Chapter 4

Obtaining Clients
Submit a proposal
◦ Contact the audit committee (selection and appointment)
◦ Make fee arrangements
Communicate with the predecessor auditor (recurring&initiate)
◦ Topics
◦ Integrity of management
◦ Disagreements over accounting principles
◦ Communications to those charged with governance regarding fraud and
noncompliance with laws
◦ Communication to management and those charged with governance
concerning internal control significant deficiencies and material weaknesses.
◦ Predecessor’s understanding of reason for change of auditors
◦ Other
◦ Overall procedure is important for evaluation of management integrity

The Audit Process -
Stages of an Audit

Audit Planning—Overall
Develop an overall audit strategy and an audit plan
Plan use of client’s staff
Plan involvement of other CPAs
Arrange for specialists
On first year audits:
◦ Communicate with predecessor auditors
◦ Establish opening balances on the financial statements (mid-year audit, audior’s
responsibility)

1. Plan the Audit
Establish an understanding with the client
◦ This is ordinarily accomplished through use of an engagement letter
◦ Related, determine that
◦ The firm meets professional independence requirements
◦ There are no issues relating to management integrity
◦ The client understands the terms of the engagement

Engagement Letters
Name of the entity
Management responsibilities
◦ Financial statements
◦ Establishing effective internal control over financial reporting
◦ Compliance with laws and regulations
◦ Making all records and client personnel available to the auditors
◦ Providing written representations at end of the audit regarding its
responsibilities and belief that the financial statements are free from
material misstatement
Auditor responsibilities
◦ Conducting an audit in accordance with GAAS or PCAOB standards
◦ Obtaining an understanding of internal control to plan audit
and to determine the nature, timing and extent of procedures (NET)
◦ Making communications required by auditing standards
◦ Nature(用什么样的方法对什么样的工作去做审计工作）

Engagement Letters
Arrangements regarding
◦ Conduct of the audit (e.g., timing, client assistance)
◦ Use of specialists or internal auditors
◦ Obtaining information from predecessor auditors
◦ Fees and billing
Other services to be provided, such as examination of
internal control over financial reporting
Limitation of or other arrangements regarding liability of
auditors or client
Conditions under which access to the auditors’ working
papers may be granted to others

Circumstances
a. Possible risk factors related to misappropriation of assets
b. The relationship between materiality used for planning versus evaluation purposes
c. Hanmei, Inc., has transactions with the corporation president's brother
d. Comparing a client's unaudited results for the year with last year's audited results
e. Requirements relating to identifying violations of occupational safety and health regulations
f. The need to “brainstorm” among audit team members about how accounts could be
intentionally misstated
g. Details on considering design effectiveness of controls
h. The importance of considering the possibility of overstated revenues (e.g., through premature
revenue recognition)
Professional Standards Topics
1. Analytical procedures
2. Materiality in planning and performing an audit
3. Consideration of fraud in a financial statement audit
4. Understanding the entity and its environment and assessing the risks of material misstatement
5. Consideration of laws and regulations
6. Management representations
7. Related parties

A. Analytical Procedures
B. Audit Risk and Materiality
C. Communications between Predecessor and Successor Auditors
D. Consideration of Fraud in a Financial Statement Audit
E. Understanding the Entity and Its Environment and Assessing the Risks of
Material Misstatement
F. Illegal Acts by Clients
G. Management Representations
H. Part of the Audit Performed by Other Independent Auditors
I. Related Parties
Example: Possible risk factors related to misappropriation of assets.
A B C D E F G H I
1. The relationship between materiality used for planning versus evaluation
purposes.
A B C D E F G H I
2. Hammei Corp. has transactions with the corporation president’s brother.
A B C D E F G H I
3. Comparing a client’s unaudited results for the year with last year’s audited results.
A B C D E F G H I
4. Auditing and reporting guidance on the possible need to reaudit previous year
results due to the disbanding of the firm that performed last year’s audit.
A B C D E F G H I
5. Requirements relating to identifying violations of occupational safety and health
regulations.
A B C D E F G H I
6. Audit report considerations when audit of a subsidiary of the client will be
performed by Williams & Co., CPAS.
A B C D E F G H I
7. The need to “brainstorm” among audit team members about how accounts could
be intentionally misstated.
A B C D E F G H I
8. Details on considering design effectiveness of controls.
A B C D E F G H I
9. The importance of considering the possibility of overstated revenues (for
example, through premature revenue recognition).

2. Obtain an Understanding of the Client and
its Environment
Perform risk assessment procedures, including
◦ Inquiries of management and others within the entity
◦ Analytical procedures
◦ Observation and inspection relating to client activities, operations,
documents, reports and premises.
◦ Other procedures, such as inquiries of others outside the company
(e.g., legal counsel, valuation experts) and reviewing information
from external sources such as analysts, banks, rating organizations,
journals.

Information
Effect on Risk of
Material
Misstatement
a. Because municipalities have received increased federal and state funding for
environmental purposes, TWD returned to profitability for the first year
following three years with losses.
b. TWD's Board of Directors is controlled by Mead, the majority stockholder,
who also acts as the chief executive officer.
c. The internal auditor reports to the controller and the controller reports to
Mead.
d. The accounting department has experienced a high rate of turnover of key
personnel.
e. TWD's bank has a loan officer who meets regularly with TWD's CEO and
controller to monitor TWD's financial performance.
f. TWD's employees are paid biweekly.
g. TWD has such a strong financial presence in its industry to allow it often to
dictate the terms or conditions of transactions with its suppliers.
h. During 20X1, TWD changed its method of preparing its financial statements
from the cash basis to generally accepted accounting principles.
i. During 20X1, TWD sold one-half of its controlling interest in United Equipment
Leasing (UEL) Co. TWD retained significant influence over UEL.
j. During 20X1, litigation filed against TWD from an action 10 years ago that
alleged that TWD discharged pollutants into state waterways was dropped by
the state. Loss contingency disclosures that TWD included in prior years'
financial statements are being removed from the 20X1 financial statements.
k. During December 20X1, TWD signed a contract to lease disposal equipment

e. TWD's bank has a loan officer who meets regularly with TWD's CEO and
controller to monitor TWD's financial performance.
f. TWD's employees are paid biweekly.
g. TWD has such a strong financial presence in its industry to allow it often to
dictate the terms or conditions of transactions with its suppliers.
h. During 20X1, TWD changed its method of preparing its financial statements
from the cash basis to generally accepted accounting principles.
i. During 20X1, TWD sold one-half of its controlling interest in United Equipment
Leasing (UEL) Co. TWD retained significant influence over UEL.
j. During 20X1, litigation filed against TWD from an action 10 years ago that
alleged that TWD discharged pollutants into state waterways was dropped by
the state. Loss contingency disclosures that TWD included in prior years'
financial statements are being removed from the 20X1 financial statements.
k. During December 20X1, TWD signed a contract to lease disposal equipment
from an entity owned by Mead's parents. This related-party transaction is not
disclosed in TWD's notes to the 20X1 financial statements.
l. During December 20X1, TWD completed a barter transaction with a
municipality. TWD removed waste from the municipally owned site and acquired
title to another contaminated site at below market price. TWD intends to service
this new site in 20X2.

a. Because municipalities have received increased federal and state funding for
environmental purposes, TWD returned to profitability for the first year following three years with
losses. D
b. TWD’s Board of Directors is controlled by Mead, the majority stockholder, who also acts
as the chief executive officer. I
c. The internal auditor reports to the controller and the controller reports to Mead. I
d. The accounting department has experienced a high rate of turnover of key personnel.
I
e. TWD’s bank has a loan officer who meets regularly with TWD’s CEO and controller to
monitor TWD’s financial performance. D
f. TWD’s employees are paid biweekly. NE
g. TWD has such a strong financial presence in its industry to allow it often to dictate the
terms or conditions of transactions with its suppliers. I
h. During 20X1, TWD changed its method of preparing its financial statements from the cash
basis to generally accepted accounting principles. I
i. During 20X1, TWD sold one-half of its controlling interest in United Equipment Leasing
(UEL)Co. TWD retained significant influence over UEL. I
j. During 20X1, litigation filed against TWD from an action 10 years ago that alleged that
TWD discharged pollutants into state waterways was dropped by the state. Loss contingency
disclosures that TWD included in prior years’ financial statements are being removed from the 20X1
financial statements. D
k. During December 20X1, TWD signed a contract to lease disposal equipment from an
entity owned by Mead’s parents. This related-party transaction is not disclosed in TWD’s notes to the
20X1 financial statements. I
l. During December 20X1, TWD completed a barter transaction with a municipality. TWD
removed waste from the municipally owned site and acquired title to another contaminated site at
below market price. TWD intends to service this new site in 20X2. I

Understanding the Client’s Business—Nature of
the Client
Competitive position
Organizational structure
Accounting policies and procedures
Ownership
Capital structure
Product and service lines
Critical business processes
Internal control

Understanding the Client’s Business,
Industry, Regulatory, and Other Factors
Competitive environment
Supplier and customer relationships
Technology developments
Major laws and regulations
Economic conditions
Attractiveness of the industry
◦ Barriers to entry
◦ Strength of competitors
◦ Bargaining power of suppliers of raw materials and labor
◦ Bargaining power of customers

Understanding the Client’s Business—Objectives,
Strategies & Business Risks
Objectives—Overall plans
Operating and financial strategies—Operational actions to achieve
objectives
Business risks—Threats to achieving objectives

Understanding the Client’s Business—Measuring and
Reviewing Performance
Budgets
Key performance indicators
Variance analysis
Segment performance reports
Balanced scorecard
External reviews of performance

Understanding the Client’s Business — Internal
Control
Need knowledge and understanding of how a client’s internal control works:
◦ What controls exists
◦ Who performs them
◦ How various types of transactions are processed and recorded
◦ What accounting records and supporting documentation exist

Understanding the Client’s Business—Sources
of Information
Inquiries of management
Industry Accounting and Auditing Guides
Industry Risk Alerts
Trade journals and news stories
Government publications
Prior company annual reports and SEC filings
Prior tax returns
Electronic sources
Tour of plant and offices
Preliminary analytical procedures
The statement of cash flows and obtaining an understanding of the
client

Determining Materiality
Use professional judgment and based on reasonable person
Considers both
◦ Quantitative and qualitative factors
Materiality used in
◦ Planning the audit
◦ At the overall financial statement level --- the smallest
◦ Allocate to individual accounts
◦ Evaluating audit findings

6-21
Materiality Definitions
FASB—Information is material if omitting it or misstating it could influence
decisions that users make on the basis of the financial information of a specific
reporting entity.
PCAOB interpretation of federal securities laws—A fact is material if there is a
substantial likelihood that the… fact would have been viewed by the
reasonable investor as having significantly altered the “total mix” of
information made available.

In 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. Tyler Co.
Total assets $34,900,000 $2,700,000
Total revenue 29,600,000 4,500,000
Equity 13,800,000 1,000,000
Net income before taxes 1,600,000 90,000
Required:
a. Develop an estimate of the appropriate amount of planning materiality for Franklin Co., and
describe how you arrived at the estimate.
b. Develop an estimate of the appropriate amount of planning materiality for Tyler Co., and
describe how you arrived at the estimate.
c. Describe five characteristics of a small misstatement that might render it qualitatively material.

a. Develop an estimate of the appropriate amount of planning materiality for Tyler Co., and
describe how you arrived at the estimate
I would apply Rules of thumb related to a financial statement base to arrive at an estimate of
the appropriate amount of planning materiality for Tyler Co.
b. Describe five characteristics of a small misstatement that might render it qualitatively
material
Five characteristics of a small misstatement that might render it qualitatively material
include:
1. Affect a company’s compliance with a contractual agreement regardless of its amounts
2. Cause a company not to make the consensus earnings per share estimate of financial
analysts
3. Affects compliance with regulatory requirements.
4. Affects compliance with loan covenants.
5. Involves concealment of an unlawful transaction.
Rules of thumb Franklin Co. Explanation
5 percent of net income before taxes
$1,600,000 x 5% = $80,000
$160,0000 x 10% = $160,000
The estimates will be
varied between 5 and 10
percent of net income
before taxes
½ percent of total assets
1 percent of total assets
$34,900,000 x 0.5% = $174,500
$34,900,000 x 1% = $349,000
varied between 0.5 and 1
percent of total assets
½ percent of total revenues
1 percent of total revenues
$29,600,000 x 0.5% = $148,000
$29,600,000 x 1% = $296,000
percent of total revenues
1 percent of total equity $13,800,000 x 1% = $138,000
Rules of thumb Tyler Co. Explanation
$90,000 x 5% = $4,500
$90,0000 x 10% = $9,000
varied between 5 and 10
percent of net income
before taxes
½ percent of total assets
1 percent of total assets
$2,700,000 x 0.5% = $13,500
$2,700,000 x 1% = $27,000
percent of total assets
½ percent of total revenues
1 percent of total revenues
$4,500,000 x 0.5% = $22,500
$4,500,000 x 1% = $45,000
percent of total revenues
1 percent of total equity $1,000,000 x 1% = $10,000

3. Assess the Risks of Material Misstatement and Design
Further Audit Procedures
Overall approach
◦ What could go wrong?
◦ How likely is it that it will go wrong?
◦ What are the likely amounts involved?
Particularly consider
◦ Inherent risks
◦ Risks of material misstatement due to fraud (fraud risks)
◦ It is presumed that there will be a risk of material misstatement regarding revenue
When performing risk assessment, the auditors should be alert for significant
risks that require special audit attention—for these risks the auditors should
carefully consider internal controls, not rely on controls tested in prior periods,
and not rely solely on analytical procedures to obtain evidence about the
related financial statement assertions.
Design further audit procedures

Assessing Fraud Risks
Fraud & Error
Two types
◦ Fraudulent financial reporting (management fraud) -- lying
◦ Misappropriation of assets (defalcations) -- stealing
Procedures to assess fraud risks
◦ Discussion among engagement team
◦ Inquiries of management and other personnel
◦ Risk assessment analytical procedures (to aid in planning the audit)
◦ Considering fraud risk factors
◦ Incentives
◦ Opportunity: a lack of effective controls
◦ Attitude or ability to analyze: an attempt to justify fraudulent behavior

Responding to Fraud Risks
Overall response
◦ Professional skepticism and audit evidence
◦ Assigning personnel and supervision
◦ Accounting principles
◦ Predictability of auditing procedures
Alterations in audit procedures
◦ More reliable evidence
◦ Shifting timing to year end
◦ Increasing sample sizes
Response to the possibility of management override
◦ Examining journal entries
◦ Review accounting estimates for biases
◦ Evaluating the business rationale for significant unusual
transactions

Consideration of Fraud Throughout the Audit
Evaluating the results of audit tests
Discovery of fraud
◦ Communication to appropriate level of management
◦ If fraud involves senior management or material misstatement communicate to
audit committee

4.Design Further Audit Procedures
Types
◦ Tests of controls
◦ Analytical procedures
◦ Tests of details of transactions and balances
Audit procedures
◦ Inspection
◦ Observation
◦ Inquiry
◦ Confirmation
◦ Recalculation
◦ Reperformance

Design Further Audit Procedures
Further audit procedures should include
◦ Substantive procedures for all relevant assertions
◦ Tests of controls when the auditors’ risk assessment includes an expectation
that controls are operating effectively, or when substantive procedures
alone are not sufficient
Procedures should be linked with the assessed risks of material
misstatement at the relevant assertion level
Overall responses when assessed risks of material misstatement
are high
◦ Heightened professional skepticism
◦ Assigning more experienced staff
◦ Assigning staff with specialized skills
◦ Providing more supervision

Audit Documentation
Audit Documentation
◦ Risk assessment
◦ Discussion of the audit team, elements of understanding, assessment of risk of material
misstatement and risks identified
◦ Procedure results
◦ Overall responses, nature, timing and extent of further audit procedures, linkage of
procedures with assessed risks, results of audit procedures, conclusions reached about
operating effectiveness of controls, significant risk identified, circumstances in which
substantive procedures alone will not provide sufficient evidence
◦ Consideration of fraud
◦ Similar to risk assessment as document discussion, procedures used to identify fraud risks,
fraud risk and response, any other conditions that caused fraud-related procedures and
communications with management or audit committee.

Audit Trail
A trail of evidence that links original recording of a transaction, journal
entries, and ledger entries
Auditor may follow the audit trail in either of two directions related to the
direction of testing
◦ Test for existence or occurrence: vouching transactions from recorded amounts to
source documents
◦ Test for completeness: Tracing of transactions from source documents to recorded
amounts

a. The auditors are concerned about source documents that reflect valid transactions that have not
been recorded in the journals. Which procedure would be most effective?
o (1) Trace from source documents to journals.
o (2) Vouch from journals to source documents.
o (3) Either (1) or (2).
b. The auditors are concerned about transactions that have been recorded in the journals (and
subsequently in the ledgers) that are not valid—that is, a transaction is recorded, but it did not
actually occur (e.g., a fraudulent overstatement of sales). Which procedure would be most
effective?
o (3) Either (1) or (2).
c. The auditors are concerned about transactions that have been recorded for improper amounts.
Which procedure would be most effective?
o (3) Either (1) or (2).
d. Tracing from source documents to journals most directly tests:
o (1) Completeness (understatements).
o (2) Existence (overstatements).
e. Vouching from journals (or ledgers) to source documents most directly tests:
o (1) Completeness (understatements).
o (2) Existence (overstatements).

1. Assume that the auditors are concerned about source documents that reflect valid transactions
that have not been recorded in the journals. Which procedure would be most effective?
a. Trace from source documents to journals.
b. Vouch from journals to source documents.
c. Either a or b.
2. Assume that the auditors are concerned about transactions that have been recorded in the
journals (and subsequently in the ledgers) that are not valid--that is a transaction is recorded,
but it did not actually occur (e.g., a fraudulent overstatement of sales). Which procedure
would be most effective?
c. Either a or b.
3. Assume that the auditors are concerned about transactions that have been recorded for
improper amounts. Which procedure would be most effective?
c. Either a or b (b/c amount has been recorded; can go either way to find
inconsistency).
4. Tracing from source documents to journals most directly tests
a. completeness (understatements)
b. existence (overstatements)
5. Vouching from journals (or ledgers) to source documents most directly tests
a. completeness (understatements)
b. existence (overstatements)

Transaction Cycles
Auditors’ consideration of internal control is often organized around client’s
major transaction cycles (examples)
◦ Revenue (sales) and collections cycle
◦ Acquisition and payments cycle
◦ Conversion cycle
◦ Payroll cycle
◦ Investing cycle
◦ Financing cycle

Audit Plan
Systems portion
◦ Deals with client’s internal control
◦ Evidence of test of controls and assessing control risk
Substantive test portion
◦ Deals with financial statement account balances
◦ Indirect and direct verification of income statement accounts

Objectives of Substantive Programs
for Asset Accounts
Establish the existence of assets
Establish that the company has rights to the assets
Establish the completeness of recorded assets
Verify the cutoff of transactions
Determine the appropriate valuation of the assets and
accuracy of related transactions
Determine the appropriate financial statement
presentation and disclosure of the assets

Relationship of
Financial
Statement
Assertions to the
Audit

Relationships
among Audit
Objectives, Risks of
Material
Misstatement, and
Audit Procedures

For each definition (or portion of a definition) in the first column, select the term that most closely
applies. Each term may be used only once or not at all.
Definition (or Portion) Term
a. Representations by management that are communicated,
explicitly or implicitly, in the financial statements.
b. A description of the nature, timing, and extent of the audit
procedures to be performed.
c. An estimate of the time required to perform each step in the
audit.
d. The purpose of this document is to avoid misunderstandings
between the auditors and the client.
e. The risk of material misstatement of an assertion about an
account without considering internal control.
f. At the overall engagement level, this is the risk that the auditors
may unknowingly fail to appropriately modify their opinion on
financial statements that are materially misstated.
g. An identified risk that requires special audit consideration.
h. A risk that threatens management's ability to achieve the
organization's objectives.
1. Audit plan
2. Assertions
3. Audit risk
4. Representation
letter
5. Business risk
6. Control risk
7. Engagement
letter
8. Inherent risk
9. Significant risk
10. Survival risk
11. Time budget

h. A risk that threatens management's ability to achieve the
organization's objectives.
5. Business risk
f. At the overall engagement level, this is the risk that
the auditors may unknowingly fail to appropriately
modify their opinion on the financial statements that
are materially misstated; at financial statement
assertion level, risk that a particular assertion about an
account balance is materially misstated.
3. Audit risk
7. Engagement letter
b. A description of the nature, timing, and extent of the
audit procedures to be performed.
1. Audit plan
a. Representations by management that are communicated,
explicitly or implicitly, by the financial statements.
2. Assertions
c. An estimate of the time required to perform each step in
the audit.
11. Time budget
d. The purpose of this document is to avoid
misunderstandings between the auditor and the client.
e. The risk of material misstatement of an assertion
about an account without considering internal control.
8. Inherent risk
g. An identified risk that requires special audit
consideration.
9. Significant risk

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