Chapter 5 - Planning an Audit of Financial Statements CHAPTER 5 PLANNING AN AUDIT OF FINANCIAL STATEMENTS Chapter Overview and Objectives: This chapter discusses audit planning phase of the audit process. At the end of this chapter, readers should be able to discuss 1. The objective and specific roles of planning in an audit of financial statements Factors affecting the nature and extent of planning activities Outputs of audit planning activities Documentation requirements when planning an audit Major audit planning activities performed by the auditor Risk assessment procedures Consideration of materiality Consideration of audit risk and its components Establishing the overall audit strategy Developing the audit plan Direction, supervision, and review Other planning considerations yen empaoge —— Relevant references: PSA 200 - Overall Objectives of the Independent Auditor and the Conduct of an Audit in accordance with International Standards on Auditing PSA 300 - Planning an Audit of Financial Statements PSA 315 (Revised) - Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and its Environment PSA 320 (Revised and Redrafted) - Materiality in Planning and Performing an Audit PSA 520 - Analytical Procedures Page 157i it Chapter 5 — Planning an Audit of Financial Statements INTRODUCTION TO PLANNING Every activity or undertaking entered into by @ person Ee hh order to attain these targets, one of the first things pe i Plan the courses of action needed to be taken. Preparing for the future enables people ty consider the impact they would like to have and to find a rd to attain those targets. In multi-personnel activities, when a team works together to set goals, i, allows everyone to be on the same page, working toward a common, shareq purpose. Planning helps people to identify and achieve these targets through making or carrying out plans and avoiding doing some random activities. This makes planning a very necessary and important procedure in any undertaking. PLANNING IN AUDIT OF FINANCIAL STATEMENTS Roles of planning Just like in any other activity or endeavor, planning is a vital phase in an audit of financial statements. Auditing standards explicitly require the auditor to prepare adequate planning for an engagement. PSA 300 further provides that the objective of the auditor is to plan the audit so that it will be performed in an effective manner. Although audit effectiveness is the primary objective of the auditor, adequate planning also leads to audit efficiency. Audit effectiveness pertains to attainment of the objective of the engagement, whereas, audit efficiency pertains to employing the least amount of resources to the engagement. Adequate planning benefits the audit of financial statements in several ways, including the following: (CAFE PA) > Assisting, where applicable, in Coordination of work done by auditors of components and experts Assisting in the selection of engagement team members wih appropriate levels of capabilities and competence to respond t : ant pated aoa and the proper Assignment of work to them ating the direction and supervision of bers and the review of their work i iain nani Helping the auditor properly organize and manage the audt engagements that is performed in an Effective and efficient manne” i ; Heb ify and resolve potential Problems on atimel! > Helping the auditor to devote i ore dik f appropriate Attention to important are > Aim... Believe... Claim.Chapter 5 - Planning an Audit of Financial Statements Factors affecting the nature and extent of planning activities The nature and extent of planning acti ary according to the: (SECTa) _ ak Planning Activities | Size and complexity of the entity must be done when the client > isalarger entity; > enters into more complex transactions; and/or >__has complex form of organization. Key engagement team | The engagement partner and other key members of members’ previous | the engagement team shall be involved in planning Experience with the | the audit, including planning and participating inthe entity discussion among engagement team members. Their experience and insight will greatly enhance the effectiveness and efficiency of the planning process. Changes in | The overall audit plan should be revised as necessary circumstances that | during the course of the audit particularly when occur during the audit | there are significant changes in condition or engagement. unexpected results of audit procedures. Timing of the | The practicability of some audit procedures could be appointment of the | affected by the time when the auditor is appointed independent auditor _| to perform the audit. Example, an auditor appointed prior to year-end may observe physical inventory count. Planning: As a phase of an audit Planning is not a discrete phase of an audit, but rather a continual and iterative Process that often begins shortly after (or in connection with) the completion of the previous audit and continues until the completion of the current audit engagement. With this, initial plans may be subjected to changes depending on information received while performing the engagement. Outputs of Audit Planning Planning an audit involves establishing the overall audit strategy for the ‘engagement and developing an audit plan. With this, the following are the main Outputs of audit planning: 1. Overall audit strategy which sets the scope, timing and direction of the audit, and that guides the development of the audit plan. 2. Audit plan which shall include a description of a. the nature, timing and extent of the following audit procedures > planned risk assessment procedures Aim... Believe... Claim... Page 159Chapter 5 — Planning an Audit of Financial Statements > further audit procedures at the assertion level b. other planned audit procedures that are required to be carrieg Out 55 that the engagement complies with PSAs. Moreover, the auditor shall update and change the overall audit strategy aNd the | audit plan as necessary during the course of the audit. Documentation The auditor shall document: 1. The overall audit strategy; 2. The audit plan; and 3. Any significant changes made during the audit engagement to the overay audit strategy or the audit plan, and the reasons for such changes. MAJOR AUDIT PLANNING ACTIVITIES Presented below is a diagram of major audit planning activities performed throughout the planning phase: Nature, Timing and Extent of Managing the Engagement Risk assessment procedures (RAPs) A. Identifiying D. Direction, and assessing smn | “cin through UE&E B. Establishing Overall Audit Strategy C. Developing an Audit Plan Nature, Timing ‘Strategy oF and Extent of approach for Audit effective and Procedures efficient audit E. Other Planning Considerations Auditor’s Expert Initial audit Smaller entities engagements .. Believe... Claim... PageChapter 5 — Planning an Audit of Financial Statements The discussion of these major audit planning activities in presented in the section below. A. IDENTIFYING AND ASSESSING RISK OF MATERIAL MISSTATEMENTS THROUGH UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT To establish an overall audit strategy, which guides the development of the audit plan, the auditor needs to perform procedures which will enable him or her to (1) obtain an understanding of the entity and its environment; and (2) identify and assess risk of material misstatements. These procedures are known as risk assessment procedures (RAPS). Below is a summary of RAPs performed when identifying and assessing risk of material misstatements through understanding the entity and its environment. Risk Assessment Procedures (RAPs): 1. Obtain an understanding of the entity and its environment, including its internal control © through Inquiry, Observation, Inspection, Analytical Procedures 2. Consider materiality 3. Identify and Assess Risks of Material Misstatements (ROMMs) 4. Determine the acceptable level of Audit Risk 5. Identify Detection Risk to determine the nature, timing and extent of further audit procedures A. Identifying and assessing ROMMs, through UE&E Risk assessment procedures (RAPS) Definition As defined in PSA 315, risk assessment procedures are audit Procedures Performed to obtain an understanding of the entity and its environment, including the entity’s internal control, to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and assertion levels. Alm... Believe... Claim... Page 161 waets Chapter 5 ~ Planning an Audit of Financial a ue cui of een ot ett od sag PSA 315 states that the objecti 55 th risks of material misstatement, whether due to fraud 7 ae at the financiy statement and assertion levels, through understan ing © entity ang environment, including the entity’s internal control, thereby Providing « basis for designing and implementing responses to the assessed rig, : material misstatement. With this, the main purposes of performing RAP is to enhance thy understanding of the entity in order to specifically identify the Applicable further audit procedures (FAP) and to appropriately respond to the different risks assessed related to audit. As mentioned in the previous chapter, Fp, include tests of controls (TOC) and substantive tests (ST). RAP = |} —______5 FAP The need to identify FAP arises mainly because RAP by themselves do not Provide sufficient appropriate audit evidence on which to base the audit opinion. Details of the RAP are discussed in the below section: 1. Obtain an understanding of the entity and its environment, including its internal control The auditor shall ensure that members of the engagement team obtain the required understanding of the entity’s business and industry which will enable them to carry out the required procedures of the engagement. The auditor shall obtain an understanding of the following: a. Relevant industry, regulatory, and other external factors including the applicable financial reporting framework b. The nature of the entity, including its operations; ownership and Bovernance structure; types of investments that the entity is making and plans to make; and the way the entity is structured and how it is financed ¢. Entity’s selection and applica Feasons for changes thereto d. Entity’s objectives and strategies, and those related business risks that may result in risk of Material misstatement e. The measurement and review of the entity’s financial performance f. Internal control (This will be discuss in the immediate edial iecedrgane 'ssed further in the immi tion of accounting policies, including Page 167as Chapter 5 — Planning an Audit of Financial Statements In order to obtain these required understanding, the auditor performs risk assessment procedures which shall include the following specific procedures: Inquiry _ Definition As defined in PSA, inquiry consists of seeking information of knowledgeable persons, both financial and nonfinancial, within the entity or outside the entity. Inquiry is used extensively throughout the audit in addition to other audit procedures. Inquiries may range from formal written inquiries to informal oral inquiries. Evaluating responses to inquiries is an integral part of the inquiry process. Inquiries during planning stage Much of the information obtained by the auditor's inquiries is obtained from management and those responsible for financial reporting. However, the auditor may also obtain information, or a different perspective in identifying risks of material misstatement, through inquiries of others within the entity and other employees with different levels of authority. For example: © Inquiries directed towards those charged with governance may help the auditor understand the environment in which the financial statements are prepared. * Inquiries directed toward internal audit personnel may provide information about internal audit procedures performed during the year relating to the design and effectiveness of the entity's internal control and whether management has satisfactorily responded to findings from those procedures. * Inquiries of employees involved in initiating, processing or recording complex or unusual transactions may help the auditor to evaluate the appropriateness of the selection and application of certain accounting policies. © Inquiries directed toward in-house legal counsel may provide information about such matters as litigation, compliance with laws and regulations, knowledge of fraud or suspected fraud affecting the entity, warranties, post- sales obligations, arrangements (such as joint ventures) with business partners and the meaning of contract terms. © Inquiries directed towards marketing or sales personnel may provide information about changes in the entity's marketing strategies, sales trends, or contractual arrangements with its customers. Aim... Believe... Claim... Page 163 etst . ments Chapter 5 ~ Planning an Audit of Financial State! ee b. Observation ____—__—~ Aeaetne in PSA, observation consists of looking at a proces. | or imple, the aud by others, for exal tory dure being performed by xarr Sservation of inventory counting by the entity's personnel, o, of | the performance of control activities; Observation during planning stage : : Auditor aims to obtain an understanding of the entity through observation of the entity's: : ; * processes used in processing information to be Teported, and © activities and operations. — c. Inspection Seta eaa [Betton es impenton a | ‘As defined in PSA, inspection involves examining records or | | documents, whether internal or external, in paper form, electronic form, or other media, or a physical examination of an asset. Inspection during planning stage The auditor can obtain an understanding of the entity through the following inspection activities during planning: * Review of prior year’s working papers and prior year’s financial statements Review of reports prepared by the entity’s management (such as quarterly management reports and interim financial statements) and those charged with governance (such as minutes of board of directors’ meetings) Review of documents (such as business plans and strategies), records, and internal control manuals Reading articles, books, periodicals, and other publications related to the entity's industry Visits to the entity’s Premises and plant facilities Note: Observation and ing management and other e information about the enti 'spection may support inquiries f ntity’s personnel, and may also provide ity and its environment, ‘him. Beleve. Cain. page 16Chapter 5 — Planning an Audit of Financial Statements da Analytical procedures Definition As defined in PSA, analytical procedures consist of evaluations of financial information made by a study of plausible relationships among both financial and non-financial data. Analytical procedures also encompass the investigation of identified fluctuations and relationships that are inconsistent with other relevant information or deviate significantly from predicted amounts. A basic premise underlying the application of analytical procedures is that plausible relationships among data may reasonably be expected to exist and continue in the absence of known conditions to the contrary. The auditor is required to perform analytical procedures during planning and overall review stages of the audit. Analytical procedures may be done thru the following techniques: Y Horizontal and trend analysis; Y Vertical analysis; and ¥ Ratio analysis. Analytical procedures during planning stage Analytical procedures may help identify the existence of unusual transactions or events, and amounts, ratios, and trends that might indicate matters that have audit implications. Unusual or unexpected relationships that are identified may assist the auditor in identifying risks of material misstatement, especially risks of material misstatement due to fraud. Procedures when applying analytical procedures 1. Develop expectations regarding financial statements using (PAA RIN) Prior year’s financial statements Annualized interim financial statements Anticipated results such as budgets, forecasts or projections Y Typical Relationships among financial statements account balances v Industry averages ¥ Non-financial information 44% LS Aim... Believe... Claim... Page 165i ial Chapter 5 — Planning an Ault of FAN the items presented in the f 2 Statements ! Manciay Compare expectations W! statements ampares the expectations with the recordeg The auditor c unts to whether 0! ere are unusua| amounts to identify wheth jot thi sual ccted relationships or fluctuations. or unexpected relationships or fluct ignific if ences Define and investigate significant differ i is a matter of judgment, Th ing significant differences is 2 deme suaitortocweson ientifed fluctuations and relationships the ae inconsistent with other relevant information or deviate significantly from predicted amounts. Where there are unusual fluctuations and relationships, the auditor ordinarily begins with inquiries of management, followed by © Corroboration of management's responses * Consideration of the need to apply other audit procedures based on the results of management inquiries Uses of analytical procedures Below is a summary of phases where anal lytical procedures may be applied. Phase Objective Required? ' * To enhance the understanding of the business | * To identify areas that may represent specific | Planning risks relevant to the audit YES | * To determine the nature, timing and extent of | FAPs * To evaluate the reasonableness of financial Substantive en | ests * To obtain corroborative evidence relating to a NO Particular assertion * To detect material mi: = To ldena isstatement 1 aia re, lentify unusual or unexpected account | Overall jennie thet Were Not previously identified in | review . . wee qepstantve testing YES | re | auditor has the ably nether Sr hot the | Sveisuethereport | | Page 166