CHAPTER THREE

PLANNING AND CONDUCTING

AUDIT
 3.1. Reasons for Audit planning
• The first GAAS of fieldwork standard requires adequate
planning. Thus, auditors must adequately plan the work and must
properly supervise any assistants.

• Reasons for proper audit plan includes;

– it enables the auditor to obtain sufficient competent
evidence.
– it helps to keep audit costs reasonable.
– it avoids misunderstanding with the client.
 Cont’d….
• There are seven major parts of audit planning.
• The followings are the basic elements of audit planning;
– 1. Preplanning
– 2. Obtain background information
– 3. Obtain information about clients legal obligation
– 4. Perform preliminary analytical procedures
– 5. Set materiality, and assess acceptable audit risk and
inherent risk
– 6. Understand internal control and assess control risk
– 7. Develop overall audit plan or audit program
 1. Pre-plan the Audit
• Preplanning the audit involves four things, all of which should
be done early in the audit.
– A decision whether to accept a new client or continue
serving an existing one.
– Identification of why the client needs an audit
– Obtaining an understanding with the client about the
terms of engagement to avoid misunderstandings.
– Select staffs for engagement.
Why investigating new clients and evaluation of
existing one is needed?
• Investigation of new client and re-evaluation of existing ones
is important;
– to assess the integrity of the client and
– the acceptable financial risk it will assume.
• If the CPA firm decides that acceptable risk is extremely low, it may
choose not to accept the engagement.
• If the CPA firm concludes that acceptable audit risk is low but the
client is still acceptable, it is likely to affect result and the fee
proposed to the client.
– I.e.: audits with low acceptable audit risk will normally result
in higher audit costs, which should be reflected in higher audit
fees.
 Cont’d….
• Investigation of client is expressed by the use of engagement
letter, even though it is not required.
• Engagement letter:- is an agreement between the CPA firm
and the client for the conduct of the audit and related
services.
– It should specify whether the auditor will perform an audit, a review,
or a collecting plus any other service such as tax returns or
management consulting.
– It should also state any restriction to be provided for the audit, an
agreement on fees.
– It also a means of informing the client that the auditor cannot
guarantee that all acts of fraud will be discovered.
2. Obtain Background Information
• There are three reasons for obtaining a good understanding of
the clients industry.
– First, many industries have unique accounting requirement
that the auditor must understand to evaluate whether the
clients F/st are in accordance with GAAP.
– Second, auditors can often identify risks that may affect
the auditor’s assessment of acceptable audit risk.
– Finally, there are inherent risks that are typically common
to all clients in certain industry.
• Understanding those risks aids the auditor in
identifying the client’s inherent risk.
 Cont’d….
• The clients industry information can be obtained in different
ways. These include:
– Discussion with previous auditor
– Discussion with clients personnel
– Tour the plant and office of the clients
– Discussion with outside specialists.
 3. Obtain Information about Client’s Legal
Documents
• This enable auditors to interpret related evidence throughout
the engagement.
• Three closely related types of legal documents and records
should be examined early in the engagement.
• A. The Corporate Charter and the Bylaws:-
• corporate charter:- is granted by the state and it is the legal
document necessary for recognizing a corporation as a separate
entity.
• Bylaw: is the rules and procedures adopted by stockholders of the
corporation.
• B. The Corporate Minutes: are the official records of the
meetings of the BoDs and stockholders.
 Cont’d…
• C. Contracts: clients involved in different types of contracts
that are interested to the auditors.
– It includes;
• long term notes and bonds payable,
• stock option & contracts of mfgred pdcts,
• contracts with vendors for future deliveries of supplies,
• government contracts and lease etc.
 4. Performing Preliminary Analytical Procedures
• Performing analytical procedure;
– assists the auditor in determining;
• the nature, timing and
• extent of auditing procedures.
– enhances to understand the client’s business and events
occurring since the prior year’s audit.
– helps to identify areas that may represent specific risks of
material misstatement.
 5. Audit Risk Assessment and Materiality
• Audit risk:- refers the possibility that the auditor may
unknowingly fail to appropriately modify their opinion on F/st
that is materially misstated.
– (e.g., an unqualified opinion on misstated financial statements.)
• The AUDIT RISK MODEL decomposes overall audit risk into
three components:
– inherent risk (IR),
– control risk (CR), and
– detection risk (DR):
• AR = IR x CR x DR
 Cont’d….
• Example: Assume that the auditor have assessed inherent risk for a
particular assertion at 50% and control risk at 40%. In addition, they have
performed audit procedures that they believe have a 20% risk of failing to
detect a material misstatement in the assertion. Compute the acceptable
audit risk.
• Solution
PDR = AAR
IR X CR
0.20 = AAR
0.50 X 0.40
• AAR = 0.04 = 4%
 A. Inherent Risk (IR)
• Inherent Risk (IR): is the likelihood that material
misstatement could occur because of internal controls’
absence.
• In other words, it is a measure of the susceptibility of an
account to misstatement.
• Factors affecting account inherent risk include:
– Dollar size of the account
– Liquidity and nature of the industry
– Volume of transactions
– Complexity of the transactions
– New accounting pronouncement
– Subjective estimates
– Competition and economy
 B. Control Risk (CR)
 Control Risk (CR):- is the likelihood that a material
misstatement would not be caught by the client’s internal
controls.
 Factors affecting control risk include:
 The environment in which the company operates (its
“control environment”).
 The existence (or lack thereof) and effectiveness of control
procedures.
 Monitoring activities (audit committee, internal audit
function, etc.).
 C. Detection risk (DR)
• Detection risk (DR):- is the risk that a material misstatement
would not be caught by audit procedures.
• In another term, DR- is the audit risk that the auditor will fail to
detect material misstatement with their audit procedures.
– Thus, detection risk is a function of the procedures auditors perform for
testing assertions.
• Factors affecting detection risk include:
– Sampling risk
– Risk of choosing an unrepresentative sample.
– Non-sampling risk
– Risk that the auditor may reach inappropriate conclusions
based upon available evidence.
 D. Acceptable Audit Risk
• Acceptable Audit Risk: is the measure of how willing the
auditor is to accept that the F/st may be materially misstated
after the audit is completed and unqualified opinion has been
issued.
– When the auditor decides on lower acceptable risk, the auditor
wants to be more certain that the F/st will not materially
misstated.
– Zero acceptable audit risk would be high certainty and
– 100% acceptable audit risk would be complete uncertainty.
6. Understand internal control and assess
control risk

• Observe the internal control using internal control

techniques.
• Assessing control risk we discussed previously.
• For more details, we will discuss on chapter four
 7. Develop an Over All Audit Plan
• The last step in the planning the audit is to develop an overall
strategy.
• This generally involves specific instructions as to;
– how the audit will be performed (procedures).
– what, and how much evidences must be collected and
evaluated.
– who will collect and analyze the data and when this should
be done.
• It also involves about; the nature, extent, and timing of audit
test to be conducted.
 3.3. Designing Audit Program
• An audit program is a set of polices and procedures that
dictate how auditing is to be implemented.
• It may also refer to a step by step procedure laid down by the
audit firm to be followed by the accountants in the audit.
• The audit program for most audits is designed in three parts:
 Test of transactions
Control and
substantive tests
 Analytical procedures
 Test of details of balance
 3.3.1. Audit Procedures
• The basic audit procedures includes;
1. Apply the transaction-related audit objectives to the class
of transactions being tested.
2. Identify key controls that should reduce control risk for
each audit objective.
3. Develop appropriate tests of controls.
4. Design substantive tests of transactions.
 Balance-Related Audit Objectives and Tests

Transaction- Balance-Related audit Relationship

Related audit objectives
objectives
Existence Existence /occurrence Direct
Completeness Completeness/ existence Direct
Accuracy Accuracy Direct

Classification Classification Direct

Timing Cutoff Direct
Posting and Detail tie-in Direct
summarization
Realizable value None
Rights an obligations None
Presentation and disclosure None
 Definitions and functions of tests
• Ss
 3.4. Materiality and the Auditor
• Materiality:- A misstatement in the f/st. can be considered
material if knowledge of the misstatement would affect a
decision of a reasonable user of the statement.
• In applying this definition, three grading of materiality are
used.
• 1. Amounts are immaterial: When a misstatement in the
financial statements exist, due to two cases;
– (1) scope restricted by client or by circumstances or
– (2) statements are not in accordance with GAAP, but is
unlikely to affect the decisions of a reasonable user.
 Cont’d….
• 2. Amounts are material but do not overshadow the
financial statement as a whole:
– This materiality exists when a misstatement in the financial
statement would affect a users' decision, but the overall
statements are still fairly stated.
– For example:- A misstatement of inventory does not mean
that cash, accounts receivable, and other elements of the
financial statements (or as a whole), are materially
incorrect.
 Cont’d….
• 3. Amounts are so material that overall fairness of
statements is in question:
• This is the highest level of materiality exists when users are
likely to make incorrect decision if they rely on the overall
financial statements.
– If the auditor determines that there is a material misstatement,
he/she will bring it to the client's attention so a correction can
be made.
– If the client refuses to correct the statements, a qualified or
adverse opinion must be issued, depending on how material
the misstatement is.
 3.4.1. Factors Affecting Materiality Judgment
• Several factors affect setting a preliminary judgment about
materiality are;
• A. Materiality is a relative rather than absolute concept:
– A misstatement of a given magnitude might be material for a
small company, whereas, the same birr amount error could be
immaterial for a large one.
– Thus, it is not possible to establish any birr- value guidelines for
a preliminary judgment about materiality applicable to all audit
clients.
– since materiality is relative, it is necessary to have base and net
income before taxation is normally the most important base for
deciding what is material.
• B/C it is regarded as a critical item of information for users.
 Cont’d….
• B. Qualitative factors also affect materiality:
• Even if the birr amounts are the same, certain types of
misstatements are likely to be more important to users than
others.
• For example: Amounts involving irregularities (frauds) are usually
considered more important than unintentional errors of equal
dollar amounts.
• Because:- irregularities reflect on the honesty and reliability
of the management or other personnel involved.
 3.4.2. Error and Fraud
• Error – An error represents an unintentional misstatement of the
financial statement. It may be material or immaterial.
• Example:-
– Mistake in gathering and reporting data, or application of GAAP
– Mistake in Unintentional omission of amount  
• Fraud: Fraud represents an intentional misstatement of the
financial statement which can be material or immaterial. The
misstatement due to fraud may occur due to either of:
– Example. Misappropriation of assets defalcations or employee
fraud. theft of cash or another asset.
 3.5. Auditor’s Working Paper
• Working papers are the records kept by the auditor of;
– the procedures applied,
– tests performed,
– information obtained and
– the conclusions reached in the engagement.

• The working paper over all objectives are to aid the auditor in
providing reasonable assurance that an adequate audit was
conducted in accordance with GAAS.
 Cont’d….
• The additional or further purposes of working paper.
• Provide a base for planning the audit.
– B/c it describes information about;
• internal control structure,
• a time budget for individual audit areas,
• the audit program and
• the results of the preceding year’s audit.
• It also serve as the primary frame of reference used by supervisory
personal to evaluate and justify audit reports.
 3.5.1. Types of audit working paper
• The filling of working paper is classified in to the following.
• 1. Permanent Files: are intended to contain data of a
historical or continuing nature pertinent to the current
examination.
• The permanent files typically include the following.
– Copies such as articles of incorporation, by laws and contracts.
– Analysis from previous years of accounts that have continuing
importance to the auditor such as long term debt, stock holders
equality accounts, good will and fixed asset.
– Information related to the understanding of the internal control
structure and assessment of control risks.
– Result of analytical procedures from previous year’s audit such as
ratio and percentage computed by the auditor.
 Cont’d….
• 2. Current Files: Includes all working papers applicable to the years
under audit.
• The types of information in the current file includes ;
– Audit program
– General information like planning memos, copies of minutes,
agreements notes on discussion with client etc.
– Working trial balance, listing of the general and subsidiary
ledger account and their year end balance.
– Adjusting and reclassification entries
– Supporting schedule such as reconciliation of amounts and etc.
Thank you !!!
End of
the chapter