CHAPTER 3

AUDIT PLANNING
3.1 PLANNING THE AUDIT
The first generally accepted auditing standards of fieldwork requires adequate planning to
be made before auditing is carried out.

The wok is to be adequately planned, and assistants, if any, are to be properly supervised.

Reasons for proper Audit Plan

To enable the auditor to obtain sufficient competent evidence

To help keep audit costs reasonable
To avoid misunderstanding with the client

SEVEN MAJOR PARTS OF AUDIT PLANNING PARTS OF AUDIT PLANNING

Preplan

Obtain background
information

Obtain information about client’s

legal obligations

Perform preliminary analytical

procedures

Set materiality, and assess

acceptable audit risk & inherent

Understand internal control and

assess control risk

Develop overall audit plan & audit

program
Definition of Terms
Acceptable audit risk – is a measure of how willing the auditor is to accept that the
financial statements may be materially misstated after the audit is completed and an
unqualified opinion has been issued.

Inherent risk – is a measure of the auditor’s assessment of the likelihood that there are
material misstatements in an account balance before considering the effectiveness of internal
control.

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I) PREPLAN THE AUDIT
Preplanning the audit involves four things, all of which should be done early in the audit.
3.1 A decision whether to accept a new client or continue serving on existing one
is important
 To assess the integrity of the client and
 To assess the acceptable financial risk it will assume.
If the CPA firm decides that acceptable risk is extremely low, it may choose
not to accept the engagement.
If the CPA firm concludes that acceptable audit risk is low but the client is
still acceptable, it is likely to affect the fee proposed to the client.
Audits with low acceptable audit risk will normally result in higher audit
costs, which should be reflected in higher audit fees.
3.2 Identification of why the client wants or needs an audit
The two major factors affecting acceptable audit risk are
 the likely statement users and
 Their intended users of the statements.
3.3 Obtaining an understanding with the client about the terms of engagement to
avoid misunderstandings.( Letter of Engagements )
3.4 Select staff for engagement

II) OBTAIN BACKGROUND INFORMATION

There are three reasons for obtaining a good understanding of the client’s industry.
o First, many industries have unique accounting requirements that the auditor must
understand to evaluate whether the client’s financial statements are in accordance with
GAAP.
o Second, the auditor can often identify risks in that may affect the auditor’s
assessment of acceptable audit risk, or even whether auditing companies in the
industry is advisable.
o Finally, there are inherent risks that are typically common to all clients in certain
industries. Understanding those risks aids the auditor in identifying the client’s
inherent risk.
Knowledge of the client’s industry can be obtained in different ways.
These include:
Discussion with previous auditor
Discussion with client’s personnel
Tour the plant and office of the client
Related parties.
Related companies are an affiliated company,
 a principal owner of the client company or
 those where the client influence the management or
 Operations of a company. Note that transactions made between the client
company and

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  Related companies be disclosed if they are material according to GAAP.
Discussion with outside specialists.

III) OBTAIN INFORMATION ABOUT CLIENT’S LEGAL LIABILITIES

Three closely related types of legal documents and records should be examined early in the
engagement:
A) THE CORPORATE CHARTER AND THE BYLAWS
Corporate charter is granted by the state in which the company is incorporated and is the
legal document necessary for recognizing a corporation as a separate entity.
It includes
The exact name of the corporation,
The date of incorporation,
The kinds and amounts of capital stock the corporation is authorized to issue, and
The types of business activities the corporation is authorized to conduct.
The bylaws include the rules and procedures adopted by stockholders of the corporation.
They specify such things as
The fiscal year of the corporation,
The frequency of stockholder meetings, and
The method of voting for directors, and
The duties and power of the corporate officers.
B) THE CORPORATE MINUTES are the official records of the meetings of the board of directors
and stockholders.
C) CONTRACTS
These can include such diverse items as
long-term notes and bonds payable,
stock options,
pension plans,
contracts of manufactured products,
contracts with vendors for future delivery of supplies,
Government contracts and leases.

IV) PERFORM PRELIMINARY ANALYTICAL PROCEDURE

 Auditors are required to perform analytical procedures while planning the audit to assist
the audit in determining the nature, timing, and extent of auditing procedures.
 Analytical procedures made during planning phase enhance the auditor’s understanding
of the client’s business and events occurring since the prior year’s audit.
 Planning analytical procedures also help the auditor identify areas that may represent
specific risks of material misstatement warranting further attention.
V) Set materiality, and assess acceptable audit risk & inherent

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 Materiality is the magnitude of an omission or misstatement of accounting information
that, in the light of surrounding circumstances, makes it probable that the judgment of a
reasonable person relying on the information would have been changed or influenced by
the omission or misstatement.
 The focus of this definition is on the users of the financial statements. In planning the
engagement, the auditor assesses the magnitude of a misstatement that may affect the
users’ decisions. This is sometimes referred to as accounting materiality. The auditor
uses accounting materiality as a starting point for determining an amount that will be
used for establishing the preliminary judgment about materiality. This assessment is
sometimes referred to as auditing materiality. Auditing materiality is generally assessed
to be less than accounting materiality because the auditor needs to allow for the
difficulty in assessing what is material to the diverse groups of financial statement users.
When “materiality” is used in the remainder of this text, it refers to auditing materiality.

Audit risk is the risk that the auditor may unknowingly fail to appropriately modify his or
her opinion on financial statements that are materially misstated.

As mentioned previously, an audit does not guarantee or provide absolute assurance that all
misstatements will be detected. The auditor’s standard report states that the audit provides
only reasonable assurance that the financial statements do not contain material
misstatements. The term reasonable assurance implies some risk that a material
misstatement could be present in the financial statements and the auditor will fail to detect
it. In conducting an audit, the auditor decides what level of audit risk he or she is willing to
accept and plans the audit to achieve that level of audit risk. The auditor controls the level of
audit risk by the effectiveness and extent of the audit work conducted. The more effective
and extensive the audit work, the less the risk that the misstatement will go undetected and
the auditor will issue an inappropriate report. However, as discussed previously, an auditor
could conduct an audit in accordance with GAAS and issue an unqualified opinion, and the
financial statements might still contain material misstatements.

Audit Programs: - an audit program is an out line of procedures to be followed in

performing an audit. The nature, timing, and extent of auditing procedures to be applied (the
content of audit programs) depends on the following:
1. Study and evaluating of existing internal control:-the study and evaluation of internal
accounting control must precede substantive testing of transactions balances, if the
collection and evaluation of audit evidences is to proceed in a systematic manner.
The stronger internal control is, the lower the probability of error in processing transactions
and events. Under these circumstances the auditor may justifiably reduce the extent of
substantive testing that otherwise would be necessary.
2 Materiality of transactions and balances:-heavier concentrations of audit resources are
needed for the more significant categories of transactions and balances.
3. Nature of the client’s activity;- audit programs must be tailored to fit the unique
characteristics of the entity being audited

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4. Cost-benefit:-given two or more sets audit procedures each of which is satisfactory in
attaining the specified audit objectives, the auditor should select the least costly from
Among The Sets
Audit Working Papers
Working papers are vitally important tools of the auditing profession.

Working papers are the connecting risk between the clients’s accounting records and the
auditor’s report. They document all of the work performed by the auditors and provide the
justification for the auditors’ report.

The documentation of audit evidence is provided in working papers. Working papers

provide:

 The principal support for the auditor’s report.

 A means for coordinating and supervising the audit.
 Evidence that the audit was made in accordance with GAAS.
Functions of working papers

Audit working papers assist auditors in several major ways: they

a) Provide a means of assigning and coordinating audit work;

b) Aid seniors, managers, and partners in supervising and reviewing the work of
assistants;
c) Provide the support for the auditors’ report;
d) Document the auditors’ compliance with GAAS; and
e) Aid in planning and conducting future audits of the client.
Confidential nature of working papers

Much of the information gained in confidence by the auditors is recorded in their working
papers; consequently, the working papers are confidential in nature. Since audit working
papers are highly confidential, they must be safeguarded at all times.

Organization of the working papers

The auditors usually maintain two files of working papers for each client:

1) Current files for every completed examination and

2) A permanent file of relatively unchanging data.

Contents of working papers

Working papers would normally include the following matters:

 Information concerning the legal and organizational structure of the entity.

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 Copies of important legal documents, agreements and minutes.
 Information concerning the industry, and economic environment.
 Evidence of the planning process.
 Evidence of the auditors’ understanding of the accounting and internal control
systems.
 Evidence of inherent and control risk asses meats.
 Analysis of transactions and balances.
 Analysis of significant ratios and treads.
 Details of procedures regarding components whose financial statements are audited
by other auditors.
 Copies of communications with other auditors, experts, and other third parties.
 Letters of representation by the client’s management.
 Copies of the approved financial statements and auditors’ reports.