Chapter 6 - Client Acceptance, Planning, and Materiality

Question 1

What is the purpose of planning the audit? What are the benefits?

Answer 1

The purpose of planning is to provide for the effective conduct of the audit.

This helps to keep costs reasonable, avoid misunderstandings with the client, and to enable the auditor to obtain sufficient appropriate audit evidence

Question 2

What is acceptable audit risk (AAR)?

Answer 2

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.

Question 3

What is the risk of material misstatement?

Answer 3

Risk of material misstatement is the risk that the financial statements are materially misstated prior to audit

Question 4

What activities are included in assessing new clients?

Answer 4

Before accepting an engagement, client investigation takes place.

The successor auditor is required to communicate with the predecessor auditor to evaluate if there are any reasons not to accept the engagement.

Permission must be obtained from the client to communicate with the predecessor auditor.

Question 5

What do we look for when assessing continuing clients? How often to we evaluate continuing clients?

Answer 5

Existing clients should be evaluated annually to determine if there are any reasons to not continue doing the audit.

Things to look for:

• Previous conflicts over audit scope, type of opinion to issue or fees may be reasons to discontinue association.
• Lack of client integrity
• Lack of independence

Question 6

How do we obtain an understanding of the terms of the engagement?

Answer 6

Engagement letter – a written agreement between the public accounting firm and the client as to the terms of the engagement for the conduct of the audit and related services.

Question 7

What are the reasons for obtaining a good understanding of the client’s industry?

Answer 7

Certain specific industries are associated with greater risk (e.g., technology, mining)

Certain inherent risks are typically common to all clients in certain industries

Many industries have unique accounting treatments that the auditor must understand to evaluate the client’s financial statements

Question 8

What are the 2 key activities to consider when gaining an understanding of the client’s business operations and processes?

Answer 8

1. Tour Client Facilities and operations (to gain an understanding of the operational and reporting structure, technology, etc.)
2. Identify related parties (require specific disclosures, higher risk)

Question 9

How can the auditor gain an understanding of the client’s management and governance system?

Answer 9

• Assess management’s philosophy and operating style, and its ability to identify and respond to risk.
• Look at articles of incorporation and bylaws
• Understand the code of ethics
• Read the minutes of meetings

Question 10

Auditors should understand client objectives related to:

Answer 10

• Reliability of financial reporting
• Effectiveness and efficiency of operations
• Compliance with laws and regulations

Risk of material misstatement may be increased if the client has set unreasonable objectives or if the performance measurement system encourages aggressive accounting.

Question 11

What is the key purpose of preliminary analytical procedures?

Answer 11

To help the auditor to better understand the client’s business and the client’s business risk.

Also used to identify areas that have high risk of misstatement as well as fraud risk.

Question 12

What are some examples of analytical procedures used during audit planning?

Answer 12

• Calculate key ratios for the client’s business and compare them with industry averages.
• Calculate the debt-to-equity ratio and compare it with those of previous years and successful companies in the industry.
• Compare the gross margin with those of prior years

Question 13

What should be considered when selecting staff for the engagement?

Answer 13

• Assigning appropriate staff is key to ensuring audit effectiveness and efficiency.
• If auditor does not have expertise, engagement should be declined.
• Continuity of staff helps the firm maintain familiarity and close interpersonal relations with the client.

Question 14

What 4 things should be considered when defining the resources required for the engagement?

Answer 14

• Select the staff for the engagement
• Evaluate the need for outside specialists
• Evaluate whether internal audit work can contribute
• Evaluate reliance on other auditors (multiple locations, subsidiaries)

Question 15

Misstatements, including omissions, are considered to be MATERIAL if….

Answer 15

they, individually or in aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements.

Question 16

What are the 4 types of materiality?

Answer 16

1. Overall (planning) materiality
2. Performance materiality
3. Specific materiality
4. Specific performance materiality

Question 17

What is overall materiality?

Answer 17

Overall materiality refers to determining materiality for the financial statements as a whole.

Question 18

What are the 5 steps for determining overall materiality?

Answer 18

1. Identify users.
2. Discuss user needs.
3. Select an appropriate benchmark. (something that is important to all users).
4. Determine the percentage to be applied to the selected benchmark.
5. Calculate materiality.

Question 19

What are the common materiality benchmark percentages?

Answer 19

• 3% to 7% of net income before taxes.
• 1% to 3% of total assets.
• 3% to 5% of shareholders’ equity.
• 1% to 3% of revenue.
• 1% to 3% of expenses or revenue (for non-profit entities).

Question 20

What does the choice of benchmark percentage depend on?

Answer 20

Choice of percentage depends on the sensitivity of the users to misstatements in the financial statements

More sensitive = lower percentage = lower materiality

Question 21

What are some qualitative factors what might lead to the conclusion that the misstatement is material, even if it is quantitatively inmaterial?

Answer 21

• The misstatement indicates fraud
• Changes a loss into a profit (correcting small misstatements results in a change from a small profit to a loss)
• Misstatement impacts management bonuses?
• All misstatements go the same way (i.e., increase net income)?

Question 22

What is performance materiality?

Answer 22

This is an amount less than overall materiality that the auditor uses to plan and conduct the financial statement audit engagement, to reduce the likelihood that uncorrected errors exceed materiality.

Generally between 50% (high risk) and 75% (low risk) of overall materiality.

Involves considerable professional judgement.

Performance materiality, not overall materiality, gears samples sizes and conclusions on material misstatements of accounts.

Question 23

What is specific materiality?

Answer 23

Specific materiality is “materiality level determined for a particular class on transactions, account balance, or disclosure.”

It is dependent on whether certain balances or accounts are of specific importance to the users.

Question 24

What is specific performance materiality?

Answer 24

Specific performance materiality is “materiality level determined for a particular class on transactions, account balance, or disclosure.” (same idea as performance materiality)

Question 25

What are the 3 categories of misstatements?

Answer 25

(1) Factual misstatements - those about which there is no doubt;
(2) Judgmental misstatements - differences in management’s judgment concerning recognition, measurement, presentation, and disclosure in the financial statements and the auditor’s judgment
(3) Projected misstatements - the auditor’s best estimate based upon a sample.

Auditors would request management to correct any factual misstatements and have discussions with management about adjustments for judgmental differences.