chapter 8

audit planning analytical procedures 1

Enron

Related Party Transactions No one could explain how Enron actually made money Incredibly complicated business structure “What we are looking at here is an example of superbly complex financial reports. They didn’t have to lie. All they had to do was to obfuscate it with sheer complexity,” John Dingell, U.S. Congressman Michigan 2

Obtain engagement Analytical procedures Understand the client Internal controls AU-c 315 Assess RoMM Tests of controls if RoMM < 1.00

Substantive tests of transactions Substantive Analytical procedures AU-c 500 Substantive tests of details of balances Reporting AU-c 700 3

environmental client

AAR = IR RoMM CR transactions

auditor

PDR balances

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Paul

What is the definition of audit risk?

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AU-C Section 200 The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated.

Audit risk is a function of the

Risk of Material Misstatement

and

Detection Risk

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David V

What is the definition of inherent risk?

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AU-C Section 200 The susceptibility of an assertion about a class of transaction, account balance, or disclosure to a misstatement that could be material, either individually or when aggregated with other misstatements before considerations of any related controls. 8

Stages of the Audit Accepting the engagement client acceptance 1) integrity of management 9

Client Acceptance

page 79-80 • Why the client needs an audit • New client investigation • Competency, industry knowledge • Communicate with predecessor auditor • Risks – Intended users of the financial statements • Independence • Engagement Letter 10

Statement on Auditing Standards AICPA

February 1997 84 Communications between Predecessor and Successor Auditors 11

Brittney

what issues need to be discussed with the predecessor auditor ?

12

Communications with Predecessor Auditor • Integrity of senior management • Disputes with the client over accounting principles • Disputes with the client over audit procedures • Disputes with the client over fees 13

Shaina

who is responsible for initiating the communication between the successor auditor and the predecessor auditor ?

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Ross

Why must the predecessor contact the audit client prior to discussing the client with the successor auditor?

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AICPA Code of Professional Conduct

Rule 301 – Confidential Client Information 16

Bradley

Do we care about the nature of the client’s business?

Do we care about the reasons they are having their financial statements audited?

Do we care who is going to rely on the audited financial statements?

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RISK RISK RIS

K identify the users of the financial statements 18

Andrew

How does the AICPA’s

Code of Professional Conduct

define the Ethical Principle “Objectivity and Independence?” 19

Objectivity and Independence

A member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. A member in public practice should be independent in fact and appearance when providing auditing and other attest services.

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Does this effect our decision whether to accept the engagement ?

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Sumeet

When an accounting firm considers a new client, it distributes an “independence memo” To whom does the audit firm need to distribute this memo ?

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independence

memo to partners and staff Partners in the engagement office Everyone in the engagement office Everyone in the firm Consulting and tax employees or just auditors must consider spouses & dependents 23

Karli

How might the

investments

of non dependent, close relatives affect the firm’s decision whether to accept a new client ?

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Jenna

If a non-dependent, close relative is

employed

by a potential client, what issues does the audit firm need to consider in their decision whether to accept the client?

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Anyone on the engagement team Anyone in position to influence the engagement All partners in the engage partner’s office

Close relatives

( including immediate family ): parent, sibling or nondependent child, spouse, dependents

Holding a key position

with the client

Holding a financial interest

in the client that is material to the relative (covered member must know)

Holding a financial interest

that enables the relative to exercise significant influence over the client 26

Key positions

– positions that allow significant influence over the client’s, accounting, financial or operating policies – positions subject to significant internal accounting controls – positions that are an element of significant internal accounting controls 27

Phases of the Audit Engagement Letter Accepting the engagement page 82 28

Understand the Client’s Business 29

Michael K

what is the objective of AU-c 315? 30

AU-C Section 315 The objective of the auditor is to identify and assess the risk of material misstatement, whether due to fraud or error, at the financial statement and relevant assertion levels through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risk of material misstatement.

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Many litigation cases result from the auditor’s failure to fully understand the nature of transactions in the client’s industry.

ZZZZ Best ESM 32

RISK of Material Misstatement

Declines in economic conditions Information technology Expansion Accounting COMPLEXITY of JUDGMENTS Accounting COMPLEXITY of ESTIMATES C OMPLEX financial instruments 33

Lauren

how does the Auditor’s Responsibility Paragraph in the independent auditor’s report describe the auditor’s responsibility to detect material misstatements?

Does the auditor’s responsibility differ for misstatements that are the result of an error or a fraud?

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Auditor’s Responsibility Paragraph

standard unmodified opinion Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States . Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement . 35

Kelly S

what is the overall objective of the indepent auditor?

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Overall Objective

AU-C 200 …obtain reasonable assurance about whether the financial statements as a whole are free of material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are presented fairly, in accordance with an applicable financial reporting framework.

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Related Parties ---

RISK

p. 86 .. an affiliated company, principal owner of the client company, or any other party with which the client deals, where one of the parties can influence the management or operating policies of the other.

investors are concerned that the terms of the transaction may not reflect “arms length” bargaining. There is risk that the transaction may not be valued at the same amount as a transaction with a non related party.

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Related Parties ---

RISK

p 77

Enron - Andy Fastow

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Related Parties

---

RISK

Essentially a related party is one that can exert significant influence over another party.

Related parties are frequently involved in fraudulent transactions because they can conceal problems that the auditor would likely detect if the transactions occurred between unrelated parties.

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RELATED PARTIES SECTION R36

Sources: ARB 43, Chapter 1A; FASB Statement 57; FASB Statement 109

Summary

Financial statements shall include disclosures of material related party transactions , other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. The nature of certain common control relationships shall be disclosed if the nature of those relationships could significantly affect the reporting enterprise. The reporting of certain related party transactions is specified in other sections. --------------------

Introduction

.101 Examples of transactions between related parties include transactions between (a) a parent company and its subsidiaries ; (b) subsidiaries of a common parent; (c) an enterprise and trusts for the benefit of employees , such as pension and profit-sharing trusts that are managed by or under the trusteeship of the enterprise's management; (d) an enterprise and its principal owners, management, or members of their immediate families ; and (e)affiliates. Transactions between related parties commonly occur in the normal course of business. Some examples of common types of transactions with related parties are: sales, purchases, and transfers of realty and personal property; services received or furnished, for example, accounting, management, engineering, and legal services; use of property and equipment by lease or otherwise; borrowings and lendings; guarantees; maintenance of bank balances as compensating balances for the benefit of another; intercompany billings based on allocations of common costs; and filings of consolidated tax returns. Transactions between related parties are considered to be related party transactions even though they may not be given accounting recognition. For example, an enterprise may receive services from a related party without charge and not record receipt of the services. [FAS57, 1]

Disclosures

.102 Financial statements shall include disclosures of material related party 42

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AU Section 334 Related Parties (Supersedes Statement on Auditing Standards No. 6, AICPA, Professional Standards, vol. 1, AU sec. 335.01ÄÄ.19) Source: SAS No. 45. See section 9334 for interpretations of this section. Effective for periods ended after September 30, 1983, unless otherwise indicated. .01 This section provides guidance on procedures that should be considered by the auditor when he is performing an audit of financial statements in accordance with generally accepted auditing standards to

identify related party relationships and transactions and to satisfy himself concerning the required financial statement accounting and disclosure

. The procedures set forth in this section should not be considered all-inclusive . Also, not all of them may be required in every audit. 44

Juan

what is Client Business Risk?

45

Box at the Bottom of Page 89 increased emphasis on how the client manages risk

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Analytical Procedures Pages 93-102 Look at table on page 94 Go to links on web page 47

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Analytical Procedures

Reasonableness tests

evaluations of financial information by a study of plausible relationships among financial and nonfinancial data … ….involving comparisons of recorded amounts … to expectations developed by the auditor.

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Jacob

at which stages of the audit are Analytical Procedures required ?

55

Analytical Procedures 

planning phase • testing phase (as substantive tests)



completion phase (as an overall review)

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Michael G

why do we perform analytical procedures during the planning stage ?

57

Analytical Procedures

During the Planning Phase

Understand the client’s business & industry Assess going concern Indicate possible misstatements (attention directing) Reduce detailed tests 58

Analytical Procedures in the planning phase • understand the client’s industry and business • to identify

potential

misstatements • attention directing • design audit procedures that reduce the risk we might fail to detect a material misstatement 59

Steps in performing Analytical Procedures Develop expectations Define significant difference (what is reasonable) Compare our predictions with recorded amount Investigate Significant differences DOCUMENT the above steps 60

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