Audit Planning and Documentation

Chapter 5 Audit Planning and Documentation

LEARNING OBJECTIVES

1.       Understand the nature and purposes of an engagement letter.
2.       Explain the importance and elements of audit planning.
3.       Explain the purposes of audit working paper and apply the concepts behind the preparation and organization of audit working papers.

1. Audit Engagement

1.1       The following issues must be considered when deciding the acceptance and retention of client because this may affect the reliability of financial information provided by the client.
(a)        Knowledge of existing or potential client’s business and industry.
(b)        Code of ethics for professional accountants (refer to Chapter 3).
(c)        Independence of the audit team (refer to Chapter 3).
(d)        Terms of engagement.

1.2 Knowledge of client’s business

1.2.1 HKSA 315 Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement requires auditors to acquire knowledge of client’s business before and during the audit engagement.
1.2.2 Before accepting an engagement, auditors would obtain a preliminary knowledge of the industry and of the background of the entity to be audited so as to assess their ability to undertake the audit.

1.2.3

Sources of knowledge of client’s business (June 09, Dec 13, Jun 14)

(a)        Review of previous years’ audit files to obtain previous experience with the entity and its industry.
(b)        Discussions with management of the entity.
(c)        Discussions with internal auditor and review of internal audit report.
(d)        Discussions with specialists including other auditors, legal advisors, and other knowledgeable people.
(e)        Publications related to the industry.
(f)        Legislation and regulations that significantly affect the entity.
(g)        Visits to the entity’s premises and plant facilities.
(h)        Internal documents of the entity.

1.2.4

Key matters to understand the client’s business operation

(Jun 11, Dec 12, Jun 13, Dec 13, Jun 14, Dec 14, Jun 15)

(a)        Nature of revenue sources – all over the world or just in certain locations?
(b)        Key customers – large number of customers across the whole population?
(c)        Products or services and markets – facing with keen competition? Different types of products for sales?
(d)        Conduct of operations – Mainly on cash sales or credit sales? Operate in a computerized billing system?
(e)        Employment – mainly in full-time staff or part-time staff?
(f)        Geographical dispersion
(g)        Alliances, joint ventures, and outsourcing activities
(h)        Research and development activities and expenditures

Question 1

HKSA 315 Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement requires auditors to acquire knowledge of client’s business before and during the engagement.

From what sources can David acquire knowledge of BFL’s business and industry?
(5 marks)
(HKIAAT PBE Paper III Auditing and Information Systems June 2009 Q1(a))

Question 2

HKSA 315 (Clarified) requires the auditor to obtain an understanding of the entity and its environment, including the entity’s internal control. An understanding of the nature of an entity enables the auditor to understand the classes of transactions, account balances, and disclosures to be expected in the financial statements.

What are the matters regarding the business operations of JPL that the auditor may consider when obtaining an understanding of the nature of the business operations of JPL? (10 marks)
(HKIAAT PBE Paper III Auditing and Information Systems June 2011 Q1(a))

1.3 Continuance of an existing audit
(Dec 12)

1.3.1

Factors to be considered for the continuance of an existing audit

(a)        The integrity of the principal owners, key management and those charged with governance of the entity.
(b)        Whether the engagement team is competent to perform the audit engagement and has the necessary capabilities, including time and resources.
(c)        Whether the firm and the engagement team can comply with relevant ethical requirements.
(d)        Significant matters that have arisen during the current or previous audit engagement, and their implications for continuing the relationship.

1.4 Acceptance of new audit engagement
(Jun 10, Dec 11, Jun 13)

1.4.1

Factors to be considered when accepting a new engagement

(a)        The knowledge for an engagement – e.g. preliminary knowledge of the ownership, directors, management and operations of the entity
(b)        The integrity of management.
(c)        Whether the auditor is competent to perform the audit engagement, for example whether the auditor is familiar with the relevant industry.
(d)        Whether the auditor has the adequate time and resources to complete the audit.
(e)        Whether the acceptance of such a new client will breach the professional ethics of independence and other professional ethics.

1.4.2

Preconditions before accepting a new engagement under HKSA 210 (Clarified) (Jun 12)

(a)        Determine whether the financial reporting framework to be applied in the preparation of the financial statements is acceptable; and
(b)        Obtain the agreement of management that it acknowledges and understands its responsibility:
(i)         for the preparation of the financial statements in accordance with the applicable financial reporting framework, including where relevant their fair presentation;
(ii)        for such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error; and
(iii)       to provide the auditor with:
1.      access to all information of which management is aware that is relevant to the preparation of the financial statements such as records, documentation and other matters;
2.      additional information that the auditor may request from management for the purpose of the audit; and
3.      unrestricted access to persons within the entity from whom the auditor determines is necessary to obtain audit evidence.

1.5 Changes in professional appointment
(Jun 10)

1.5.1

Obligations of the incoming auditors regarding the change in auditors

(a)        Find out whether the change of auditor was properly dealt with in accordance with the Companies Ordinance and/or other legislation; and
(b)        request the prospective client’s permission to communicate with the auditor last appointed. If the prospective client does not permit the member to do so, he should decline the offer.
(c)        After receiving the permission to communicate with the previous auditor, the new auditor should write to previous auditor to obtain professional clearance; that is, a request in writing to previous auditor to establish if there are any unusual circumstances surrounding the proposed change which the new auditor should be aware of, so that the new auditor may determine whether he or she should accept such nomination.

Question 3

(a)      What are the responsibilities of the auditors regarding the acceptance of the audit engagement?                                                                                                 (5 marks)
(b)      What are the obligations of the incoming auditors regarding the change in auditors of GF Limited?                                                                                              (5 marks)
(HKIAAT PBE Paper III Auditing and Information Systems June 2010 Q1(a)&(b))
(c)      What matter should be considered by CBA & Co. for the acceptance of a new client?                                                                                                                       (4 marks)
(HKIAAT PBE Paper III Auditing and Information Systems December 2011 Q1(a))

1.6 Engagement letter

1.6.1 HKSA 210 “Terms of Audit Engagement” requires an auditor to agree the terms of engagement with the new client and to issue letters of engagement to new clients before the new audit assignments begin.
1.6.2 On recurring audits, the auditor should consider whether circumstances require the terms of engagement to be revised so that a new engagement letter should be issued.

1.6.3	Purposes of engagement letter
	(a) confirm the acceptance of his appointment; (b) state the objective and scope of the audit; (c) define the extent of the auditor’s responsibilities; and (d) minimize misunderstanding between auditor and client.

1.6.4

Content of engagement letter

(a)        the terms of appointment;
(b)        respective responsibilities of auditor and client;
(c)        scope, objectives and limitations of the audit;
(d)        unrestricted access to records, documents and other information for audit purpose;
(e)        form of the report;
(f)        management representations;
(g)        arrangement regarding the planning of the audit;
(h)        involvement of internal auditor, other auditor, outgoing auditor and expert;
(i)         restriction of auditor’s liabilities, if possible;
(j)         other services, such as accounting and taxation services.

2. Audit Planning

2.1 The importance of planning

2.1.1 An effective and efficient audit relies on proper planning procedures. The planning process is covered in general terms by HKSA 300 (Clarified) Planning an Audit of Financial Statements which states that the auditor shall plan the audit so that the engagement is performed in an effective manner.

2.1.2

HKSA 300 (Clarified) states that auditors should undertake the following:

(a)        Plan the audit to enable it to be carried out in the most effective and efficient manner.
(b)        Consider whether to continue the entity relationship in the case of an existing entity.
(c)        Ensure the terms of the engagement are understood.
(d)        Consider ethical guidance including independence.
(e)        Consider entity acceptance procedures and professional clearance.
(f)        Establish the overall audit strategy for the audit and update any changes during the course of the audit.
(g)        Develop and document an overall audit strategy for the expected scope and conduct of audit in order to reduce audit risk to an acceptably low level.
(h)        Develop and document an audit plan which sets out the nature, extent and timing of planned audit procedures.

2.1.3 The audit strategy and plan should be revised during the audit when there are changes in conditions or unexpected results are obtained.

2.1.4

Benefits of audit planning (Dec 10, Dec 12, Jun 14, Dec 14)

(a)        Carry out a most effective and efficient audit.
(b)        Conduct the audit in a timely manner.
(c)        Achieve audit objectives.
(d)        Allocate appropriate team members and assignment of work.
(e)        Achieve better co-ordination.
(f)        Draw attention to high risk important areas.
(g)        Complete audit on a timely basis.
(h)        Respond appropriately to recent changes in industry regulations and financial reporting.

Question 4

Discuss the benefits of audit planning. (6 marks)
(HKIAAT PBE Paper III Auditing and Information Systems December 2010 Q2(a))

2.2 The audit strategy

2.2.1    The audit strategy sets the scope, timing and direction of the audit, and guides the development of the more detailed audit plan.
2.2.2    Each entity is unique and an audit strategy should be adapted to suit the particular requirements and characteristics of the entity concerned.
2.2.3    A strategy should be derived from the audit engagement partner's understanding of the entity and its particular environment, which indicate where the most significant risks of misstatements lie. The audit partner's responsibilities in this regard are set out in HKSA 315 (Clarified).
2.2.4    However, there are common elements to all strategies which are presented in the table that follows:

The audit strategy: matters to consider
Characteristics of the engagement	Relevant financial reporting framework Industry regulation Expected scope of audit Characteristics of business segments Availability of internal audit staff and work performed Use of service organisations Effect of information and communications technology on audit procedures Availability of entity staff and information
Reporting objectives, timing of the audit and nature of communications	Entity's timescale for reporting and accounting policies New accounting standards Organisation of meetings with management and those charged with governance Discussions with management and those charged with governance Expected communications with third parties
Significant factors, preliminary engagement activities, and knowledge gained on other engagements	Determination of materiality Areas identified with higher risks of material misstatement Results of previous audits Need to maintain professional scepticism Evidence of management's commitment to design, implementation and maintenance of sound internal controls Volume of transactions Significant business developments Significant industry developments and conditions Significant changes in financial reporting framework Other significant recent developments Any going concern issues
Nature, timing and extent of resources	Selection of engagement team Assignment of work to team members Engagement budget

2.3 Prepare the audit plan

2.3.1    The audit plan converts the audit strategy into a more detailed plan and includes the nature, timing and extent of audit procedures to be performed by engagement team members in order to obtain sufficient appropriate audit evidence to reduce audit risk to an acceptably low level.
2.3.2    The audit plan shall include the following:
(a)        A description of the nature, timing and extent of planned risk assessment procedures
(b)        A description of the nature, timing and extent of planned further audit procedures at the assertion level
(c)        Other planned audit procedures required to be carried out for the engagement to comply with HKSAs

2.4       Conducting preliminary analytical procedures
(Jun 11)
2.4.1    Preliminary analytical procedure is useful in gaining an understanding of client’s business and industry at planning stage.
2.4.2    Analytical procedures consist of the evaluations of financial information made by a study of plausible relationships among both financial and non-financial data. They also encompass the investigation of identified fluctuations and relationships that are consistent with other relevant information or deviate significantly from predicted amounts.

2.4.3	Preliminary analytical procedures performed by auditors (Jun 11)
	(a) Industry data, e.g. industry average. (b) Prior period data, e.g. account balance, total balance, ratios. (c) Auditor-determined expected results, e.g. commission calculated by multiplying sales amount with commission rate. (d) Client-determined expected results, e.g. budgeted data. (e) Expected non-financial data.

2.4.4

Purposes of preliminary analytical procedures (Jun 11)

(a)        To understand the client’s business and industry in order to assess the client’s business risk.
(b)        To understand the client’s classes of transactions and account balances.
(c)        To indicate aspects of the entity of which the auditor was unaware and will assist in assessing the risks of material misstatement, in particular risks of material misstatement due to fraud in order to determine nature, timing and extent of further audit procedures.
(d)        To identify financial statement accounts that are likely to contain errors.
(e)        To provide an indication of the company’s performance by comparing client’s ratios to ratios of industry or competitors.
(f)        To identify areas of increased risk of misstatements that may require further attention during the audit where unusual changes in ratios compared to prior years or industry average.
(g)        To identify areas of specific risk by comparing the liquidity and activity ratios with prior years.
(h)        To allocate more resources for investigation of areas of high risk of material misstatement.
(i)         To help identify the existence of unusual transactions or events, and amounts, ratios, and trends that might indicate matters that have audit implications.

Question 5
The firm of WM & Co., your employer, is the external auditor of North West Limited (NWL) which is a company in the manufacturing and retail business.

You have worked on this audit assignment for a few years and this year you are the senior in charge of the audit. You have to prepare the audit plan. The audit team consists of three members. You decide to let the senior assistant carry out the preliminary risk assessment procedures. The other assistant, Mary, a newly recruited accounting graduate, has no practical experience. Mary requested you to assign more tasks to her as she wants to accumulate more experience. She is confident that she can carry out the tasks effectively and efficiently because her boyfriend works at NML as the accounting manager.

Required:

(a)     What are the purposes of analytical procedures to be applied as part of risk assessment procedures at the planning stage?                                                (6 marks)
(b)     State some preliminary analytical procedures that may be performed by auditors.
(4 marks)
(c)     What is auditor’s independence? Explain why it is essential for an auditor to be independent of his or her assurance clients?                                                  (6 marks)
(d)     What is the independence issue in this case and how should the issue be solved?
(4 marks)
(HKIAAT PBE Paper III Auditing and Information Systems June 2011 Q3)

2.5 Materiality in audit planning

2.5.1    Materiality considerations during audit planning are extremely important. The assessment of materiality at this stage should be based on the most recent and reliable financial information and will help to determine an effective and efficient audit approach.
2.5.2    Materiality assessment will help the auditors to decide:
(a)        the cut off point on how much information should be obtained (quantity) and what type of information is relevant (nature).
(b)        whether to use sampling techniques.
(c)        what level of error is likely to lead to a qualified audit opinion. It serves the objective of audit, i.e. express an opinion whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework.

Question 6
J Limited ('J') is a listed entity with a wide spread of shareholders. The entity is engaged in the manufacture and trading of civil engineering products. Your firm has been the auditor of J for the past five years, and has not encountered any significant audit problems during this period. J has been operating with its present entity structure and its basic product range for the past three-and-a half years. The entity has built a strong reputation in the market place based on its astute, conservative management style and quality product range. The 'geotextile' products, targeted mainly at the road construction market, which represent 40 per cent of J's revenue, have come under heavy competition in the last six months, eroding J's profit margins on these products significantly.

The following is a summary of J's key financial data:

Year	Revenue	Operating profit	Total assts	Net assets
	$m	$m	$m	$m
2011	1,324	56	1,555	755
2010	1,266	72	1,494	685
2009	1,275	90	1,617	615
2008	1,512	78	1,387	580
2007	1,739	67	1,629	605

Required:

Determine the audit planning materiality figure to be adopted in the audit of J's financial statements for the year ended 31 December 2011. Discuss and justify your selection of the key financial data used as bases for the materiality calculations and the percentages applied to these bases.

2.6 Assessing risks of material misstatements

2.6.1    Before accepting an audit appointment, auditors should screen potential new clients in order to identify the risk which may be attached to accepting the audit of that client.
2.6.2    After materiality level and acceptable audit risk have been determined, the auditor have to consider what level or error or misstatement in the financial statements would cause them not to show a true and fair view.
2.7       Determining the nature, timing and extent of audit procedures

2.7.1 At the planning stage of the audit, the auditor determines the extent and nature of the audit work to be performed.
2.7.2 Clearly, the greater the degree of audit risk attached to an assignment, the more audit work should be built into the audit plan. This in turn is likely to affect the time spent on the audit and the level of experience of audit staff employees on the audit.

3. Audit Documentation

3.1	Definition
	Audit documentation means the record of audit procedures performed, relevant audit evidence obtained, and conclusions the auditor reached (terms such as “working papers” (工作底稿) or “workpapers” are also sometimes used). (HKSA 230)

3.2 Purposes of preparing audit documentation
(Dec 10)

3.2.1

Purposes of preparing audit documentation (HKSA 230)

(a)        A sufficient and appropriate record of the basis for the auditor’s report; and
(b)        Evidence that the audit was performed in accordance with HKSAs and applicable legal and regulatory requirements.
(c)        Assisting or enable the audit team to:
(i)         plan and perform the audit;
(ii)        direct and supervise the audit work;
(iii)       discharge their review responsibilities; and
(iv)       be accountable for its work.
(d)        Retaining a record of matters of continuing significance to future audits.
(e)        Enabling an experienced auditor to conduct:
(i)         quality control reviews and inspections; and
(ii)        external inspections in accordance with applicable legal, regulatory or other requirements.

Question 7
According to HKSA 230 (Clarified), the auditor should prepare, on a timely basis, audit documentation that provides:

A sufficient and appropriate record of the basis for the auditor’s report’ and
Evidence that the audit was planned and performed in accordance with HKSAs and applicable legal and regulatory requirements.

What are the purposes of preparing audit working papers? (6 marks)
(HKIAAT PBE Paper III Auditing and Information Systems December 2010 Q3(e))

3.3 Contents of working papers

3.3.1    Working papers should include contents of audit objective, audit testing, evaluation of results and conclusion.
(a)        Audit objectives – that is the purpose of the audit testing recorded on that working paper.
(b)        Sampling method –
(i)         Definition of population, sampling units, error or deviation.
(ii)        Means of determining the sample size.
(iii)       The sampling method selected.
(c)        Audit tests carried out –
(i)         Details of the items selected.
(ii)        Details of test and checking on documents, records, etc.
(iii)       Errors or deviations noted and the explanations as to their causes.
(d)        Interpretation of the results –
(i)         Projection of error or deviations.
(ii)        Auditor’s assessment of the assurance obtained as to the possible size of actual error or deviation rate.
(e)        Conclusions –
(i)         Nature and details of the conclusion drawn from the sample testing results.
(ii)        Details of further action taken where required.
3.3.2    Working papers should show:
(a)        The name of the client
(b)        The balance sheet date
(c)        The file reference of the working paper
(d)        The name of the person preparing the working paper
(e)        The date the working paper was prepared.
(f)        The subject of the working paper
(g)        The name of the person reviewing the working paper
(h)        The date of the review
3.3.3    Sample working paper

3.4 The use of standardized working papers

3.4.1    Benefits of using standardized working papers:
(a)        Efficient in organizing.
(b)        Facilitate communication and planning.
(c)        Ease of delegation.
(d)        Promote control and review.
3.4.2    Limitations of using standardized working papers:
(a)        Working papers are designed and organized to meet the circumstances and the auditor’s needs for each individual audit.
(b)        It is inappropriate to use a mechanical approach without regard to the need to exercise professional judgement.
3.5       Audit files

3.5.1	Definition
	There are two types of audit files: (a) Permanent file () – it is kept to record all data of a permanent nature which provides the necessary background information to the auditor from year to year. (b) Current file () – it is kept to record all audit work programs and working papers for the year under review.

3.5.2    Permanent files contain information of continuing importance to the audit.
(a)        Engagement letters
(b)        New client questionnaire
(c)        The memorandum and articles
(d)        Other legal documents such as prospectuses, leases, sales agreement
(e)        Details of the history of the client’s business
(f)        Board minutes of continuing relevance
(g)        Previous years’ signed accounts, analytical review and management letters
(h)        Accounting systems notes, previous years’ control questionnaires
3.5.3    Current files contain information of relevance to the current year’s audit.
(a)        Financial statements
(b)        Accounts checklists
(c)        Management accounts details
(d)        Reconciliation's of management and financial accounts
(e)        A summary of unadjusted errors
(f)        Ascertaining (探知) and evaluation of internal controls
(g)        Report to partner including details of significant events and errors
(h)        Review notes
(i)         Time budgets and summaries
(j)         Letter of representation
(k)        Management letter
(l)         Notes of board minutes
(m)       Communications with third parties such as experts or other auditors

Question 7
The auditors have two types of working paper files, the current file (CF) and the permanent file (PF). Using the initials and the spaces provided, indicate which file each of the following documents would most likely be filed.

1. A lease agreement.	PF
2. A confirmation of financial institution deposits.	CF
3. Articles of incorporation.	PF
4. An analysis of long-term debt.	PF
5. A pension agreement.	PF
6. An adjusted trial balance.	CF
7. Adjusting journal entries.	CF
8. An analysis of miscellaneous expense.	CF
9. An analysis of owners’ equity accounts.	CF
10. A chart of accounts.	PF

3.6 Confidentiality, safe custody and ownership

3.6.1    Judgement may have to be used in deciding the length of holding working papers, and further consideration should be given to the matter before their destruction. As HKSQC 1 indicates, the retention period for audit engagements ordinarily is no shorter than five years from the date of the auditor’s report, or, if later, the date of the group auditor’s report.
3.6.2    Working papers are the property of the auditors. They are not a substitute for, or part of, the entity’s accounting records.
3.6.3    Auditors should not release parts of or whole working papers to third parties without permission of the entity. Auditors can disclose the working papers to the entity as long as it does not undermine the independence or validity of the audit process.

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Audit Planning and Documentation

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