Planning ActivitiesTable 3-1 – page 71 – excellent summary of procedures for evaluating a prospective client*Communicating with predecessor auditors (if new client) - Must have prospective clients permissionBefore “acceptance” (required):- Verify managements integrity (communicate with suppliers of clients, social media, etc.)- Disagreements with management over accounting policies or audit procedures - Why the change in auditors?After “acceptance” (not required):- Make specific inquiries involving audit- As predecessor to review their work papers (not obligated to provide to new auditors)*Audit Team Requirements- Size- Competence/training- Independence – unpaid audit fees: if a company didn’t pay for prior year audit it affects independence (wouldn’t start audit for this year until the pay*Establish an understanding with the client regarding services to be performed = engagement letter (Exhibit 3-1, page 73)Engagement letter IS required…”should document the understanding through a written communication with the client”- Objective of the engagement letter – express opinion on financial statements1- Management responsibilitieso Financial statementso Internal controlso Follow laws and regulationso Availability of accounting records o Make adjustments if auditors find misstatements o Provide a management representation letter (example in Ch. 17)- Auditor responsibilitieso Conduct audit in accordance with GAAP- Limitations – that auditors provide “reasonable assurance”- Fees/timing- Other matters – could have anything related to audit*Internal Auditors – Work for the company and this affects their independence - Gain understanding of internal auditors role – should report to audit committee of Board of Directors- Assess competence and objectivity - Use internal auditors as a resource to gain understanding of client- ****Internal auditors cannot make audit decisions for external auditors2*Audit Committee –- “Outside” of client (audit committee and other board members)- External auditors- Board of Directors – 10-20 members (includes audit committee, other board members, and management)What is an audit committee?3-5 members of the BOD who are “independent directors” – not management, not employees, and no financial interest inthe company (they are paid for doing their job but that is it)Purpose of the audit committee?Enhance internal control by creating a means of direct communication with auditors (internal and external)Functions of audit committee:- Approve auditors selection- Approve services to be performed by auditors (includes non-audit services)- On-going communication with auditor (Ch. 17: communication between auditor and audit committee)*Planning the Audit – be effective and efficient. 1. Assess Risk (Chapter 4) 2. Materiality3. Consider Multilocations or Business Units4. Assess need for specialists 5. Assess the possibility of illegal acts - Violations of laws and regulations- Direct and material effect on financial statements – planthe audit to obtain “reasonable assurance”- Indirect effect on financial statement – (example: environmental regulation that the company does not follow) no assurance 6. Identify related parties - Concern: not an “arm’s length transaction” must be disclosed3- Procedures to find related party:o Inspect SEC filingso Request from managemento Inspect BOD minuteso Scan transactions with major customers, suppliers,borrowers, and lenderso Scan for large, unusual transactionso Inspect loan confirmations for guarantees5. Consider value-added services 6. Document strategy, plan, and audit programs (Exhibit 3-2,pg 82) – if it’s not documented, it didn’t happen.*Supervision of the Audit – engagement partner has overall responsibility - Senior Associate and Staff/Associate are on-site- Each member should know responsibilities- Bring major issues to partners attention- Supervision should ensure audit is conducted accordingto GAAS/PCAOBTypes of Audit Tests, pages 82-84: Scan, will be covered indepth later4Staff/Associates – 0-3 years of experienceSenior Associate – 3-5 years of exp.Manager – 6-10 yearsPartner – 10+years*Materiality = Something is material if it affects a decision made by an average prudent investor (a reasonable person, page 85).During planning, determine a preliminary estimate of materiality for the entire set of financial statements. (Reevaluate estimate throughout audit and at conclusion of audit.)How do you determine materiality?See Figure 3-2, page 86Three general steps:1. Determine materiality for financial statement as a whole (planning materiality) 3-5% of Net Income before taxes2. Determine tolerable misstatement for each line item 3. Evaluate audit findings a. Consider known misstatements and likely misstatementsb. Make your decision (qualified or unqualified