Planning and Auditing Process

Chapter Three


3.1 Audit Planning & Documentation


The first generally accepted auditing standards of fieldwork requires adequate planning to be made before auditing is carried out.

The wok is to be adequately planned, and assistants, if any, are to be properly supervised.

Reasons for proper Audit Plan

  • To enable the auditor to obtain sufficient competent evidence
  • To help keep audit costs reasonable
  • To avoid misunderstanding with the client

Obtaining sufficient competent evidence is essential if the CPA firm is to minimize legal liability and maintain a good reputation in the business community. Keeping costs reasonable helps the firm remains competitive and thereby retains or expands its client base, assuming the firm has a reputation for doing high-quality work. Avoiding misunderstanding with the client is important for good client relations and for facilitating high-quality work at reasonable cost.

Audit planning includes the following steps:

  1. Preplan
  2. Obtain background information
  3. Obtain information about client's legal obligation
  4. Perform preliminary analytical procedure
  5. Set materiality, and assess acceptable audit risk and inherent risk
  6. Understand internal control and assess control risk
  7. Develop overall audit plan and audit program

3.1.1. Preplan the audit-It involves three things, all of which should be done early in audit. First, the auditor decides whether to accept a new client or continue serving an existing one. This is typically done by an experienced auditor who is in a position to make important decisions. The auditor wants to make that decision early, before incurring any significant costs that can not be recovered. Second, the auditor identifies why the client wants or need an audit. This information is likely to affect the remaining part of the planning process. Thirdly, the auditor obtains an understanding with the client about the terms of the engagements to avoid misunderstandings and staff the engagements.

Client acceptance procedure

i)   Obtaining clients-As a starting point, it is essential for an auditor or auditors/audit firms/ to maintain its integrity, objectivity, and reputation for providing high-quality services. No auditor can afford to be regularly associated with clients who are engaging in management fraud or other misleading practices. The continuing wave of litigation involving auditor underscores the need for audit firms to develop quality control policies for thoroughly investigating prospective clients before accepting an engagement. The auditor should investigate the history of prospective client, including such matters as the identities and reputations of the directors, officers and major stockholders, financial strength and credit rating of a prospective client to help assess the overall risk associated with particular business (business risk).


In addition to considering business risk the auditors should consider:

< >Whether they can complete the audit in accordance with generally accepted auditing standards

Whether there are any conditions that would prevent them from performing an independent audit of the client.

Whether the partners and staff have appropriate training and experience to competently complete the engagement.

Submitting a proposal- To obtain the audit, the auditors may be asked to submit a competitive proposal that will include information on the nature of services that the firm offers, the qualifications of the firm’s personnel, anticipated fees, and other information to convince the prospective client to select the firm.

Communication with audit committees- Arrangements for the audit may be made through contact with the company’s audit committee (if any). An audit committee must be composed of at least three independent directors. During the course of the audit the discussions with  the audit committee members will focus on:

Weakness in internal control

Proposed audit adjustments

Disagreement with management as to accounting principles

The quality of accounting principles used by the company

Indications of management fraud other illegal acts by corporate officer.

Disagreement with management over accounting principles

The predecessor’s understanding of the reasons    for the change in auditors

On the nature of client’s internal control structure

Other matters that will assist the successor auditors in deciding whether to accept the engagement

Contracts- Clients become involved in different types of contracts that are of interest to the auditors. These can include such diverse items as long-term notes and bond payable, stock options, pension plans, contracts with vendors for future delivery of supplies, government contracts for completion and delivery of manufactured products, royalty agreements, union contracts and leases and others. 


The scope paragraph in auditors’ reports includes two important phrases that are directly related to materiality and risk. These phrases are emphasized in bold italic print in the following two sentences of a standard scope paragraph.

We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material statements.

The phrase obtained reasonable assurance is intended to inform users that auditors do not guarantee or ensure the fair presentation of the financial statements. The phrase communicate that there is some risk that the financial statements are not fairly stated even when the opinion is unqualified.

The phrase free of material misstatement is intended to inform users that the auditor’s responsibility is limited to material financial information. Materiality is important because it is impractical for auditors to provide assurance on immaterial amounts.

Thus, materiality and risk are fundamental concepts that are important to planning the audit and designing the audit approach. Materiality is a major consideration in determining the appropriate audit report to issue.

FASB has defined materiality as

The magnitude of an omission or misstatements of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.

The auditor’s responsibility is to determine whether financial statements are materially misstated. If the auditor determines that there is a material misstatement, he or she will bring it to the client’s attention so that there is a material misstatement, he or she will bring it to the client’s attention so that a correction can be made. If the client refuses to correct the statements, a qualified or an adverse opinion must be issued, depending on how material the misstatement is. Therefore, auditors must have a thorough knowledge of the application of materiality.

A careful reading of the FASB definition reveals the difficulty that auditors have in applying materiality in practice. The definition emphasizes reasonable users who rely on the statements to make decisions. Therefore, auditors must have knowledge of the likely users of their client’s statements and the decisions that are being made. For example, if an auditor knows that financial statements will be relied on in a buy- sell agreement for the entire business, the amount that the auditors material may be smaller than for an otherwise similar audit. In practice, the auditors may not know who all users are or what decisions will be made.

There are five closely related steps in setting materiality. These are:

Step-1:  Set preliminary judgment about materiality                                       

Step-2: Allocate preliminary judgment about materiality to segments             

Step-3: Estimate total misstatement in segments

Step-4: Estimate the combined misstatements                       

Step-5: Compare combined estimate with preliminar or revised judgment about materiality


Step-1: Setting a preliminary judgment about materiality- Ideally, an auditor decides early in the audit the combined amount of misstatement in the financial statements that would be considered material. SAS-47 defines the amount as the preliminary judgment about materiality. This judgment need not be quantified but often is. It is called a preliminary judgment about materiality because it is a professional judgment and may change during the engagement if circumstances change. The preliminary judgment about materiality is thus, the maximum amount by which the auditors believes the statements could be misstated and still not affect the decisions of reasonable users

The reason for setting a preliminary judgment about materiality is to help the auditors plan the appropriate evidence to accumulate. If the auditor sets a low dollar amount, more evidence is required than for a high amount.

Factors affecting materiality judgment- Several factors affects a preliminary judgment about materiality for a given set of financial statements. The most important of these are discussed below.

  1. Materiality is a relative term- a misstatements of a given magnitude might be material for a small company, whereas the same dollar misstatement could be immaterial for a large one.
  2. Bases are needed for evaluating materiality-Because materiality is relative, it is necessary to have bases for establishing whether misstatements are material. Net income before taxes is normally the primary base for deciding what is material because it is regarded as a critical item of information for users

  3. A qualitative factor also affects materiality- certain types of misstatements are likely to be more important to users than others, even if the dollar amounts are the same.

For example,

  • Amounts involving fraud are usually considered more important that unintentional errors of equal dollar amounts because fraud reflects on the honesty and reliability of the managements or other personnel involved. For example total of $100,000 may extremely material for small company while it could be immaterial for large company case. 

  • Misstatements that are otherwise minor may be material if there are possible consequences arising from contractual obligations. An example is when net working capital included in the financial statements is only a few hundred dollars more than the required minimum in a loan agreement.
  • Misstatements that are otherwise immaterial may be material if they affect a trend in earnings. For example, if reported income has increased by 3-percent annually for the past 5-years but income for the current year has declined by 1-percent, that change of trend may be material. 

Step-2: Allocate preliminary judgment about materiality to segments (tolerable misstatements)

The allocation of the preliminary judgment about materiality to segments is necessary because, evidences are accumulated by segments rather than for the financial statements as a whole. If auditors have preliminary judgments about materiality for each segment, it helps them decide the appropriate audit evidence to accumulate. For example, an auditors is likely to accumulate more evidences for an accounts receivable balance of $1,000,000 when a misstatement of $50,000 in accounts receivable is considered material than if $300,000 were material. When auditors allocate the preliminary judgment about materiality to accounts balance, the materiality allocated to any given accounts balance is referred to in SAS-39 as tolerable misstatements


Step-3: Estimate total misstatement in segments- When auditors perform audit procedures for each segment of the audit, a worksheet is kept of all misstatements found. For example, assume that the auditor finds six client misstatements in a sample of 200 in testing inventory costs. These misstatements are used to estimate the total misstatements in inventory. The total is called an estimate or often called a “projection” because only a sample, rather than the entire population, was audited.


Step-4: Estimate the combined misstatements-Estimation of projected misstatements is required by SAS-39. The projected misstatements amounts for each account are combined on the worksheet.


Step-5: Compare combined estimate with preliminary or revised judgments about materiality- The combined misstatements of certain amount may exceeds the preliminary judgment about materiality of a given amount. In such cases, since the estimated combined misstatements exceed the preliminary judgment, the financial statements are not acceptable. The auditor can either determine whether the estimated misstatements actually exceed

a given amount of preliminary judgment by performing additional audit procedures or require the client to make an adjustment for estimated misstatements


3.1.6 Understand internal control and assess control risk-To effectively assess internal control for the purpose of reducing planned audit evidence, auditors need to understand key internal control and control risk concepts. As discussed in previous chapter, a system of internal control consists of policies and procedures designed to provide managements with reasonable assurance that the company achieves its objective and goals. These policies and procedures are often called control especially those controls related to the reliability of financial reporting , are important to the auditors purpose.


3.1.7: Develop over all audit plan and audit program-It deals the last step in the planning phase of audit. It is critical step because it results in the entire audit program the auditors plans to follow in the audit, including all audit procedures, sample size, items to select, and timing. It is the process of making correct decisions in both the effectiveness of evidences and the efficiency of the audit process.

             3.2 Overview of the Audit Process

The phases of the audit  include…client acceptance and retention, Establish the terms of the engagement, Plan the audit, Consider internal control, Conduct substantive tests, Feedback on the results of the audit work in these phases, Complete the audit and  Issue audit report


Client Acceptance and Retention

The Statements on Quality Control Standards require that public accounting firms establish policies and procedures for deciding whether to accept new clients or retain current clients. The purpose of such policies is to minimize the likelihood that an auditor will be associated with clients who lack integrity. If an auditor is associated with a client who lacks integrity, material misstatements may exist and not be detected by the auditor. This can lead to lawsuits brought by users of the financial statements.

In discussing this issue, a distinction is made between evaluating a prospective client and continuing a current client. In the case of a continuing client, the auditor has more first hand knowledge about the entity’s operations and management’s integrity.

Prospective Client Acceptance

Public accounting firms should investigate a prospective client prior to accepting an engagement. Performance of such procedures would normally be documented in a memo or by completion of a client acceptance questionnaire or checklist. The successor auditor’s communications with the predecessor auditor should include questions related to the integrity of management; disagreements with management over accounting and auditing issues; communications with audit committees or an equivalent group regarding fraud, illegal acts, and internal-control-related matters; and the predecessor’s understanding of the reason for the change in auditors.

If the client has not previously been audited, the public accounting firm should complete all the procedures listed below, except for the communication with the predecessor auditor.

Procedures for evaluating a prospective client:

1. Obtain and review available financial information (annual reports, interim financial statements, income tax returns, etc.).

2. Inquire of third parties about any information concerning the integrity of the prospective client and its management. (Such inquiries should be directed to the prospective client’s bankers and attorneys, credit agencies, and other members of the business community who may have such knowledge.)

3. Communicate with the predecessor auditor about whether there were any disagreements about accounting principles, audit procedures, or similar significant matters.

4. Consider whether the prospective client has any circumstances that will require special attention or that may represent unusual business or audit risks, such as litigation or going-concern problems.

5. Determine if the firm is independent of the client and able to provide the desired service.

6. Determine if the firm has the necessary technical skills and knowledge of the industry to complete the engagement.

7. Determine if acceptance of the client would violate any applicable regulatory agency requirements or the Code of Professional Conduct.

Continuing Client Retention

     Public accounting firms need to evaluate periodically whether to retain their current clients. This evaluation may take place at or near the completion of an audit or when some significant event occurs. Conflicts over accounting and auditing issues or disputes over fees may lead a public accounting firm to disassociate itself from a client.

       The auditor should establish an understanding with the client regarding the services to be performed. For small, privately held entities, the auditor normally negotiates directly with the owner-manager. For larger private or public entities, the auditor will normally be appointed by a vote of the stockholders after recommendation by the audit committee of the board of directors. In all cases, an engagement letter should document the terms agreed to by the auditor and client. Such terms would include, for example, the responsibilities of each party, the assistance to be provided by client personnel and internal auditors, and the expected audit fees.

Audit Planning

      Proper planning of an audit is important to ensure that the audit is conducted in an effective and efficient manner. The steps taken during this phase include (1) gaining knowledge of the client’s business and industry so that the auditor understands events, transactions, and practices that may affect the financial statements and (2) conducting preliminary analytical procedures (such as ratio analysis) to identify specific transactions or account balances that should receive special attention because they may contain material misstatements. In many instances, audit planning will include a preliminary consideration of the client’s internal control system.

       Based on this initial work, an overall audit strategy is developed. This includes the preliminary assessment of materiality and audit risk, as well as an audit plan involving the types of audit procedures to be performed and the amount of evidence to be gathered. The audit plan serves as a starting point for the engagement, but adjustments may be required as the audit progresses.

Assessment of Internal Control

Internal control is a process affected by an entity’s board of directors, management, and other personnel that is designed to provide reasonable assurance regarding the achievement of objectives in the following categories:

(1) Effectiveness and efficiency of operations,

 (2) Reliability of financial reporting, and

 (3) Compliance with applicable laws and regulations.

The auditor must sufficiently understand the client’s internal controls in order to determine which controls exist within the entity. The auditor then evaluates the internal controls in order to assess the risk that they will not prevent or detect a material misstatement in the financial statements. This risk (referred to as control risk) directly impacts the scope of the auditor’s work. When the auditor assesses control risk at less than the maximum, the internal controls should be tested. The auditor’s tests are intended to ensure that the internal controls are operating in the manner intended and therefore are effective in preventing or detecting misstatements. The evidence gathered from testing the internal controls is used to arrive at a final assessment on the level of control risk. When control risk is assessed low, based on tests of the internal controls (referred to as tests of controls), less audit work is required to audit the account balances (referred to as substantive tests) because the auditor has evidence that the accounting systems are generating materially accurate financial information. Conversely, if control risk is high, the auditor has to conduct more extensive audit work in the account balances because the evidence about internal controls suggests that material misstatements could occur because controls do not exist or are not operating effectively.

Conduct Substantive Tests

In this phase, the auditor conducts more analytical procedures and examines the details of the account balances. For example, the auditor may calculate an estimate of interest expense by multiplying total debt by the average interest rate on the entity’s debt. This estimate of interest expense can be compared to interest expense reported in the general ledger for reasonableness. The purpose of such analytical procedures is to determine whether the accounts contain a material misstatement.  On most engagements, this phase comprises most of the time spent on the audit.

Complete the Audit

After the auditor has completed testing the account balances, the sufficiency of the evidence gathered needs to be evaluated. The auditor must have sufficient competent evidence in order to reach a conclusion on the fairness of the financial statements. In this phase, the auditor also assesses the possibility of contingent liabilities, such as lawsuits, and searches for any events subsequent to the balance sheet date that may impact the financial statements.

Issue the Audit Report

The final phase in the audit process is choosing the appropriate audit report to issue. When the auditor has gathered sufficient competent evidence and complied with GAAS, and the financial statements conform to GAAP, the auditor can issue a standard unqualified audit report. When sufficient evidence is not gathered or the financial statements are not in accordance with GAAP, the auditor will issue a different type of report.


Audit planning involves the development of an overall strategy based on the understanding of the organization being audited, the environment in which it operates; the possible lines of enquiry and the kinds of information that should be gathered for the identified areas of audit.  It integrates the various aspects of auditing task, which is aimed at achieving the primary objective of the audit, for example, enhancing the government accountability.  The Planning also optimises the transfer of knowledge from one audit to another, with minimal cost and disruption to the audit entity.

      Audit planning is a vital area of the audit which is primarily conducted at the beginning of the audit process. The plan developed will be revised as necessary during the course of the audit.

Adequate planning includes:

  • Investigating a prospective client before deciding whether to accept the engagement
  • Obtaining in understanding of the client business operations

  • Developing an overall strategy to organize, coordinate, and schedule the activities of the audit staff ( develop overall audit strategy)


  • Design a detail list of the audit procedures to be performed in the course of the examination(develop appropriate audit programs)

Audit planning is a vital area of the audit process to help to:

  • Determine the audit requirements

  • Determine the time budget

  • Assess the level of risk and materiality

  • Perform the audit work at effective manner

  • Acquire knowledge of the client's accounting systems, policies and internal control procedures

  • Establish the expected degree of reliance to be placed on internal control

  • Determine and program the nature, timing, and extent of the audit procedures to be performed

  • Ensure that appropriate attention is devoted to important areas of the audit

  • Ensure that potential problems are promptly identified

  • Ensure that the work is completed expeditiously

  • Utilize the assistants properly

  • Co-ordinate the work done by other auditors and experts

Advantages of Audit Planning

Audit planning is a continuous process and must continue throughout the audit. A properly drawn-up audit plan helps in the efficient and effective conduct of audit. Some of the main advantages of audit planning are: Audit planning helps in ensuring that adequate attention is devoted to important areas of the audit. Audit planning helps in identifying potential problems. Audit planning helps in ensuring that the audit work is completed expeditiously. Planning helps in utilising the staff properly. Audit planning acts as a direction. Audit planning acts as a direction for auditors in the planning, conducting and reporting of an audit assignment.


The major steps in planning audit are:

  • Pre-plan the audit
  • Obtain background information

  • Obtain information about client’s legal obligations

  • Set materiality and assess acceptable audit risk

  • Understand internal control structure and assess control risk

  • Develop the audit plan and audit program

The extent of planning will vary according to :-

  • The size of the entity

  • The complexity of the audit and the specific methodology of technology used by the auditor

  • The auditors experience with the entity and knowledge of the business

Engagement Letter

Having decided to accept a client, the first step the auditor should take is to send the client an engagement letter to set forth the terms of the type of engagement to be performed and to identify any understandings between the auditor and client. By returning a signed copy of the letter, the client agrees to cooperate, render assistance, and compensate the auditor. Many audit firms send engagement letters not only to new clients but also to continuing clients for each engagement, whether the services performed are for audit, tax, compilation, review, or some other special engagement. An engagement letter is a written contract between an auditor and client and generally serves as to:

  • Minimize misunderstandings between the client and auditor

  • Alert the client to the purpose of the engagement and  the role of the external auditor

  • Help to minimize legal liability for services neither contracted for nor performed

  • Indicate the work to be performed by the client’s staff and client’s responsibilities. An engagement letter should explain in nontechnical language the nature of the services to be rendered and establish that the financial statements are the responsibility of the client.

  • Indicate the scheduled dates for performance and completion of the examination, and the basis for computing the auditor’s fee

  • Provide audit staff with an understanding of the nature of the engagement. 


Audit Risk

In planning the audit, the auditor should make a preliminary judgment about whether or not the financial statements are materially misstated. Audit risk and materiality must be considered in the planning stages of the audit so that the auditor can determine the nature, timing, and extent of audit tests.

Audit risk is the risk of giving an inappropriate opinion when financial statements are materially misstated. Audit risk is the chance that a material misstatement exists in the financial statements and the auditors do not detect the misstatement with their audit procedures. The auditor should use professional judgment to assess audit risk and to design audit procedures to ensure it is reduced to an acceptably low level.

In theory, audit risk ranges anywhere from zero, here there is complete certainty of no material misstatement, to one where there is complete certainty of a material misstatement. In practice, however, audit risk is always greater than zero. There is always some risk of material misstatement as it is not possible, (except for the audit of the simplest of financial statements), due to the limitations inherent in both accounting and auditing, to be absolutely certain a material misstatement will not exist.

The auditor must plan and perform the audit to obtain reasonable assurance those material misstatements, whether caused by errors, irregularities, or illegal acts are detected. The auditors’ concern about fraud does not stop at the planning phase of the audit. Throughout the engagement, they should be alert for conditions that may indicate that a fraud was committed.  

When Audit Risk increase:      

  • Perform additional audit tests
  • Modify the nature, extent and timing of the audit procedures to obtain evidence that is more reliable.

  • Apply increased professional skepticism about material transactions; increase the nature and extent of the documentation examination.

  • Assign personnel with particular skill in audit areas with high risk

  • Obtain additional evidence about the appropriateness of management selection and application of significant accounting principles.

  • Document the assessment of risk in working papers.

                - Risk factors

                - Responses

                - Management representation

The time budget is used as:

  • Basis of estimating fees

  • As means of communication of the audit staff to indicate critical and time – consuming areas
  • To measure efficiency of the audit work (review procedure)

Planning a recurring engagement:

The precious year audit is a good working knowledge of the clients business. Use Information from previous audit working papers.

 Use of the client’s staff:

The auditors should obtain an understanding with the client on to the extent to which the client’s staff, including the internal auditors, can help prepare for the audit. The client’s staff should have the accounting records up – to-date when the auditors arrive. Among the tasks that may be assigned to the client’s employers are:

  • the preparation of - trial balance of the general ledger

  • Aging analysis of accounts receivables

  • Analyses of account receivables written off

  • List of property additions and retirements during the year

  • Analyses of various revenue and expense accounts

The audit trail – a continuous trail of evidence that links the business transactions with the summary figures in the financial statements. The audit trail is a record left by the accounting information system of movements in individual transaction data. This record, in the form of references to the processing of the data, provides a trail of the processing of transactions and other events entered into by the entity. Note that while some accounting information systems provide a visible and complete audit trail, others may provide an invisible and/or incomplete trail.

Depending on the accounting information system, the trail may start from the moment data about the event is first captured within the system to the time of its ultimate disposition in the financial statements. For example, the audit trail of a sales transaction may enable the tracing of the movement in data concerning the transaction from the time the order is placed by the customer until the time the transaction data is included in the appropriate general ledger accounts. The system records may also provide a link to other related transaction cycles. Continuing the example, the system may enable the linking of a particular sales transaction to the related cash receipt transactions and inventory transactions. These related transaction cycles may have their own audit trail. An auditor may follow the audit trail of a transaction as part of a systems walk-through.


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