AUDITING – MOD4

1. ACCEPTING THE ENGAGEMENT

2. AUDIT PLANNING

ACCEPTING THE ENGAGEMENT

An important element of a firm’s quality control policies and procedures is a system

for deciding whether to accept or reject an audit engagement . In making this
decision , the firm should consider

1. Its competence
2. Its independence
3. Its ability to serve the client properly
4. The integrity of the prospective client’s management

COMPETENCE

One of the primary considerations before accepting an audit engagement is to

determine whether the auditor has the necessary skills and competence to handle
the engagements. According to the code of ethics, professional accountants should
not portray themselves as having expertise which they do not possess. Competence
is acquired through a combination of education, training and experience.

Before accepting an audit engagement, the auditor should obtain a preliminary

knowledge of the client’s business and industry to determine whether the auditor
has the degree of competence required by the management or whether such
competence can be obtained before the completion of the audit.

INDEPENDENCE

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

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

ABILITY TO SERVE THE CLIENT PROPERLY

Closely related to competence is the auditors ability to serve the client properly. An
engagement should be accepted if there are no qualified personnel to perform the
audit. PSA 220 suggests that audit work should be assigned to personnel who have
the appropriate capabilities, competence, and time to perform the audit
engagement in accordance with professional standards. There should be sufficient
direction , supervision and review of work at all levels in order to provide
reasonable assurance that the firm’s standard of quality is maintained in the
performance of the engagement.

INTEGRITY OF MANAGEMENT

The recent wave of litigation involving auditors has made pre-acceptance

investigation procedures very important. PSA220 requires the firm to conduct a
background investigation of the prospective client in order to minimize the
likelihood of association with clients whose management lacks integrity. This task
involve :

- Making inquiries of appropriate parties in the business community such as

prospective clients, bankers , legal counsel , or underwriter to obtain
information about the reputation of the client.
- Communicating with the predecessor auditor . Communication with
predecessor auditor is not only a matter of courtesy to the predecessor
auditor. This communication allows the incoming auditor to obtain
information about the client that will be useful in determining whether the
engagement will be accepted. Once permission of the client is obtained , the
incoming auditor should inquire into matters that may affect the decision to
accept the engagement . This includes questions regarding :

1. The predecessor auditor’s understanding as to the reason’s for the change of

auditors
2. Any disagreement between the predecessor auditor and the client
3. Any facts that might have a bearing on the integrity of the prospective
client’s management

The Code of ethics requires the predecessor auditor to respond fully to the incoming
auditor’s inquiry and advise the incoming auditor if there are any professional
reasons why the engagement should not be accepted.
RETENTION OF EXISTING CLIENTS

The auditor’s evaluation of client’s is not a one time consideration. Clients should be
evaluated at least once a year or upon occurrence of major events such as changes
in management, directors, ownership, nature of client’s business, or other changes
that may affect the scope of the examination.

In general, conditions which have caused an accounting firm to reject a prospective

client may also result or lead to a decision of terminating an audit engagement

ENGAGEMENT LETTER

After accepting the audit engagement, an engagement letter should be prepared.

This serves as a written contract between the auditor and the client. This letter sets
forth

- The objective of the audit of financial statements which is to express an

opinion on the financial statements
- The management’s responsibility for the fair presentation of the financial
statements
- The scope of the audit
- The forms or any reports or other communication that the auditor expects to
issue
- The fact that because of the limitations of the audit, there is unavoidable risk
that material misstatements may remain undiscovered
- The responsibility of the client to allow the auditor to have unrestricted
access to whatever records , documentation and other information requested
in connection with the audit

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

- Billing arrangements
- Expectations of receiving management representation letter
- Arrangements concerning the involvement of others (experts, other auditors,
internal auditors and other client personnel)
- Request for the client to confirm the terms of the engagement

IMPORTANCE OF THE ENGAGEMENT LETTER

It is in the interest of both the auditor and the client that the auditor sends
engagement letter in order to
 - Avoid misunderstanding with respect to the engagement
- Document and confirm the auditors acceptance of the appointment

RECURRING AUDITS

The auditor does not normally send new engagement letter every year. The
following factors may cause the auditor o send a new engagement letter.

- Any indication that the client misunderstands the objective and scope of the
audit
- Any revised or special terms of the engagement
- A recent change of senior management, board of directors or ownership
- A significant change in the nature or size of the client’s business
- Legal requirements and other government agencies pronouncements

When the auditor decides not to send a new engagement letter, it may be
appropriate for the auditor to remind the client of the original arrangements .

AUDIT OF COMPONENTS

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

- Who appoints the auditor of the component

- Whether a separate audit report is to be issued on the component
- Legal requirements
- The extent of any work performed by other auditor
- Degree of ownership by parent
- Degree of independence of the components management
11. AUDIT PLANNING

Audit planning involves developing a general audit strategy and a detailed approach
for the expected conduct of the audit. The auditors main objective in planning the
audit is to determine the scope of the audit procedures to be performed.

The auditor should plan the audit work so that audit will be performed in an
effective and efficient manner. The extent of planning will vary according to the size
of the entity , the complexity of the audit and the auditor’s experience with the
entity , and knowledge of the business.

Adequate planning of the audit work is important because

- Planning helps ensure that appropriate attention is devoted to important

areas of the audit
- It helps identify potential problems
- It allows the work to be completed expeditiously
- It helps ensure that the audit is conducted effectively and efficiently

PAS 315 requires the auditor to obtain sufficient understanding of the entity and its
environment including its internal control. Such understanding involves obtaining
knowledge about the entity’s

a. Industry, regulatory and other external factors , including financial reporting

framework
b. Nature of the entity, including entity’s selection and application of accounting
policies
c. Objectives and strategies and the related business risks that may result in a
material misstatement of the financial statements
d. Measurement and review of the entity’s performance
e. Internal control

UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT

Knowledge of the client’s business and industry- how and why a client does what it
does – is essential if the audit is to be carried out effectively . The auditor should
obtain a sufficient level of knowledge of the entity’s business to identify and
understand the events, transactions and practices that may have significant effect
on the financial statements. The better the auditor understands the client’s
operations, the more efficient the examination is likely to be , and the greater the
value of the client of the auditor’s services.
Sources of information:

The auditor can obtain knowledge of the industry and the entity from a number of
sources. These may include

- Review of prior years working papers

- Tour of clients facilities
- Discussion with people within and outside the entity
- Reading books , periodicals and other publications related to the client’s
industry
- Reading corporate documents and financial reports

Uses of information obtained:

Knowledge of the client’s business is a frame of reference within which the auditor
exercises professional judgment. Understanding the business and using , this
information appropriately assists the auditor in :

- Assessing risks and identifying potential problems

- Planning and performing the audit effectively and efficiently
- Evaluating audit evidence as well as the reasonableness of client’s
representations and estimates
- Providing better service to the client

Additional consideration on new engagements

A first time audit requires more work than a repeat engagement because of the
problem associated with the verification of the opening balances of the balance
sheet accounts. In this regard , PSA 510 requires the auditor obtain sufficient
appropriate audit evidence that :

- The opening balance do not contain misstatements that materially affect the
current year’s financial statements.
- The prior period’s closing balances have been correctly brought forward to
the current period or when, appropriate have been restated and
- Appropriate accounting policies are consistently applied or changes in
accounting policies have been properly accounted for and adequately
disclosed

The auditor may be able to obtain sufficient appropriate evidence regarding opening
balances by reviewing the predecessors auditor’s working papers. In these
circumstances, the auditor would also consider the independence and professional
reputation of the predecessor auditor.
UNDERSTANDING THE INTERNAL CONTROL

Another very important step in planning an audit is to obtain an understanding of

the entity’s accounting and internal control systems. The auditor should obtain an
understanding of the accounting and internal control systems sufficient to plan the
audit and develop an effective audit approach.

DEVELOPING AN OVERALL AUDIT STRATEGY

Once the auditor has gained a sufficient understanding a bout the entity and its
environment including its internal control, the auditor should formulate an overall
audit strategy for the upcoming engagement. The best audit strategy is the
approach that results in the most efficient audit that is an effective audit performed
at the least possible cost. An audit plan should be made regarding

- How much evidence to accumulate

- How and when this should be done

When developing an audit strategy, the auditor must consider carefully the
appropriate levels of materiality and audit risk.

MATERIALITY

Materiality is defined in the Financial Reporting Standard Council’s Framework for

the preparation and presentation of financial statements , in the following terms “
information is material if its omission or misstatement could influence the economic
decision of users taken on the basis of financial statements .

In designing an audit plan, the auditor should make a preliminary estimate of

materiality for use during the examination . the concept of materiality recognizes
that some matters are important for fair presentation of financial statements while
other matters are not important.

Materiality maybe viewed as :

- The largest amount of misstatement that the auditor could tolerate in the
financial statements or
- The smallest aggregate amount that could misstate the financial statements

Materiality Is a matter of professional judgment and necessarily involves

quantitative factors (amount of the item in relation to the financial statements ) and
qualitative factors ( the nature of misstatement)
IMPORTANCE OF MATERIALITY IN PLANNING AN AUDIT

The auditor should make a preliminary estimate of materiality to determine the

amount of evidence to accumulate. There is an inverse relationship between
materiality and evidence. This means more evidence will be required for a low peso
amount of materiality than for a high peso amount .

USES OF MATERIALITY

According to PSA 320 ,the materiality should be considered by the auditor:

- In the planning stage, to determine the scope of audit procedures

- In the completion phase of audit , to evaluate the effect of misstatements on
the financial statements

USING MATERIALITY LEVELS

The following steps may be used as a guide when using materiality levels . steps 1
and 2 are performed in the planning phase while step 3 is performed in the
completion phase of the audit . .