the sample deviation rate and an appropriate allowance for sampling risk.
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LO# 5, 6, & 7
LO# 5, 6, & 7
Evaluation
Evaluation
6. Calculate the Sample Deviation and Upper Deviation Rates 7. Draw Final Conclusions
Attribute Sampling Example

The auditor has decided to test a control at Calabro Wireless Services. The test is to determine the sales and service contracts are properly authorized for credit approval. A deviation in this test is defined as the failure of the credit department personnel to follow proper credit approval procedures for new and existing customers. Here is information relating to the test:
Desired confidence level Tolerable deviation rate Expected population deviation rate Sample size 95% 6% 1% 78
The auditor compares the tolerable deviation rate to the computed upper deviation rate.
True State of Internal Control Auditor's Decision Based on Sample Evidence Supports the planned level of control risk Does not support the planned level of control risk Reliable Correct decision Risk of incorrect rejection (Type I) Not Reliable Risk of incorrect acceptance (Type II) Correct decision
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LO# 5, 6, & 7
LO# 5, 6, & 7

Part of the table used to determine sample size when the auditor specifies a 95% desired confidence level.
Sample Size at 95% Desired Confidence Level Expected Population Tolerable Deviation Rate Deviation Rate 2% 3% 4% 5% 6% 0.00% 149 99 74 59 49 0.25% 236 157 117 93 78 0.50% 157 117 93 78 0.75% 208 117 93 78 1.00% 156 93 78 1.25% 156 124 78 1.50% 192 124 103

17,063 59,096 89,904 42,970 74,184 1,755 37,285 92,096 22,113 59,304 34,989 34,027 18,965 30,393 27,951 38,383 30,521 96,603 42,914 24,423 32,014 44,994 25,484 3,475 1,986 19,308 35,744 10,350 6,937 96,813 12,104 37,183 67,965 52,597 66,533 87,003 54,109 6,184 65,785 11,531 64,036 95,084 11,027 67,454 97,613 39,602 52,705 45,839 50,006 91,083 52,496 40,817 34,783 92,628 81,175 93,234 13,350 77,035 45,594 37,490 96,213 28,664 62,828 42,756 67,446 71,586 60,481 24,202 66,805 80,382 60,169 8,210 10,374 50,282 72,563 72,886 57,267 80,027 31,130 62,333 44,899 23,758
7% 42 66 66 66 66 66 66
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There are 125,000 audit items in the population numbered from 1 to 125,000. The auditor generates these random numbers using Excel. Each number represents a contract that was to be reviewed for credit approval.
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LO# 5, 6, & 7
LO# 5, 6, & 7

The auditor examines each selected contract for credit approval and determines the following:
Number of deviations Sample size Sample deviation rate Computed upper deviation rate Tolerable deviation rate 2 78 2.6% 8.2% 6.0%

Part of the table used to determine the computed upper deviation rate at 95% desired confidence level:
Sample Size 25 30 35 40 45 50 55 60 65 70 75 80
8-43
Lets see how we get the computed upper deviation rate.
Actual Number of Deviations Found 0 1 2 3 11.3 17.6 9.5 14.9 19.6 8.3 12.9 17.0 7.3 11.4 15.0 18.3 6.5 10.2 13.4 16.4 5.9 9.2 12.1 14.8 5.4 8.4 11.1 13.5 4.9 7.7 10.2 12.5 4.6 7.1 9.4 11.5 4.2 6.6 8.8 10.8 4.0 6.2 8.2 10.1 3.7 5.8 7.7 9.5
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LO# 5, 6, & 7
LO# 8

Tolerable Deviation Rate (6%)
Nonstatistical Sampling for Tests of Control

Determining the Sample Size
An auditing firm may establish a nonstat sampling policy like the one below:
Desired Level of Controls Sample Reliance Size Low 1520 Moderate 2535 High 4060
<
Computed Upper Deviation Rate (8.2%)
Auditors Decision: Does not support reliance on the control.
Such a policy will promote consistency in sampling applications.

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LO# 8
LO# 8

Selecting the Sample Items
Nonstatistical sampling allows the use of random or systematic selection, but also permits the use of other methods such as haphazard sampling.
When haphazard sample selection is used, sampling units are selected without any bias, that is to say, without a special reason for including or omitting the item in the sample.
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Calculating the Upper Deviation Rate
With a nonstatistical sample, the auditor can calculate the sample deviation rate, but cannot formally quantify the computed upper deviation rate and sampling risk associated with the test.
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LO# 8
Considering the Effect of Population Size

This table assumes a desired confidence of 90%, a tolerable deviation rate of 10%, and an expected population deviation rate of 1%:
Population Size 100 500 1,000 5,000 Sample Size 31 38 39 39
End of Chapter 8
Finite population = correction factor
1 (n/N)
n = sample size from tables N = number of units in the population

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Substantive Tests of Details of Account Balances
LO# 1
Chapter 9
Audit Sampling: An Application to Substantive Tests of Account Balances
The statistical concepts we discussed in the last chapter apply to this chapter as well. Three important determinants of sample size are 1. Desired confidence level. 2. Tolerable misstatement. 3. Estimated misstatement. Population plays a bigger role in some of the sampling techniques used for substantive testing. Misstatements discovered in the audit sample must be projected to the population, and there must be an allowance for sampling risk.
McGraw-Hill/Irwin
9-2
LO# 1
LO# 1

Consider the following information about the inventory account balance of an audit client:
Book value of inventory account balance Book value of items sampled Audited value of items sampled Total amount of overstatement observed in audit sample $ 3,000,000 $ 100,000 98,000 $ 2,000

The results of our audit test depend upon the tolerable misstatement associated with the inventory account. If the tolerable misstatement is $50,000, we cannot conclude that the account is fairly stated because our best estimate of the projected misstatement is greater than the tolerable misstatement.
9-4
The ratio of misstatement in the sample is 2% ($2,000 $100,000)

Applying the ratio to the entire population produces a best estimate of misstatement of inventory of $60,000. ($3,000,000 2%)
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LO# 2
LO# 2
Monetary-Unit Sampling (MUS)

MUS uses attribute-sampling theory to attributeexpress a conclusion in dollar amounts rather than as a rate of occurrence. It is commonly used by auditors to test accounts such as accounts receivable, loans receivable, receivable, receivable, investment securities, and inventory. securities, inventory.

MUS uses attribute-sampling theory (used attributeprimarily to test controls) to estimate the percentage of monetary units in a population that might be misstated and then multiplies this percentage by an estimate of how much the dollars are misstated.
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LO# 2
LO# 2

Advantages of MUS
1. When the auditor expects no misstatement, MUS usually results in a smaller sample size than classical variables sampling. 2. The calculation of the sample size and evaluation of the sample results are not based on the variation between items in the population. 3. When applied using the probability-proportional-to-size probability-proportional- toprocedure, MUS automatically results in a stratified sample.
9-7

Disadvantages of MUS
1. The selection of zero or negative balances generally requires special design consideration. 2. The general approach to MUS assumes that the audited amount of the sample item is not in error by more than 100%. 3. When more than one or two misstatements are detected, the sample results calculations may overstate the allowance for sampling risk.
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LO# 2
LO# 2
Steps in MUS Sampling

Steps in MUS Sampling Application
Planning 1. Determine the test objectives. 2. Define the population characteristics. Define the population. Define the sample unit. Define a misstatement. 3. Determine the sample siz e, using the following inputs: The desired confidence level or risk of incorrect acceptance. The tolerable misstatement. The expected population misstatement. Population size. Performance 4. Select sample items. 5. Perform the auditing procedures. Understand an alayzye any missstatements observed. Evaluation 6. Calculate the projected misstatement and the upper limit on misstatement. 7. Draw final conclusions.
9-9

Planning 1. Determine the test objectives. 2. Define the population characteristics. Define the population. Define the sample unit. Define a misstatement.
Sampling may be used for substantive testing to: 1. Test the reasonableness of assertions about a financial statement amount (i.e., is the amount fairly stated). This is the most common use of sampling for substantive testing. 2. Develop an estimate of some amount.
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LO# 2
LO# 2


For MUS the population is defined as the monetary value of an account balance, such as accounts receivable, investment securities, or inventory.
An individual dollar represents the sampling unit.
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LO# 2
LO# 2


3. Determine the sample size, using the following inputs: The desired confidence level or risk of incorrect acceptance. The tolerable misstatement. The expected population misstatement. Population size.
Relationship to Sample Size Direct Inverse Direct Direct Change in Factor Lower Higher Lower Higher Lower Higher Lower Higher Effect on Sample Decrease Increase Increase Decrease Decrease Increase Decrease Increase
9-14
Factor
A misstatement is defined as the difference between monetary amounts in the clients records and amounts supported by audit evidence.
Desired confidence level Tolerable mistatement Expected mistatement Population size
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LO# 2
LO# 3

Performance 4. Select sample items. 5. Perform the auditing procedures. Evaluation 6. Calculate the projected misstatement and the upper limit on misstatement. 7. Draw final conclusions.

Assume a clients book value of accounts receivable is $2,500,000, and the auditor determined a sample size of 93. The sampling interval will be $26,882 ($2,500,000 93). The random number selected is $3,977 the auditor would select the following items for testing:
Account 1001 Ace Emergency Center 1002 Admington Hospital 1003 Jess Base, Inc. 1004 Good Hospital Corp. 1005 Jen Mara Corp. 1006 Zippy Corp. 1007 Green River Mfg. 1008 Bead Hospital Centers 1213 Andrew Call Medical 1214 Lilly Heather, Inc. 1215 Janyne Ann Corp. Total Accounts Receivable Balance 2,350 15,495 945 21,893 3,968 32,549 2,246 11,860 26,945 1,023 $ 2,500,000 $ Cumulatvie Dollars 2,350 17,845 18,780 40,673 44,641 77,190 79,436 91,306 2,472,032 2,498,977 $ 2,500,000 $ Sample Item $ 3,977 30,859 57,741 84,623 2,477,121 (1) (2) (3) (4)
The auditor selects a sample for MUS by using a systematic selection approach called probabilityproportional-to-size selection. The sampling interval can be determined by dividing the book value of the population by the sample size. Each individual dollar in the population has an equal chance of being selected and items or logical units greater than the interval will always be selected. 9-15
$ 3,977 26,882 $ 30,859
(93)
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LO# 3
LO# 3

Performance 4. Select sample items. 5. Perform the auditing procedures. Evaluation 6. Calculate the projected misstatement and the upper limit on misstatement. 7. Draw final conclusions.

Evaluation 6. Calculate the projected misstatement and the upper limit on misstatement. 7. Draw final conclusions.
The misstatements detected in the sample must be projected to the population.

Example Information Book value Tolerable misstatement Sample size Desired confidence level Expected amount of misstatement Sampling interval $ 2,500,000 $ 125,000 93 95% $ 25,000 $ 26,882
After the sample items have been selected, the auditor conducts the planned audit procedures on the logical units containing the selected dollar sampling units.
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LO# 3
LO# 3

Basic Precision using the Tables
If no misstatements are found in the sample, the best estimate of the population misstatement would be zero dollars.
Sample Size 65 70 85 80 90 100 125 Actual Number of Deviations Found 0 1 2 3 4.6 7.1 9.4 11.5 4.2 6.6 8.8 10.8 4.0 6.2 8.2 10.1 3.7 5.8 7.7 9.5 3.3 5.2 6.9 8.4 3.0 4.7 6.2 7.6 2.4 3.8 5.0 6.1

Misstatements Detected
In the sample of 93 items, the following misstatements were found:
Customer Good Hospital Marva Medical Supply Axa Corp. Learn Heart Centers Book Value $ 21,893 6,705 32,549 15,000 Audit Value $ 18,609 4,023 30,049 Difference $ 3,284 2,682 2,500 15,000 Tainting Factory 15% 40% NA 100%
Because the Axa balance of $32,549$21,893 = than the $3,284 is greater 15% interval of $26,882, no sampling risk is added. Since all the dollars in the large accounts are audited, there is no sampling risk associated with large accounts.
$26,882 3.0 = $80,646 upper misstatement limit

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LO# 3
LO# 3

Computed Upper Misstatement Limit using Tables
We compute the upper misstatement limit by calculating basic precision and ranking the detected misstatements based on the size of the tainting factor from the largest to the smallest.
Tainting Customer Factor Basic Precision 1.00 Learn Heart Centers 1.00 Marva Medical 0.40 Good Hospital 0.15 Add misstatments greater that the sampling interval: Axa Corp. NA Sample Interval $ 26,882 26,882 26,882 26,882 Projected Misstatement NA (26,882) (10,753) (4,032) 95% Upper Limit 3.0 1.7 (4.7 - 3.0) 1.5 (6.2 - 4.7) 1.4 (7.6 - 6.2) Upper Misstatement $ 80,646 45,700 16,130 5,645

Evaluation 6. Calculate the projected misstatement and the upper limit on misstatement 7. Draw final conclusions.
In our example, the final decision is whether the accounts receivable balance is materially misstated or not. We compare the tolerable misstatement to the upper misstatement limit. If the upper misstatement limit is less than or equal to the tolerable misstatement, we conclude that the balance is not materially misstated. misstated.
26,882 NA Upper Misstatement Limit
2,500 150,621
(0.15 $26,882 1.4 = $5,645)
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LO# 3
LO# 3

In our example, the upper misstatement limit of $150,621 is greater than the tolerable misstatement of $125,000, so the auditor concludes that the accounts receivable balance is materially misstated. When faced with this situation, the auditor may: 1. Increase the sample size. 2. Perform other substantive procedures. 3. Request the client adjust the accounts receivable balance. 4. If the client refuses to adjust the account balance, the auditor would consider issuing a qualified or adverse opinion.
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Risk When Evaluating Account Balances

True State of Financial Statement Account Auditor's Decision Based on Sample Evidence Supports the fairness of the account balance Does not support the fairness of the account balance Not Materially Misstated Correct decision Risk of incorrect rejection (Type I) Materially Misstated Risk of incorrect acceptance (Type II) Correct Decision
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Why is the Sampling Interval Rather than the Sample Size Used in Evaluating MUS Results?
LO# 3
LO# 3
Effect of Understatement Misstatements

MUS is not particularly effective at detecting understatements. An understated account is less likely to be selected than an overstated account.
Customer Wayne County Medical Book Value $ 2,000 Audit Value $ 2,200 Difference $ (200) Tainting Factor -10%
Due to simplifying assumptions about accounting populations, the misstatement factors used in most MUS evaluation approaches are nearly identical to the misstatement factors associated with a sample size of 100, regardless of the actual sample size used by the auditor. Always use these factors:
Number of Errors 0 1 2 3 4 95% Confidence Level Misstatement Incremental Factor Increase 3.0 4.7 1.7 6.2 1.5 7.6 1.4 9.0 1.4 90% Confidence Level Misstatement Incremental Factor Increase 2.3 3.9 1.6 5.3 1.4 6.6 1.3 7.9 1.3
The most likely error will be reduced by $2,688 ( 0.10 $26,882)
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LO# 4
LO# 4
Nonstatistical Sampling for Tests of Account Balances

The sampling unit for nonstatistical sampling is normally a customer account, an individual transaction, or a line item on a transactions. When using nonstatistical sampling, the following items must be considered: o Identifying individually significant items. o Determining the sample size. o Selecting sample items. o Calculating the sample results.
Identifying Individually Significant Items

The items to be tested individually are items that may contain potential misstatements that individually exceed the tolerable misstatement. These items are tested 100% because the auditor is not willing to accept any sampling risk.
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LO# 4
LO# 4

Sampling Population book value Sample = Tolerable Expected misstatement Assurance factor Size
Selecting Sample Items

Auditing standards require that the sample items be selected in such a way that the sample can be expected to represent the population.
Assessment of Risk of Material Misstatement Maximum Slightly below maximum Moderate Low
Maximum 3.0 2.7 2.3 2.0
Desired Level of Confidence Slightly Below Maximum Moderate 2.7 2.3 2.4 2.0 2.1 1.6 1.6 1.2
Low 2.0 1.6 1.2 1.0
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LO# 4
LO# 4
Calculating the Sample Results

One way of projecting the sampling results to the population is to apply the misstatement ratio in the sample to the population. Assume the auditor finds $1,500 in misstatements in a sample of $15,000. The misstatement ratio is 10%. If the population total is $200,000, the projected misstatement would be $20,000 ($200,000 10%)

A second method is the difference estimation. This method projects the average misstatement of each item in the sample to all items in the population. Assume misstatements in a sample of 100 items total $300 (for average misstatement of $3), and the population contains 10,000 items.
The projected misstatement would be $30,000 ($3 10,000). ($3
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Nonstatistical Sampling Example

The auditors of Calabro Wireless Service have decided to use nonstatistical sampling to examine the accounts receivable balance. Calabro has a total of 11,800 (15 + 250 + 11,535) accounts with a balance of $3,717,900. The auditors stratify the accounts as follows:
Number and Size of Accounts 15 accounts > $25,000 250 accounts > $3,000 11,535 accounts < $3,000 Total Book Value $ 550,000 850,500 2,317,400 $ 3,717,900
LO# 4

The auditors decide . . .
o There is a low assessment for inherent and control risk.
LO# 4
o The tolerable misstatement is $40,000, and the expected misstatement is $15,000. o There is a moderate risk that other auditing procedures will fail to detect material misstatements. o All customer account balances greater than $25,000 are to be audited.
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LO# 4
LO# 4
Sampling population book value Sample = Tolerable - Estimated misstatement Assurance factor Size $3,717,900 $550,000
Sample = Size
$55,000 $15,000
$3,167,900 $40,000
1.2 = 95 (rounded)
The auditor sent positive confirmations to each of the 110 (95 + 15) accounts selected. Either the confirmations were returned or alternative procedures were successfully used. Four customers indicated that their accounts were overstated and the auditors determined that the misstatements were the result of unintentional error by client personnel. Here are the results of the audit testing:
Stratum >$25,000 >$3,000 <$3,000 Book Value $ 550,000 850,500 2,317,400 Book Value of Sample $ 550,000 425,000 92,000 Audit Value of Sample $ 549,500 423,000 91,750 Amount of OverStatement $ 500 2,000 250
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Combined Assessment of Inherent and Control Risk Maximum Slightly below maximum Moderate Low
Risk That Other Substantive Procedures Fail to Detect Material Misstatement Slightly Below Maximum Maximum Moderate Low 3.0 2.7 2.3 2.0 2.7 2.4 2.0 1.6 2.3 2.1 1.6 1.2 2.0 1.6 1.2 1.0
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As a result of the audit procedures, the following projected misstatement was prepared:
Ratio of Misstatement Amount of in Stratum Tested Stratum Misstatement >$25,000 $ 500 Not Applicable--100% Tested >$3,000 2,000 $2,000 425,000 $850,500 <$3,000 250 $250 92,000 $2,317,400 Total projected misstatement
LO# 4
LO# 4
Why Did Statistical Sampling Fall Out Of Favor?

1.Firms found that some auditors were over relying on statistical sampling techniques to the exclusion of good judgment. 2.There appears to be poor linkage between the applied audit setting and traditional statistical sampling applications.
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Projected Misstatement $ 500 4,002 6,298 $ 10,800
The total projected misstatement of $10,800 is less than the expected misstatement of $15,000, so the auditors may conclude that there is an acceptably low risk that the true misstatement exceeds the tolerable misstatement.
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LO# 5
LO# 5
Classical Variable Sampling

Classical variables sampling uses normal distribution theory to evaluate the characteristics of a population based on sample data. Auditors most commonly use classical variables sampling to estimate the size of misstatement. Sampling distributions are formed by plotting the projected misstatements yielded by an infinite number of audit samples of the same size taken from the same underlying population.
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A sampling distribution is useful because it allows us to estimate the probability of observing any single sample result.
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LO# 5
LO# 5

Advantages
1. When the auditor expects a large number of differences between book and audited values, this method will result in smaller sample size than MUS. 2. The techniques are effective for both overstatements and understatements. 3. The selection of zero balances generally does not require special sample design considerations.
In classical variables sampling, the sample mean is the best estimate of the population mean.
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LO# 6

Disadvantages
1. Does not work well when little or not misstatement is expected in the population. 2. To determine sample size, the auditor must estimate the standard deviation of the audited value or differences. 3. If few misstatements are detected in the sample data, the true variance tends to be underestimated, and the resulting projection of the misstatements to the population is likely not to be reliable.
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Applying Classical Variables Sampling

Defining the Sampling Unit
The sampling unit can be a customer account, an individual transaction, or a line item. In auditing accounts receivable, the auditor can define the sampling unit to be a customers account balance or an individual sales invoice included in the account balance.
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LO# 6
LO# 6

Population size (in sampling units) CC SD Sample = Tolerable misstatement Estimated misstatement Size 2

The Confidence Coefficient (CC) is associated with the desired level of confidence. The desired level of confidence is the complement of the risk that the auditor will mistakenly accept a population as fairly stated when the true population misstatement is greater than tolerable misstatement.
Desired Level of Confidence 95.0% 90.0% 80.0% 70.0% CC Value 1.96 1.65 1.28 1.04
where CC = Confidence coefficient SD = Estimated standard deviation.
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LO# 6
LO# 6

The year-end balance for accounts receivable contains 5,500 accounts with a book value of $5,500,000. The tolerable misstatement for accounts receivable is set at $50,000. The expected misstatement has been judged to be $20,000. The desired confidence is 95%. Based on work completed last year, the auditor estimates the standard deviation at $31. Lets calculate sample size. Sample = Size 5,500 1.96 $31 $50,000 $20,000
2

The sample selection usually relies on random-selection techniques. Upon completion, 30 of the customer accounts selected contained misstatements that totaled $330.20. Our first calculation is the mean misstatement in an individual account which is calculated as follows: Mean Total audit difference misstatement = Sample size per sampling item $2.65 = $330.20 125
= 125
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The mean misstatement must be projected to the population Projected population = Population size Mean misstatement (in sampling units) per sampling item misstatement $14,575 = 5,500 $2.65 = SD =

The formula for the standard deviation is . . .
Total audit differences squared Mean difference Sample per sampling item2 Size
Sample size 1
$36,018.32 (125 2.652) 124
= $16.83
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LO# 6
LO# 6

Confidence Population = CC bound size SD Sample size

Lower limit
($1,653)
Projected misstatement
$14,575
Upper limit
$30,803
$16,228
= 5,500 1.96
Projected misstatement
16.83 125
($50,000) $0 $50,000
Confidence = interval
Confidence bound
Tolerable Misstatement If both limits are within the bounds of tolerable misstatement, the evidence supports the conclusion that the account is not materially misstated.
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= $14,575 $16,228
End of Chapter 9
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The Phases of an Audit That Relate to Audit Planning Chapter 5

Establish the terms of the engagement

Assess risks and establish materiality

Plan the audit

Prospective Client Acceptance

Continuing Client Retention

Near audit completion or after a significant event

Conflicts over accounting & auditing issues

Dispute over fees

Establish Terms of the Engagement

The Engagement Letter

Arrangements for use of specialists or

Any limitations of liability of the auditor

Additional services to be provided. Arrangements regarding other services.

The Audit Committee

Preliminary Engagement Activities

No specific requirements for privately held companies

Must preapprove all audit and nonaudit services

Assess Compliance with Ethical Requirements, Including Independence

Preliminary Engagement Activities

Planning the Audit

Use audit risk model

Restrict risk at account balance level

Achieve acceptable level of audit risk

Planning the Audit

Lets look at each of these steps.

Consider additional value-added

Document Audit Strategy and Plan and Prepare Audit Programs

Material & Indirect

Preliminary Analytical Procedures

Affiliates of the enterprise. Entities using equity method to

Review board minutes. Review conflict-of-interest

Review transactions with major

Review large, unusual, or

Other parties that can have

Review loan agreements for

Additional Value-Added Services

Document Audit Strategy and Plan

Types of Audit Tests

Inquiry Observation Walk Through

Tests for errors or fraud in individual transactions

Dual Purpose Tests

Purposes of Analytical Procedures

Dual Purpose Test

Types of Analytical Procedures

Substantive Analytical Procedures Decision Process

Ratio Analysis Reasonableness Analysis

Define a Tolerable Difference

Financial and operating data

Compare and Investigate

Investigate Differences for Planning and Final Analytical Procedures

Corroborating evidence is not required

Corroborating evidence is required

Audit Testing Hierarchy

Filling the Assurance Bucket

Short-Term Liquidity Ratios

Operating Cash Flow Ratio

Days of Inventory on Hand

Times Interest Earned

Internal Control Chapter 6

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.