Knowledge of Audit Planning Needed for the AUD Test
When taking the auditing and attestation (AUD) test on the CPA exam, you must demonstrate knowledge of the audit planning process. When planning an audit, an auditor needs to consider whether certain preconditions are present. These preconditions make it possible for the CPA firm to efficiently perform an audit and help the auditor obtain sufficient audit evidence to support an audit opinion:
The client uses an acceptable framework for financial reporting. On a basic level, the client uses a chart of accounts and reconciles bank accounts on a monthly basis. A chart of accounts is a listing of each account title and account number. The company also posts adjusting entries and uses the accrual method of accounting.
The company accepts responsibility for designing and implementing internal controls.
Management is willing to provide all relevant financial information and to make employees available to the audit staff.
An engagement letter
After both parties agree on the terms of the audit, the terms are documented in an engagement letter. An engagement letter, which is a written agreement between the client and the auditor, spells out the responsibilities of each party. The financial statements are the responsibility of management. The auditor, on the other hand, gathers sufficient audit evidence to support an opinion on the financial statements.
Here are some points that you find in an engagement letter:
The objective of the audit: This includes the specific financial statements to be audited. If the audit will include comparative financial statements, the engagement letter lists the years compared.
The responsibilities of both the auditor and company management: This includes management’s responsibility to inform the auditor of any subsequent events. A subsequent event is an event of transaction that occurs after the balance sheet date but before the financial statements are issued.
Agreements involving the work of internal auditors
A statement about the unavoidable risk that some material misstatements may not be detected, even if the audit is properly planned and performed in accordance with GAAP: This risk exists because of the inherent limitations of both an audit and internal controls. Audit risk is the risk that an auditor will issue an unqualified audit opinion when the financial statements are materially misstated. This portion of the engagement letter explains audit risk.
Identification of the applicable financial reporting framework for the preparation of the financial statements and the expected form and content of the reports
If an auditor is replacing another auditor, the CPA asks management for permission to contact the predecessor. Management should give the previous auditor permission to respond to all of the current auditor’s inquiries. If the CPA determines that management has limited the inquiry — or that the predecessor auditor isn’t answering all of the inquiries — the auditor should consider not taking the engagement.
If the auditor worked on the client’s audit in the prior year, the engagement is a recurring audit. A CPA and the company management should evaluate whether the terms of the engagement letter should be changed. If so, a new engagement letter is created and signed by the client. Here are some circumstances that may require a new engagement letter:
A significant change has occurred in senior management or in the ownership of the company.
The company has had a significant change in the nature or size of the business. A manufacturer that sells all its assets and becomes an investment company would require a new engagement letter. If Company A bought Company B and doubled in size, the new entity would require a new engagement letter.
Significant changes have occurred in legal or regulatory requirements. Companies that issue stock to the public for the first time must start to comply with the requirements of the SEC.
In some cases, a law or regulation may require a specific layout, form, or wording of an audit report. The report wording may be significantly different from what GAAS (generally accepted auditing standards) requires.
The auditor needs to evaluate whether the report format will cause confusion for the users of the audit report. Auditors also consider whether the legally required wording can be changed to be in accordance with GAAS or if a separate report can be attached. If not, the auditor should remove any reference to the audit being performed in accordance with GAAS. If law or regulation allows it, the CPA shouldn’t accept the audit at all.
Internal auditors and outside specialists
Internal auditors are employees of the company being audited. They perform evaluations on business operations to improve risk management and internal controls. Internal auditors report to senior management, which means that the work of internal auditors can help improve corporate governance.
Internal audit departments may perform procedures that are similar to that of an external auditor. For example, an internal auditor may observe a process to determine whether internal controls are operating effectively.
Suppose a clothing store has a process for handling returned merchandise. Customers returning goods must fill out a form explaining why the goods are being returned. The customer must turn in the return form and the original purchase receipt before receiving a refund. This control is to ensure that all refunds are legitimate.
An internal auditor may take a sample of refund payments to verify whether a return form and purchase receipt are on file for each refund payment. If the sample work reveals that documentation is missing for some of the items sampled, the internal auditor may need to test more items and let management know that the control may not be effective.
If the internal auditor’s work will have any bearing on the CPA firm’s audit, the CPA must consider the competence, objectivity, and work competence of the internal auditor.
Another outside specialist is an actuary. Actuaries use math and statistics to assess probability. In the auditing field, actuaries are brought in to assess probability related to insurance and pension plans.
For a company pension plan, an actuary will use several factors (worker age, salary levels, investment rate of return) to compute the firm’s future liability for pension payments to retired employees. The business needs to contribute enough dollars into the pension fund to meet the firm’s future pension payment obligations.
The actuary assesses whether or not the company’s pension contributions are sufficient. The CPA firm will rely on the assessment performed by the actuary.
Actuaries also assist with life insurance company audits. The actuary will assess the age, gender, and health history of those who are insured. The actuary will use that analysis to assess, on average, when insured people will pass away. The CPA firm will rely on that analysis to determine whether the insurance company has enough assets to pay death benefits to each insured person’s beneficiaries.