Chapter

Expected Learning Outcomes

After studying this chapter, you should be able to:

1. Understand what and how the auditor performs the preliminary

engagement activities in relation to:
• Client selection and retention
• Audit firm limitations

• Planning the audit to develop an overall audit strategy and audit

plan
• Applying the concept of materiality to audit
• Preparing an audit plan
2. Know the considerations specific to the audit of smaller entities and
initial audit engagements.
3. Discuss briefly the other critical matters in an engagement planning
such as
Application of an analytical procedures
Establishment: of an engagement or audit team
Consideration of work performed by other auditors / parties
Assessment of going concern assumption
Identification of related parties
Client' legal obligation
 217 Chapter 9
Completion of the initial audit program

Preparation of a time budget

Assignment of personnel to the engagement Scheduling of

work
4. Document audit plan / audit program.

CHAPTER 9
RISK ASSESSMENT - PART 1
PHASE 1-A PERFORMANCE OF PRELIMINARY ENGAGEMENT
ACTVITIES

At the beginning of the current audit engagement, the auditor should perform the
following activities:
Perform procedures required by PSA 220 “Quality Control of an Audit of
Financials Statements" regarding the continuance of the client relationship
and the specific audit engagement.
Evaluate compliance with ethical requirements, including independence as
required by PSA 220.

@ Establish an understanding of the terms of engagement as required by PSA

210, "Agreeing the Terms of Audit Engagements."

Client Selection and

Retention

The auditor's consideration of client continuance and ethical requirements, including

independence, occurs throughout the performance of the audit engagement as
conditions and changes in circumstances occur. However, the auditor's initial
procedures on both client continuance and evaluation of ethical requirements
(including independence) are performed prior to performing other significant
activities for the current audit engagement. For continuing audit engagements, such
initial procedures often occur shortly after (or in connection with) the completion of
the previous audit.

The purpose of performing these preliminary engagement activities is to help

ensure that the auditor has considered any events or circumstances that may
adversely affect the auditor's ability to plan and perform the audit
engagement to reduce audit risk to an acceptably low level.
Performing these preliminary engagement activities helps to ensure that the
auditor plans an audit engagement for which:
The auditor maintains the necessary' independence and ability to perform
the engagement.
There are no issues with management integrity that may affect the
auditor's willingness to continue the engagement.
There is no misunderstanding with the client as to the terms of the
engagement.

Most CPA firms are desirous and anxious to obtain new clients. Some new
engagements are easily obtained through business transactions such as the
acquisition of a company by an existing client and the client's desire to have the
entire audit performed by one CPA firm. Others are obtained competitively
through social contacts which lead to a request that the CPA firm submit a
proposal for performing the company's annual audit. Such prospective clients
may range from start-up companies seeking a first audit to long-established
companies seeking replacement oftheir current auditor.

Client Acceptance/ Retention Decisions

Another element of quality-control deals with accepting and retaining clients. This
decision should involve more than just a consideration of management's
integrity. Strict client acceptance/continuance guidelines should be
established-to Screen out the following:

 Clients that are in financial and/or organizational difficulty — For

example, clients that could go bankrupt or clients with poor internal
accounting controls and sloppy records.
219 Chapter 9
 Clients that constitute a disproportionate percentage of the firm’s total
practice - Clients may attempt to influence the auditor into allowing
unacceptable accounting principle or issuing inappropriate opinions.

Disreputable clients — External audit firms cannot afford to have their

good reputation tarnished by serving a disreputable client or by
associating with a clear that has disreputable management.

 Clients that offer an unreasonably low free for the auditor's services
— In response, the auditor may attempt to cut corners imprudently or
lose money on the engagement. Conversely, auditors may bid for
audits at unreasonably low prices.
 Risk Assessment — Part 1 220
Audit Firm Limitations

An external audit firm should not undertake an engagement that it is not

qualified to handle. Doing so is especially important for smaller, growing firms
that may be tempted to agree to conduct an audit for which they are not qualified
or not large enough to perform. Statistics show that firms covered by a
professional liability insurance plan that are most susceptible to litigation are
those with staffs of eleven to twenty-five auditors. They appear to become
overzealous, leading to low audit quality and exposure to subsequent litigation.

It is essential for a CPA firm to maintain its integrity, objectivity and reputation
for providing high quality services. No auditor can afford to be regularly
associated with clients who are engaging in management fraud or other unlawful
activities. Before accepting an engagement, the CPA should investigate the
history of the prospective client, including such matters as the identities and
reputation of the directors, officers, and major shareholders. To help assess
engagement risk, the auditors generally obtain management's permission to
make inquiries of other third parties (e.g., client's banker or legal counsel) about
a prospective client. Generally, CPAs choose to avoid engagements entailing a
relatively high engagement risk; others may accept such engagements,
recognizing the need to expand audit procedures .to offset the unusually high
levels of risk.

To reduce their own business risk, public accounting firms try to carefully
manage their audit engagements. An important element of a public accounting
firm's quality control policies and procedures is a system for deciding whether
to accept a new client and, on a continuing basis, deciding whether to continue

providing services to existing clients. Public accounting firms are not obligated
to accept undesirable clients, nor are they obligated to continue to serve clients
when relationships deteriorate or when the management comes under a cloud of
suspicion.

In addition to evaluating engagement risk, the auditor should assess whether they

can complete the audit in accordance with the Philippine Standards on Auditing
which are based on international Standards on Auditing. The CPA must
determine whether there are conditions that would prevent them from
 221 Chapter 9
performing an independent audit of the client. Consideration will also be given
to whether the partners and staff have the necessary competence and capability
to conduct the audit.

In summary, before accepting an engagement with a new client, the CPA firm
shall assess whether it
1. is competent to perform the engagement and has the capabilities, including
time and resources to do so,
2. can comply with the relevant ethical requirements, and
3. has considered the integrity of the client and does not have information that
would lead it to conclude that the client lacks integrity

The CPA firm shall likewise establish whether the preconditions for an audit
are present such as:
 Whether the financial reporting framework to be applied in the
financial statements are acceptable;
Agreement of management that •it acknowledges and understands its
responsibility,
l. for the preparation of financial statements in accordance with applicable
financial reporting framework including where relevant to their fair
presentation,
2. 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
3. to provide the auditor with:
(a) Access to all information of which management is aware that is
relevant to the preparation of 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.

Engagement letter
 Risk Assessment — Part 1 222
The engagement letter, which includes the audit free, also includes a
description of the timing of the external auditor’s work and a description
of documentation that the client is expected to provide to the external auditor.
In writing an engagement letter, care should be taken when describing the
degree of responsibility the auditor takes with respect to discovering fraud
and misstatements. If the client wants its auditors to go beyond the
requirements of the auditing standards, the auditors should have their
attorneys review the wording to make sure that it says not only what is intended
but also what is possible.
As a final step, the CPA firm will confer and agree with management or those
charged with governance the appropriate terms of the audit engagement.

The agreed terms of the audit engagement shall be recorded in an audit

engagement letter or other suitable form of written agreement and shall
include:
(a) The objective and scope of the audit of the financial statements;
(b) The responsibilities of the auditor;
The responsibilities of management;
(d) Identification of the applicable financial reporting framework for the
preparation of the financial statements; and
(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. Figure

9-1 shows an illustration of an Audit Engagement Letter.

Recurring Audits
On recurring audits, the auditor shall assess whether circumstances require the terms
of the audit engagement to be revised and whether there is need to remind the entity
of the existing terms of the audit engagement. The auditor shall not agree to the
change in the terms of the audit engagement where there is no reasonable
justification for doing so.

If the terms of audit engagement are changed, 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.
 223 Chapter 9
If the auditor is unable to agree to a change in terms of the audit engagement and is
not permitted by management to continue the original engagement the auditor shall:
a. Withdraw from the audit engagement where withdrawal is 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.

Figure 9-1: Illustrative Engagement Letter

 Risk Assessment — Part 1 224

7560 Sen. Gil Puyat Avenue, Makati City

October 15, 2020

Mr. Alberto
Santos, Managing
Director ABC, Inc.
165 Tandang Sora, Quezon' City
Dear Mr. Santos:

You have requested that we audit the financial statements of ABC, Inc. which comprise
the statement of financial position as at December 31, 2020, and the income
statement, statement of changes in equity and cash-flow statement for the year ended,
and a summary of significant accounting policies and other explanatory information.
We are pleased to confirm our acceptance and our understanding of this audit,
engagement by means of this letter. Our audit will be conducted with the objective of
our expressing an opinion on the financial statements.

Our Responsibilities

We will conduct our audit in accordance with Philippine Standards on Auditing. Those
standards require that we comply with ethical requirements and plan and perform the
audit to obtain reasonable assurance about whether the financial statements are free
from material misstatement. An audit involves performing procedures to obtain audit
evidence about the amounts and disclosures in the financial statements. The procedures
selected depend on the auditors judgment, including the assessment of the risks of
material misstatement of the financial statements, whether due to fraud or error. An
audit also includes evaluating the appropriateness of accounting policies used and the
reasonableness of accounting estimates made by management, as well as evaluating the
overall presentation of the financial statements.

Because of the inherent limitations of an audit, together with the inherent limitations Of
intemal control, there is an unavoidable risk that some material misstatements may
notbe detected, even though the audit is properly planned and performed in accordance
with PSAS.
 225 Chapter 9

In making our risk assessments, we consider internal control relevant to the entity's
preparation of the financial statements in order to design audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an opinion
on the effectiveness of the entity's internal control. However, we will communicate
to you in writing any significant deficiencies in internal control relevant to the audit
of the financial statements that we have identified during the audit.

Unless unanticipated difficulties are encountered, our report will be substantially in the
following form:

[Form and content of the auditor's report has not been reproduced.]

The form and content of our report may need to be amended in the light of our audit
findings.

Management's Responsibility

Our audit will be conducted on the basis that management and those charged with
governance acknowledge and understand that they have responsibility:
 Risk Assessment — Part 1 226
ha) For the preparation and fair presentation of the financial statements im

accordance with Philippine Financial Reporting Standards;

b) 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
c) To provide us with:
i) Access to all information of which you are aware that is relevant to the
preparation of the financial statements such as records, documentation
and other matters; ii) Additional information that we may request from you
for the purpose of the audit; and iii) Unrestricted access to persons within
the company from whom we determine it necessary to obtain audit
evidence.

As part of our audit process, we will request from management and, where
appropriate, those charged with governance written confirmation concerning
representations made to us in connection with the audit.

We look forward to full cooperation from your staff during our audit.

Fees
Our fees which are based on the time required by individuals assigned to the
engagement will be Php100,000 plus out-of-pocket expenses and will be billed as
work progresses. Individual hourly rates vary according to the degree of responsibility
involved and the expenence and skill required.

This letter will be effective for future periods unless it is terminated, amended, or
superseded.

Please sign and retum the attached copy of this letter to indicate that it is accordance
with your understanding of the arrangements for our audit of the financial
statements.

Yours truly, Acknowledged on behalf of ABC, Inc. by

 227 Chapter 9

Alvin Monico Mr. Alberto Santos

Valderama & Co., CPAs Managing Director
Date

PHASE 1-B4 PLANNING THE AUDIT TO DEVELOP AN OVERALL

AUDIT STRATEGY AND AUDIT PLAN

Introduction

Once the client has been obtained and the engagement letter signed by both
parties (auditor and client), the planning process intensifies as the auditors
concentrate their efforts in obtaining a detailed understanding of the client's
business in developing an overall audit strategy and assess the risks of material
misstatement of the financial statements.

PSA 300, "Planning an Audit of Financial Statements " establishes standards

and provides guidance on the considerations and activities applicable to
planning and audit of financial statements. It states that the auditor should plan
the audit so that the engagement will be performed in an effective manner.

The auditor-in-charge must develop a "plant of action" to organize, coordinate'

and schedule activities of the audit staff. An audit plan is normally drafted prior
to starting the work at the client's offices.

Nature and Scope of Audit Planning

Audit planning involves the establishment of the overall audit strategy for the
engagement and developing an audit plan, in order to reduce audit risk to an
Acceptably low level. Planning involves the engagement partner and other key
members of the engagement team to benefit from their experience and insight
and to enhance the effectiveness and efficiency of the planning process.

The nature and extent of planning activities will vary according to the size and
complexity of the entity, the auditor's previous experience with the entity, and
changes in circumstances that occur during the audit engagement.
 Risk Assessment — Part 1 228
Planning is a continuous and iterative process that often begins shortly after or in
connection with the completion of the previous audit and continues until the completion
of the current audit engagement. However, in planning an audit, the auditor considers
the timing of certain planning activities and audit procedures that need to be completed
prior to the performance of further audit procedures. For example, the auditor plans the
discussion among engagement team members, the analytical procedures to be applied as
risk assessment procedures, the obtaining of a general understanding of the legal and
regulatory framework applicable to the entity and how the entity is complying
with that framework, the determination of materiality, the involvement of experts and
the performance of other risk assessment procedures prior to identifying and assessing
the risks of material misstatement and performing further audit procedures at the
assertion level for classes of transactions, account balances, and disclosures that are
responsive to those risks.

The auditor may decide to discuss elements of planning with the entity's
management to facilitate the conduct and management of the audit engagement
(for example, to coordinate some of the planned audit procedures often occur, the
overall audit strategy and the audit plan remain the auditor's responsibility.

Benefits of Audit Planning

Audit planning generally involves the determination of the expected nature, timing
and extent of the audit. Among the benefits derived from audit planning are the
following:
a) It helps ensure that appropriate attention is devoted to important areas of
the audit.
b) It aids in identifying potential problems and resolving them on a timely
basis.

c) It helps ensure that the audit is properly organized, managed and performed in
an effective and efficient manner.
d) It assists in the proper assignment and review of the work of the engagement
team members.
e) It helps coordinate the work to be done by auditors of components and
other parties involved such as experts, specialists, etc.

The Overall Audit Strategy

 229 Chapter 9
PSA 300 requires that the auditor establishes the overall strategy for the audit. This
overall audit strategy sets the scope, timing and direction of the audit and guides the
development of the more detailed audit plan. In developing the audit strategy, the
auditor considers the results of the preliminary activities described in the preceding
section. The process of establishing the audit strategy involves
a. Identifying the characteristics of the engagement that define its scope.
Examples are:

l. The financial reporting framework

2. Industry specific reporting requirements, and
3. The locations of the components of the entity.

b. Ascertaining the reporting objectives of the engagement to plan the timing

of the audit and the nature of the communication required such as:
l. Deadlines for interim and final reporting, and
2. Key dates and organization of meetings with management and those
charged with governance to discuss the nature and extent of audit

3. Discussion with management regarding the expected communication on the

status of audit work throughout the engagement.
c. Considering the important factors that will determine the focus and direction
of the engagement teams efforts, such as:
I. Determination of appropriate materiality levels
2. Preliminary identification of areas where there may be higher risks of
material misstatement.
3. Preliminary identification of material components and account balances.
4. Evaluation of whether the auditor may plan to obtain evidence
regarding the effectiveness of internal control, and
5. Identification of recent significant entity-specific, industry. financing
reporting or other relevant developments.

d. Considering the results of preliminary engagement activities and, where

applicable, whether knowledge gained on other engagements performed by
the engagement partner for the entity is relevant; and
 Risk Assessment — Part 1 230
e. Ascertaining the nature, timing and extent of resources necessary to perform
the engagement.

Benefits of Developing the Audit Strategy

• The resources to deploy for specific audit areas, such as the use of
appropriately experienced team members for high risk areas or the

involvement of experts on complex matters.

• The amount of resources to allocate to specific audit areas, such as the

number of team members assigned to observe the inventory count at
material locations, the extent of review of other auditors' work in the case
of group audits, or the audit budget in hours to allocate to high risk areas;

• When these resources are to be deployed, such as whether at an interim

audit stage or at key cut-off dates; and

• How such resources are managed, directed and supervised, such as when
team briefing and debriefing meetings are expected to be held, how
engagement partner and manager reviews are expected to take place (for
example, on-site or off-site), and whether to complete engagement quality
control reviews.

Once the overall audit strategy has been established, an audit plan can be
developed to address the various matters identified in the overall audit strategy,
taking into account the need to achieve the audit objectives through the efficient
use of the auditor's resources. The establishment of the overall audit strategy
and the detailed audit plan are not necessarily discrete or sequential processes,
but are closely inter-related since changes in one may result in consequential
changes to the other.

In audits of small entities, the entire audit may be conducted by a very small
audit team. Many audits of small entities involve the engagement partner (who
may be a sole practitioner) working with one engagement team member (or
without any engagement team members). With a smaller team, co-ordination of,
 231 Chapter 9
and' communication between, team members are easier. Establishing the overall
audit strategy for the audit of a small entity need not be a complex or time
consuming exercise; it varies according to the size of the entity the complexity
of the audit, and the size of the engagement team. For example, a brief
memorandum prepared at the completion of the previous audit, based on a
review of the working papers and highlighting issues identified in the audit just
completed, updated in the current period based on discussions with the owner
manager, can serve as the documented audit strategy for the current audit
engagement if it covers the matters noted in paragraph 7 of PSA 300.

A. Application of the Concept of Materiality to Audit

PSA 320, "Materiality in Planning and Performing an Audit" establishes

standards and deals with the auditor's responsibility to apply the concept of
materiality in planning and performing an audit of financial statements.

To reiterate the importance of the concept of materiality to audit, the

definition of materiality in accordance with the FRSC's "Framework for
the Preparation and Presentation of Financial Statements" follows:

"Information is material if its omission or misstatement could

influence the economic decisions of users taken on the basis of the
financial statements. Materiality depends on the size of the item or
error judged in the particular circumstances of its omission or
misstatement. Thus, materiality provides a threshold or cut-off
point rather than being a primary qualitative characteristic which
information must have if it is to be useful."

This definition emphasizes the importance of materiality to reasonable

users Who rely on the statements to make decisions. Auditors, therefore,
must have knowledge of the likely uses of their client's statements and the
decisions that are being made.

Materiality involves both quantitative and qualitative considerations.

In assessing the quantitative importance of a misstatement, it is necessary to
relate the peso amount of the error to the financial statements under
examination, Qualitative considerations; on the other hand, relate to the causes
of misstatement. An error that may not be material quantitatively, may be
 Risk Assessment — Part 1 232
material qualitatively. This may occur, for instance, when the misstatement is
attributed to an irregularity or an illegal act by the client.

The objective of an audit of financial statements is to enable the auditor to

express an opinion whether the financial statements are prepared, in all
material respects, in accordance with an identified financial reporting
framework. The assessment of what is material is a matter of professional
judgment.

In planning the audit, materiality should be considered by the auditor when:

(a) determining the nature timing and extent of audit procedures;

(b) identifying and assessing the risks of material misstatement;

and (c) determining the nature, timing and extent of further audit.

The auditor's determination of materiality is a matter of professional judgment

and is affected by the auditor's perception of the financial information
needs of users of the financial statements. In this context, it is
reasonable for the auditor to assume that users:

(a) Have a reasonable knowledge of business and economic activities and

accounting and a willingness to study the information in the financial

statements with renewable diligence;

(b) Understand that financial statements at prepared mud and audited to

levels of materiality;

(c) Recognize the uncertainties inherent in the measurement of amounts

based on the use of estimates, judgment and the consideration of
future events; and

(d) Make reasonable economic decisions on the basis of the

information in the financial statements.
233 Chapter 9

Levels of Materiality
The auditor assesses materiality at two levels:

• First is the overall materiality (or materiality level for the financial
statements as a whole)

• Second is the specific materiality (or materiality level for particular

classes of transactions. account balances or disclosures)

The auditor considers materiality at both the overall financial statement

level and in relation to individual account balances, classes of transactions
and disclosures. Materiality may be influenced by considerations
such as legal and regulatory requirements and considerations relating to
individual financial statement account balances and relationships. This
process may result in different materiality levels depending on the aspect
of the financial statements being considered.

I. Overall materiality

Materiality for the financial statements as a whole (overall

materiality) is based on the auditor's professional judgment as to the
highest amount of misstatement(s) that could be included in the
financial statements without affecting the economic decisions taken
by a financial statement user. If the amount of unconnected
misstatements, either individually or in the aggregate, is higher
than the overall materiality established for the engagement, it
would mean that the financial statements are materially
misstated.
Overall materiality is. based on the common financial information
needs of the various users as a group. Consequently, the possible
effect of misstatements on specific individual users, whose needs
may vary widely, is not considered.

2. Specific materiality
 Risk Assessment — Part 1 234
In some cases, there may be a need to identify misstatements of lesser
amounts than overall materiality that would affect the economic
decisions of financial statement users. This could relate to sensitive areas
such as particular note disclosures (i.e., management remuneration or
industry-specific data), compliance with legislation or certain terms in a
contract, or transactions upon which bonuses are based. It could also
relate to the nature of a potential misstatement.

PSA 320 likewise requires that performance materiality be set.

Performance Materiality
Performance materiality is used by the auditor to reduce the risk to an
appropriate low level that the accumulation of uncorrected and unidentified
misstatements exceeds materiality for the financial statements as a whole
(overall materiality), or materiality levels established for particular classes
of transactions, account balances, or disclosures (specific materiality).
Performance materiality is set at a lower amount (or amounts) than overall
specific materiality. The objective is to perform more audit work than would be
required by the overall or a specific materiality to:

• Ensure that misstatements less than overall or specific materiality are

detected, so as to appropriately reduce the probability that the
aggregate of uncorrected errors and undetected misstatements exceed
materiality for the financial statements as a whole; and thus

• Provide a margin or buffer for possible undetected misstatements. This

buffer is between detected. but uncorrected misstatements in the
aggregate and the overall or specific materiality.
The margin provides some assurance for the auditor that undetected'
misstatements, along with all uncorrected misstatements, will not likely
accumulate to reach an amount that would cause the financial statements to
be materially misstated.

Performance materiality is set in relation to overall materiality or specific

materiality. For example, a specific performance materiality can be set at a
lower amount than overall performance materiality for testing repairs and
235 Chapter 9
maintenance expenses if there is a higher risk of assets not being
capitalized. Specific performance materiality may also be used to' perform
additional work in areas that may be sensitive due to the nature of potential
misstatements and their occurrence, rather than their monetary size.

For example, if overall materiality was set at P200,000 and the audit procedures
were planned to detect all errors •in excess of P200,000, it is quite possible that
an error of say P80,000 would go undetected. If three such errors existed totaling
to P240,000, the financial statements would be materially misstated. If
performance materiality was set at P 120,000, it would be much more likely that

at least one or all of the P80,000 errors would be detected. Even if only one of
the three errors is identified and corrected, the remaining P160,000 misstatement
would still be less than P200,000 and the financial statements as a whole would
not be materially misstated.

How to Determine Materiality

Auditors make a preliminary assessment of materiality of the financial

statements as a whole by determining the amount by which they believe
the financial statements could be misstated without affecting users'
decisions. This-amount is called "preliminary judgment about
materiality" or 'planning materiality". This judgment need not be
quantified but often is. It is called a preliminary judgment about materiality
because it is a professional judgment and may change during the
engagement if circumstances change. The reason for determining "planning
materiality' is to help the auditor plan the appropriate evidence to
accumulate. If the auditor sets a low peso amount, more evidence is
required than for a high amount.

In establishing planning materiality or preliminary judgment about

materiality, an auditor must also consider any potential effect a misstatement
might have which may be greater than the peso amount involved. A
misstatement which may not be material based on quantitative factors but that
does not allow a client to meet a condition in a contractual obligation or
expectations of a financial statement user may be considered material. In these
instances, amount of planning materiality based on the users expectations of
 Risk Assessment — Part 1 236
income or alter those working on the engagement to the potential for these
types of material misstatement.

Rules of Thumb (For Use as a Starting Point)

Overall Specific Performance

Materiality is a matter of Establish a lower, No specific guidance is
professional judgment specific materiality provided in the PSAs.
rather than a mechanical amount (based on Percentages range from
existence. As a result, no professional judgment) 60% (of overall or
specific guidance is specific materiality),
for the audit of specific
provided in the PSA. where there is a higher
However, profit from or sensitive financial
risk of material
continuing profit from statement areas.
misstatement, up to
continuing operations (3% 85% where the assessed
to 7%) is often used in risk of material
practice as having the misstatement is less.
greatest significance to
financial statement users.
If this is not a useful

Other Considerations

• When accepting new audit engagement, inquire about the overall

materiality used by the previous auditor. If available, this would help
in determining whether further audit procedures may be required on
the opening asset and liability balances.
237 Chapter 9
Ensure that any experts employed by the entity (to assist the entity
in preparing the financial statements), or used by the audit team
are instructed to use an appropriate materiality level in relation to
the work they perform.

Relationship between Materiality and Audit Risk

When planning the audit, the auditor considers what would make the financial
statements materially misstated. The auditor's assessment of materiality,
related to specific account balances and classes of transactions, helps the
auditor decide such questions as what items to examine and whether to use
sampling and analytical procedures. This enables the auditor to select audit
procedures that, in combination, can be expected to reduce audit risk to an
acceptably low level.

There is an inverse relationship between materiality and the level of audit

risk, that is, the higher the materiality level, the lower the audit risk and
vice versa. The auditor takes the inverse relationship between materiality
and audit risk into account when determining the nature, timing and
extent Of audit procedures. For example, 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 either:

(a) reducing the assessed level of control risk, where this is possible, and
supporting the reduced level by carrying out extended or additional tests
of control; or
(b) reducing detection risk by modifying the nature, timing and extent of
planned substantive procedures.

Audit Plan

The auditor should develop an audit plan for the audit in order to reduce
audit risk to an acceptably low level.

The audit plan shall include a description of:

(a) The nature, timing and extent of planned risk assessment procedures,
as determined under PSA 315, "Identifying and Assessing the Risks of
 Risk Assessment — Part 1 238
Material Misstatement through Understanding the Entity and Its
Environment."
(b) The nature, timing and extent of planned further audit procedures at
the assertion level, as determined under PSA 330, "The Auditor's
Responses to Assessed Risks."
(c) Other planned audit procedures that are required to be
carried out so that the engagement complies with PSAs.
The auditor shall update and change the overall audit strategy and the
audit plan as necessary during the course of the audit.

The auditor shall plan the nature, timing and extent of direction and
supervision of engagement team members and the review of their work.

The auditor shall document:

(a) The overall audit strategy;
(b) The audit plan; and
(c) Any significant changes made during the audit engagement to the
overall audit strategy or the audit plan, and the reasons for such
changes.

Once the audit strategy has been established, the auditor is able to start the
development of a more detailed audit plan to address the various matters
identified in the audit strategy; taking into account the need to achieve the
audit objectives through the efficient use of the auditor's resources.
Although the auditor ordinarily establishes the audit strategy before
 Risk Assessment — Part 1
developing the detailed audit plan, the two planning activities are not
necessarily discrete or sequential processes but are closely inter-related
since changes in one may result in consequential changes to the other.

The audit plan is more detailed than the audit strategy and includes the

nature, timing and extent of audit procedures t0'be performed by

engagement team members in order to obtain sufficient appropriate audit
evidence to reduce audit risk to an acceptably low level. Documentation of
the audit plan also serves as a record of the proper planning and
performance of the audit procedures that can be reviewed and approved
prior to the performance of further audit procedures.

Direction, Supervision and Review

The auditor should plan the nature, timing and extent of direction and
supervision of engagement team members and review of their work.

The nature, timing and extent of the direction and supervision of

engagement team members and review of their work vary depending on
many factors, including:
The size and complexity of the entity.
The area of the audit.
The assessed risks of material misstatement (for example, an increase in
the assessed risk of material misstatement for a given area of the audit
ordinarily requires a corresponding increase in the extent and timeliness of
direction and supervision of engagement team members, and a more
detailed review of their work).
The capabilities and competence of the individual team members
performing the audit work. PSA 220 contains further guidance on the
direction, supervision and review of audit work.

Changes to Planning Decisions during the Course of the Audit

The overall audit strategy and the audit plan should be updated and changed as
necessary during the course of the audit.

Planning an audit is a continual and iterative process throughout the audit

engagement. As a result of unexpected events, changes in conditions, or the
 Risk Assessment — Part 1 240
audit evidence obtained from the results of audit procedures, the auditor
may need to modify the overall audit strategy and audit plan, and thereby
the resulting planned nature, timing and extent of further audit

procedures. Information may come to the auditor's attention that differs

significantly from the information available when the auditor planned the
audit procedures. For example, the auditor may obtain audit evidence
through the performance of substantive procedures that contradicts the
audit evidence obtained with respect to the testing of the operating
effectiveness of controls. In such circumstances, the auditor reevaluates
the planned audit procedures, based on the revised consideration of
assessed risks at the assertion level for all or some of the classes of
transactions, account balances or disclosures.

Consideration Specific to Smaller Entities

In audits of small entities, an audit may be carried out entirely by the audit
engagement partner (who may be a sole practitioner). In such situations,
questions of direction and supervision of engagement team members and
review of their work do not arise as the audit engagement partner, having
personally conducted all aspects of the work, is aware of all material issues.
The audit engagement partner (or sole practitioner) nevertheless needs to
be satisfied that the audit has been conducted in accordance with PSAs.
Forming an objective view on the appropriateness of the judgments made in
the course of the audit can present practical problems when the same
individual also performed the entire audit. When particularly complex or
unusual issues are involved, and the audit is performed by a sole
practitioner, it may be desirable to plan to consult with other suitably
experienced auditors or the auditor's professional body.
A suitable, brief memorandum may serve as the documented strategy for
the audit of a smaller entity. For the audit plan, standard. audit programs or
checklists (see paragraph A 18 of PSA 300) drawn up on the assumption of
few relevant control activities, as is likely to be the case in a smaller entity,
may be used provided that they are tailored to the circumstances Of the
engagement, including the auditor's risk assessments.
241 Chapter 9
Documentation

The auditor should document the overall audit strategy and the audit plan,
including any significant changes made during the audit engagement.
The auditor's documentation of the overall audit strategy records the
key decisions considered necessary to properly plan the audit and to
communicate significant matters to the engagement team. For example,
the auditor may summarize the overall audit strategy in the form of a
memorandum that contains key decisions regarding the overall scope,
timing and conduct of the audit.

The auditor's documentation of any significant changes to the originally planned

overall audit strategy and to the detailed audit plan includes the reasons for the
significant changes and the auditor's response to the events, conditions, or
results of audit procedures that resulted in such changes. For example, the
auditor may significantly change the planned
overall audit strategy and the audit plan as a result of a material business
combination or the identification of a material misstatement of the financial
statements. A record of the significant changes to the overall audit
strategy and the audit plan, and resulting changes to the planned nature, timing
and extent of audit procedures, explains the overall strategy and audit plan finally
adopted for the audit and demonstrates the appropriate response to significant
changes occurring during the audit.

The form and extent of documentation depend on such matters as the size
and complexity of the entity, materiality, the extent of other
documentation, and the circumstances of the specific audit engagement

Additional Considerations in Initial Audit Engagements

The auditor should perform the following activities prior to starting an initial
audit;
(a) Perform procedures regarding the acceptance of the client relationship
and the specific audit engagement [see PSA 220 for additional
guidance].
 Risk Assessment — Part 1 242
(b) Communicate with the previous auditor, where there has been a change
of auditors, in compliance with relevant ethical requirements.

Other Critical Matters in Engagement Planning

l. Application of Analytical Procedures in Planning the Audit

The purpose of applying analytical procedures in planning the audit is

to assist in understanding the business and in identifying areas of
potential risk. It will therefore assist the auditor in planning the nature,
time, and extent of auditing procedures that will be used to obtain
evidential matter for specific account balances or classes of transactions.
By identifying such things as the existence of unusual transactions and
events, and amount ratios and trends, matters that have financial
statement and audit planning ramifications might be
brought to light. Likewise, relevant non-financial information such as
number of employees, area of selling Space, volume of goods produced
may also contribute to the accomplishment of the purpose of the
analytical procedures. PSA 520 requires the auditors to perform analytical
procedures as a part of the planning process for every audit.

2. Establishment of an Engagement or Audit Team

An audit team consists of people with different levels of expertise

and experience. The team usually is composed of an engagement
partner, a manager, at least one senior, and one or more staff auditors.
In determining the number of people who will be assigned to an
engagement, an auditor normally considers the audit's size and
complexity, the availability and experience of personnel, the necessity
for special expertise, and the opportunity to train personnel, and the
continuity and rotation of personnel. The audit team assembled for a
larger engagement typically is larger than that needed for a smaller
engagement. An engagement involving an entity in a regulated industry,
such as banking, also requires that the major members of the audit team
have necessary knowledge and experience in that industry.

3. Consideration of Work Performed by Other Auditors/Parties

The following factors should be considered in assessing the work

performed by other auditors / parties:
243 Chapter 9
• The involvement of other auditors in the audit of
components, for example, subsidiaries, branches and divisions.
The involvement of experts. The
number of locations.

a. Predecessor Auditor
The successor auditor's examination may be greatly facilitated
by consulting with the predecessor auditors and reviewing the
predecessor's working papers. Communication with the
predecessor auditors can provide the successor CPA with
background information about the client, details about the
client's system of internal control, and evidence as to the
account balances at the beginning of the year under audit.
Auditors are ethically prohibited from disclosing confidential
information obtained in the course of an audit without th e
consent of the client. The successor auditor should therefore

obtain the client's consent before making inquiries from the predecessor
auditors.
If the auditor is unable to obtain cooperation from the preceding
auditors, or if he feels that the work done by the preceding
auditors does not meet the requirements of generally accepted
auditing standards, he may have to treat the audit of the• new
client, previously audited by other accountants, just as he would
the first audit of a client who has never been audited before.

b. Other CPAs
Large companies generally consist of divisions and subsidiaries
located in many different parts of the country
or the world. For a variety of reasons, one or several of the
subsidiaries or divisions may have different auditors.
TO be able to •report on the statements of the combined entity, an
auditor must determine that she or he is able to be the principal
auditor. Principal auditor means the auditor with responsibility
for reporting on the financial statements of an entity when those
financial statements include financial information of one or more
components audited by another auditor. Other auditor means an
 Risk Assessment — Part 1 244
auditor, other than the principal auditor, with responsibility for
reporting on the financial information of a component which is
included in the financial statement audited by the principal auditor.
Other auditors include affiliated firms whether using the same
name or not, correspondents as well as unrelated auditors,
Component means a division, branch, subsidiary, joint venture,
associated company or other entity whose financial information is
included in financial statements audited by the principal auditor.

c. Specialists
CPAs may lack the qualifications necessary to perform certain technical
tasks relating to the audit. A specialist brings unique knowledge
and judgment in a field other than accounting and auditing. An auditor
might decide to have an art appraiser place values on works of art, a
mineralogist determine the physical characteristics of mineral reserves, or
an actuary provide data related to a group's life expectancy. Effective
planning involves

arranging for the appropriate use of specialists both inside and

outside of the client organization.

d. Use of Client 's Staff

The client's staff should have the accounting records up-to-date

when the auditors arrive. In addition, many audit working papers can be
prepared for the auditors by the client's staff, thus reducing the cost of the
audit and freeing the auditors from routine work. The auditors may set up
the columnar headings for such working papers and give instructions to the
client's staff as to the information to be gathered. These working papers
should bear the label Prepared by Client, or PBC, and also the initials of the
auditor who verifies the work performed by the client's staff. Working
papers prepared by the client should never be accepted at face value; such
papers must be reviewed and tested by the auditors. Among the tasks that
may be assigned to the client's employees are the preparation of a trial
balance of the general ledger, preparation of an aged trial balance of
accounts receivable, analyses of accounts receivable written off, lists of
property additions and retirements during the year, and analyses of various
revenue and expense accounts. Many of these "working papers" may be in
the form of computer spreadsheets and other computerized data files.
245 Chapter 9
e. Internal Auditors
Internal auditors can affect the audit in two ways. First, they
can enhance internal control. In deciding whether to reduce the
amount of testing for specific assertions because of work
performed by internal auditors, the independent auditor should
consider (l) the materiality of the amount, (2) the risk Of
misstatement, and (3) the degree of subjectivity involved in
evaluating the accumulated audit evidence. As these factors
increase, the auditor is less likely to rely on the internal auditor's

The second way internal auditors affect an audit is by assisting

independent auditors in performing specific audit procedures• For
example, an internal auditor may observe client personnel

4. Assessment of Going Concern Assumption

PSA 570 requires auditors to evaluate whether substantial doubt exists
about an entity's ability to continue as a going concern, based on
procedures planned and performed to obtain evidence about the
management assertions embodied in e financial statements. That is, an
auditor is not required to design specific procedures to evaluate
whether an entity is a going concern.
When planning and performing audit procedures and in evaluating the
results thereof, the auditor should consider the appropriateness of management's
use of the going concern assumption in the preparation

of the financial statements.

Examples of events or conditions, which individually or collectively,
may cast significant doubt about the going concern assumption are set
out below. This listing is not all-inclusive nor does the existence of one or
more of the items always signify that a material uncertainty exists.
Financial
• Net liability or net current liability position.
• Fixed-term borrowings approaching maturity without realistic
prospects of renewal or repayment; or excessive reliance on short-
term borrowings to finance long-term assets.
 Risk Assessment — Part 1 246

• Indications of withdrawal of financial support by debtors and other

creditors.

Operating
• Loss of key management without replacement.

• Loss of a major market, franchise, license, or principal supplier.

• Labor difficulties or shortages of important supplies.

Other

• Non-compliance with capital or other statutory requirements.

• • Pending legal or regulatory proceedings against the entity that may,

if successful, result in claims that are unlikely to be satisfied.

• Changes in legislation oh government policy expected to adversely

affect the entity.
The significance of such events or conditions often can be
mitigated by other factors. For example, the effect of an entity
being unable to make its normal debt repayments may be counter-
balanced by management's plans to maintain adequate cash flows
by alternative means, such as by disposal of assets, rescheduling
of loan repayments, or obtaining additional capital. Similarly, the
loss of a principal supplier may be mitigated by the availability of
a suitable alternative source of supply.

5. Identification of Related Parties

A related party is defined as an affiliated company, a principal
owner of the client company, or any other party with which the
client deals where one of the parties can influence the management
or operating policies of the other. A related party transaction is any
transaction between the client and a related party. Common
examples include sales or purchase transactions between a parent
company and its subsidiary, exchanges of equipment between two
247 Chapter 9
companies owned by the same person, and loans to officers. A less
common example is the exercise of significant management
influence on an audit client by its most important customer.
Because material related party transactions must be disclosed, it is
important that all related parties be identified and included in the
permanent files early in the engagement. Finding undisclosed
related party transactions is thereby enhanced. Common ways of
identifying related parties include inquiry of management, review of
SEC filings, and examination of stockholders' listings to identify
principal stockholders.

6. Client 's Legal Obligations

Pertinent current-year information that auditors should review
includes (1) minutes of directors' and stockholders' meetings. (2)
changes to articles of incorporation or by-laws, and (3) any
significant contracts executed during the year. By reading the
minutes, an auditor will obtain information about significant events
that have or will have an impact on the client.
For new clients for which historical information relating to these
matters is unavailable, the auditor should review
information relating to prior years.
7. Completion of the Initial Audit Program
An audit program is a set of audit procedures specifically designed for
each audit. The program which includes both substantive tests and
tests of controls will enable the auditor to express an opinion on the
financial statements taken as a whole.
The auditor should develop and document an audit program setting
out the nature, timing and extent of planned audit procedures required
to implement the overall audit plan. The audit program serves as a set
of instructions to assistants involved in the audit and as a means to
control and record the proper execution of the work. The audit
program may also contain the audit objectives for each area and a
time budget in which hours are budgeted for the various audit areas or
procedures. Considering materiality, risk of misstatement, and the
relative cost of performing audit procedures, auditors determine the
procedures to test the assertions embodied in the financial statements.
 Risk Assessment — Part 1 248
Auditing standards require that a audit program be prepared as a
part of each engagement.
In preparing the audit program, the auditor would consider the
specific assessments of inherent and control risks and the required level
of assurance to be provided by substantive procedures. The

auditor would also consider the timing of tests of controls and

substantive procedures, the coordination 0 any assistance expected
from the entity, the availability of assistants and the involvement of
other auditors or experts. Other matters may also need to be considered
in more detail during the development of the audit program.
On initial engagements, the audit program typically will develop in three
Stages:
(l) the broad phases of the program can be outlined at the time of
engagement;
(2) other details of the program can be identified after the review of
internal control structure and accounting procedures has begun; and
(3) procedures on specific phases of the audit can be further challenged
and revised as the work progresses.
On recurring engagements, the program for the preceding audit should
be studied before preparing the program for the current audit. The
program for the current audit should reflect modifications or are
required by the experience gained in the business, internal control or
accounting methods of the client.

8. Preparation of a Time Budget

A time budget is an estimate of the total hours an audit is expected to
take. It is based on the information obtained in the first major step in
the audit that is, obtaining an understanding of the client. It takes into
consideration such things as:
(a) the client's siie as indicated by its gross assets, sales, number of
employees
(b) location of client facilities
(c) the anticipated accounting and auditing problems
(d) the competence and experience of staff available.
 249 Chapter 9
The total time must be allocated by the preparation of work schedules
indicating who is to do what and how long it should take. Thus, total hours are
budgeted by major categories and may be scheduled on a
weekly basis. Time budget also serves as the basis for estimating fees. [t is also
an important tool to Communicate to the audit staff those areas the manager
or partner believes are critical and require more time. Furthermore, a time
budget is used to measure the efficiency of the staff and to determine at each
stage of the engagement whether the work is progressing at a satisfactory rate.
An illustration of an Audit Budget and Time Summary is shown in Figure 9-
2.

Figure 9-2: Portion of an Audit Budget and Time Summary

For repeat engagement, the development of time budgets is facilitated

by reference to the preceding year's detailed time records.
 Risk Assessment — Part 1 250

Managing time is an important consideration because billing is often

based on the amount of time charged to the engagement. Indeed, the most
costly element of an engagement is the auditor's time. ,Time budgets
can motivate staff to perform efficiently, and one criterion by which
audit personnel are evaluated is their ability to complete assignments within
the allotted time. (However, placing too much emphasis on time
management can lower the quality of the audit.)

A periodic accounting of time and budget may be prepared as a basis

for determining the cause(s) of the variance between actual and
budgeted hours. This is illustrated in Figure 9-2. This report will also
serve as a guide in projecting the audit time for the succeeding audits.

9. Assignment of Personnel to the Engagement

Staff must, therefore, be assigned with that standard in mind. On larger
engagements, there are likely to be one or more partners and staff at
several experience levels doing the audit. Specialists in such technical
areas as statistical sampling and computer auditing may also be
assigned. On smaller audits there may be only one or two staff
members.
A major consideration affecting staffing is the need for continuity from
year to year. An inexperienced staff assistant is likely to become the
most experienced non-partner on the engagement within a few years.
Continuity helps the CPA firm maintain familiarity with the technical
requirements and closer interpersonal relations with client personnel.
Another consideration is that the persons assigned be familiar with the

client's industry.
In PSA 220, "Quality Control for an Audit of Financial Statements," the
auditor, and assistants with supervisory responsibilities, will consider
the professional competence of assistants performing work delegated to
them when deciding the extent of direction, supervision and review
appropriate for each assistant.
Any delegation of work to assistants would be in a manner that provides
reasonable assurance that such work will be performed with due care by
251 Chapter 9
persons having the degree of professional competence required in the
circumstances.

10. Scheduling of Work

Audit work that can always be performed during the interim
period includes the consideration of internal control, issuance Of
management letter, and substantive tests of transactions that have
occurred to the interim date.
Interim tests of certain financial statement balances, such as
accounts receivable, may also be performed, but this results in
additional risk that must be controlled by the auditors. Significant
errors or
irregularities could arise in these accounts during the remaining period
between the time that the interim test was performed and the statement
of financial position date. Thus, to rely on the interim test of a
significant account balance, the auditors must perform additional tests
of the account during the remaining period.
Performance of other substantive tests is scheduled near at, and after year
end. Consideration should be given to such factors as:

a) Deadline for submitting final audit report and filing of income tax
returns
b) Ability of the client's staff to submit required schedules
c) Other audit clients

Documentation of Audit Plan / Audit Program

Documentation of the planning process is done through the preparation of

working papers showing:
(l) Audit Plans (discussed in this section)
(2) Audit Programs
(3) Time Budget (refer to page 245)

An audit plan contains the overview of the engagement, outlining the nature
and characteristics of the client's business operations and the overall audit
strategy.
 Risk Assessment — Part 1 252
The following information are included in a typical audit plan:

I . Description of the client company its structure, nature of business and

organization.
2. Audit objectives (i.e., if the audit is for stockholders, creditors or it is
special-purpose audit)
3. Description of the nature and extent of other services such as tax returns
preparation, etc.
4. Timetable of the audit work

5. Work to be done by the client's employer

6. Assignment of audit staff
7. Target completion dates of the major segments of the engagement
8. Preliminary evaluation and judgment about materiality level for the
engagement

9. Any special problems to be resolved during the engagement particularly

those revealed by analytical procedures
10. Conditions that may require changes in audit test

Normally, the audit plan is prepared before starting work at the client's
office. It may, however be modified throughout the engagement as the
auditor deems necessary depehding on his consideration of internal
control or as special problems are encountered.

The auditor may wish to prepare a memorandum setting forth the

preliminary audit plan, particularly for large and complex entity.

Planning a Repeat Engagement

It is far easier to plan for a repeat engagement than planning for a first
audit of a new client. The working papers in the previous year's audit
provide a wealth of information useful in planning the recurring
engagement. Of course, the auditor-in-charge of a repeat engagement
would have a good working knowledge of the client's business. The
253 Chapter 9
auditor however should not merely duplicate last year 5 audit program but
should modify his approach to the audit for any changes in the client's
operations, internal control structure, or business environment.
 Risk Assessment — Part 254

REVIEW QUESTIONS AND EXERCISES

Questions

1. What information should CPA firm seek in its investigation of a prospective

client?

2. State the purpose and nature of an engagement letter.

3. Discuss what is meant by the phrase "shopping for accounting

principles". What mechanisms have served to prevent this practice by
management?

4. Criticize the following statement. "Throughout this audit, for all purposes
we will define a "material amount" as "P500,000".

5. Describe the two types of misstatement due to fraud. Which one is

generally is of more concern to the auditor?

6. Many CPA firms are taking a business risk approach to audits. Define what is
meant by business risk. Provide an example of a business risk that could result
in a risk of material misstatement of 'the financial statements.

7. Should a separate audit program be prepared for each audit engagement, or can
a standard program be used for most engagements?

8. "An audit plan is desirable when new staff members are assigned to an
engagement, but an experienced auditor should be able to conduct an audit
without reference to an audit program." Do you agree? Discuss.

9. Describe the risk of material misstatement of an assertion. List the

two components that make up this risk.

10. Certain audit risks are significant in that they require special audit
consideration. Describe the typical characteristics of these risks.
 255 Chapter 9
I I. Suggest some factors that might cause an audit engagement to exceed the
original time estimate. Would the extra time be charged to the client?
12. What problems are created for a CPA firm when audit staff members
underreport the amount of time spent in performing the specific audit
procedures?
13. The overall audit strategy, the audit plan, and the time budget are
three important working papers prepared early in an audit. What
functions do these working papers serve in the auditors' compliance
with generally accepted auditing standards? Discus.
14. Auditing standards require the auditors to have a team meeting
regarding the risk of fraud for the engagement. What is the purpose of
this meeting?
15. When planning an audit, the auditors should assess the levels of risk
and materially for the engagement. Explain how the auditors'
judgments about these two factors affect the auditors' planned audit
procedures.

Multiple Choice Questions

1. In planning and performing an audit, auditors are concerned about risk

factors for two distinct types of fraud: fraudulent financial reporting and
misappropriation of assets. Which of the following is a risk factor for
misappropriation of assets?
a. Generous performance-based compensation systems.
b. Management preoccupation with increased financial performance.
c. An unreliable accounting system.
d. Strained relationships between management and the auditors.

2. Which of the following should not normally be included in the engagement

letter for an audit?
a. A description of the responsibilities of client
personnel to provide assistance.
b. An indication of the amount of an audit.
c. A description of the limitations of an audit.
d. A listing of the client's branch offices selected for testing.
 Risk Assessment — Part 256
3. Which portion of an audit is least likely to be completed before the
balance sheet date?
a. Test of controls. c. Substantive procedures.
b. Issuance of an engagement letter. d. Assessment of control risk.

4. Which of the following should the auditor obtain from the predecessor
auditors before accepting an audit engagement?
a. Analysis of balance sheet accounts.
b. Analysis of income statement accounts.
c. All matters of continuing accounting significance.
d. Facts that might bear on the integrity of management.
5. The primary objective of tests of details of transactions performed as
substantive procedures is to:
a. Comply with generally accepted auditing standards.
b. Attain assurance about the reliability of the accounting system.
c. Detect material misstatements in the in the financial statements.
d. Evaluate whether management's policies and procedures are opening
effectively.

6. The risk that the auditor will conclude, based on substantive procedures,
that a material misstatement does not exist in an account balance when, in
fact, such misstatement does exist is referred to as
a. Business risk c. Control risk
b. Engagement risk d. Detection risk

7. Which of the following best describes what is meant.by the term "fraud risk
factor"?
a. Factors that, when present, indicate that risk exists.
b. Factors often observed in circumstances where frauds have
occurred.
c. Factors that, when present, require modification of planned audit
procedures.

d. Weakness in internal control identified during an audit.

257 Chapter 9
8. Three conditions generally are present when fraud occurs. Select the one
below that is not one of those conditions.
a. Incentive or pressure c. Supervisory position
b. Opportunity d. Attitude

9. Which of the following is most likely to be an overall response to fraud risks

identified in an audit?
a. Supervise members of the team less closely and rely more upon
judgment.
b. Use less predictable audit procedures.
c. Use only certified public accountants on the engagement.
d. Place increased emphasis on the audit of objective transactions rather
than subjective transactions.

Cases

Case 1
The audit committee of the Board of Directors of Violet Corp. asked Argante &
Tan, CPAs, to audit Violet's financial statements for the year ended December
3 1, 2013. Argante & Tan explained the need to make an inquiry of the
predecessor auditor and requested permission to do so. Violet's management
agreed and authorized the predecessor auditor to respond fully to Argante &
Tan's inquiries,

After a satisfactory communication with the predecessor auditor, Argante & Tan
drafted an engagement letter that was' mailed to the audit committee of the
Board of Directors of Violet Corp. The engagement letter clearly set forth
arraogements Eonceming the involvement of the predecessor auditor and other
matters.

Required:
a. What information should Argante & Tan have obtained during their
inquiry of the predecessor auditor prior to acceptance of the engagement?

b. Describe what other matters Argante & Tan would generally have included
in the engagement lettei.
 Risk Assessment — Part 258
Case 2

A CPA has been asked to audit the financial statements of a company for
the first time. All preliminary verbal discussions and inquiries have been
completed between the CPA, the company, the predecessor auditor, and all
other necessary parties. The CPA is now preparing an engagement letter.

Required:
a. List the items that should be included In the typical engagement letter.
Describe the benefits derived from preparing an engagement letter.
c. Who should prepare and sign the engagement letter?
d. Why should the engagement letter be sent?
e. Why should the engagement letter be renewed periodically?
1

Case 3
Nikolai, Inc., a closely held company, wishes to engage Francis, CPA, to examine its
annual financial statements. Nikolai was generally pleased with the services
provided by its prior CPA, 10, but thought the audit work performed was too
detailed and interfered excessively with Nikolai's normal office routines. Francis asked
Nikolai to inform Jo of the decision to change auditors but Nikolai did not wish to do
so.

Required:
a. List and discuss the steps Francis should follow before accepting the engagement.
b. What additional procedures should Francis perform on this first-time engagement
over and beyond those Francis would perform on the Nikolai engagement of the
following year?

Case 4
You are a CPA is a regional accounting firm that has 5 offices in the Philippines. Mr.
Sello has approached you with a request for an audit. He is president of Funtech
Software and Games, Inc., a five-year old company that has recently grown to P40
million in sales and P20 million in total assets. Mr. Sello is thinking about going public
with a P 17 million issuq of common stock, of which FIG million would be a secondary
 259 Chapter 9
issue of shares he holds. You are very happy about this opportunity because you know
Mr. Sello is the new president of the Symphony Society board and has made quite a
civic impression since he came to your medium-size city seven years ago. Funtech

is one ofthe growing employers in the city.

Required:
a. Discuss the sources of information and the types of inquiries you and the firm's
partners can make in connection with accepting Funtech as a new client.
b. Suppose Mr. Sello has also told you that 10 years ago his closely held hamburger
franchise business went bankrupt, and upon investigation you learn from its former
auditors (your own firm) that Sello played "fast and loose" with franchise-fee
income recognition rules and presented such difficulties that your office in another
city resigned from the audit (before the bankruptcy). Do you think the partner in
charge of the audit practice should accept Funtech as a new client?
260

Case 5
Nah, the sole owner of a small hardwarc business, has been told that the
business should have financial statements audited by an independent CPA.
Filan, having some bookkeeping experience, has personally prepared the
company's financial statements and docs not understand why such
statements should be audited by a CPA. Filan discussed the matter with Egan,
a CPA, and asked Egan to explain why an audit is considered important.

Required:
a. Describe the objectives ofan independent audit.
b. Identify five ways in which an independent audit may be beneficial to
Filan.
Case 6
Jn planning every audit, the auditors are required to consider materiality for
audit purposes. Described below are financial statement data from two
separate companies:
Franklin Co. T erCo.
Total assets P2,700.ooo
Total revenue 29,600.000 4 500,000
13,800.00

Net income before taxes 1.600/000 90,000

Required:
a. Develop an estimate of the appropriate materiality amount for planning
for Franklin Co. and describe how you arrived at the estimate.
b. Develop an estimate of the appropriate materiality amount of planning
materiality for Tyler Co., and describe how you arrived at the estimate.
c. Describe five characteristics ofa small misstatement that might render it