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Improving Your Audit Process, Part 4: Applying Professional Judgment and Skepticism

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Jun 2nd 2016
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The first Clarified Auditing Standard, Principles and Objectives of Audits, discusses the concepts of professional skepticism and professional judgment in the application material.  This 10-part series of articles will focus on ways to improve the audit process, reduce audit costs, and enable CPA firms to make some money on audit engagements.

Professional skepticism includes being alert for contradictory audit evidence, information that brings doubt as to the reliability of documents, and management’s responses to inquiries and errors or fraud that indicate the need for additional substantive procedures.

Professional judgment is necessary on every engagement when considering audit risk and materiality; the nature, extent, and timing of audit procedures; evaluating the appropriateness and reasonableness of financial statement assertions; and the applicable financial reporting framework. Professional judgment is defined as the application of training, knowledge, and experience, and knowledge of professional standards, in decision-making about actions necessary in any accounting or auditing engagement.

The auditor’s professional skepticism and professional judgment applied in planning, performing, and completing an audit must be clearly documented in engagement files. Many auditors use a Planning Document to document the exercise of professional judgment and professional skepticism applied in planning an audit, developing a cost-efficient audit strategy, and modifying audit programs.

Timely completion and use of a Planning Document can greatly improve the audit process.

Documenting Professional Judgment and Professional Skepticism in a Planning Document

The Planning Document is a vehicle for guiding planning activities and the engagement team’s brainstorming meeting. A standardized format, outlined below, ensures uniformity of the planning activities among engagements, provides leaders assurance that the in-charge accountant has considered all aspects of planning and professional judgment, and professional skepticism will be properly applied during the engagement.

The Planning Document can be presented to the engagement leader during or after the engagement team meeting, or to save time, a draft can be submitted in advance for the leader’s reading. During the meeting, changes in information or approaches can be reflected in the document for the leader’s final approval before fieldwork begins.

Creating the Planning Document in a template format will facilitate its revision and completion. An illustration follows:

Planning Document                                                               

Client: _________________________________________________________________

Engagement Date: _______________________________________________________

Instructions:

This document should be completed by the group engagement in-charge accountant and reviewed by the group engagement leader (partner, sole proprietor) before engagement personnel begin fieldwork. It should describe engagement procedures accomplished and/or planned for both the group and component audits. It may contain cross-references to other planning documentation as applicable.

I. Group Engagement Administration:

A. Delivery of Group Engagement Letter:

The letter should indicate the components for which the group auditor is taking audit responsibility and the component auditors’ reports to which it will refer in the group audit report.

Discussion of the letter with the party or parties engaging the CPA firm should be one of the primary sources for discovering potential misstatements, fraud, or illegal acts, as well as other information relevant to the group audit. The group audit partner should determine that component auditor partners have delivered and discussed their engagement letters with responsible management persons, even if the group auditor is not taking responsibility for the component auditor’s work.

B. Assignment of Staff Personnel:

Personnel should be assigned to engagements and tasks that are commensurate with their experience and capabilities. When persons assigned don’t have experience and capabilities commensurate with engagement risks, more and more frequent supervision is required from the engagement leader. A primary audit response to risk at the financial statement level required by audit and quality control standards is to assign experienced staff persons to the high-risk area or provide more supervision to lesser-experienced persons.

When the group auditor is taking responsibility for component auditor’s work, the component auditor should confirm compliance with this element of quality control and required audit standard, and that appropriate documentation has been included in its engagement documentation files.

C. Target Dates:

Timely engagement completion involves setting target dates during planning. These target dates should be entered in the firm’s staff scheduling system.

Communications to component auditors should include target dates for the group auditor’s involvement when taking responsibility for the component auditor’s work, as well as dates financial information is required by the group auditor from all components

D. Use of Specialists:

Consider using outside specialists whenever any auditing procedures outside the firm’s expertise are expected to be performed. Such circumstances may include actuarial computations for pension funds, questions of law, observations of inventories of products or materials, required tests of client accounting software, and complex accounting and auditing problem situations.

When the auditor outsources any services in connection with an engagement, the engagement letter should contain a paragraph notifying the client. The auditor is also required to obtain a confidentiality agreement from the person or organization performing outsourced services.

When group audit specialists are engaged to perform work that will also be applicable to components, the group auditor’s communication to component auditors should discuss the selection of the specialists and their processes.

E. Audit Budgets:

Prepare a group audit budget based on circumstances, not fees, during engagement planning. Summarize the budget here for discussion among the group engagement team. Include a separate section for involvement in the work of component auditors.

II. Group Technical Audit Planning Decisions:

A.  Describe the Process for Selecting Significant Components:

Cross-reference this section to a separate memorandum or other documentation summarizing organizational, operational, and financial information for all components. Summarize the components determined to be significant and whether the group engagement team will take responsibility for component auditors’ work, or instead, refer to component auditors in the group audit report.

B. Risk of Misstatement at the Group Financial Statement Level:

Use of Group Statements:

Describe high-risk uses of statements.

Potential for Group Going-Concern Problems:

Describe continued losses, high debt, and external situations that threaten the continued existence of the group or any of its components.

Integrity of Group Management:

Discuss specific information that could cast doubt on group or component management’s integrity.

Evaluate the risk of material misstatement at the group and component financial statement levels, and document the subjective impact on audit responses and engagement procedures.

Document the group and components’ risk of misstatements evaluation at the assertion level (financial statement classification level for smaller entities), and the impact on the group and components’ audit strategy by major financial statement classification. This and other sections may be cross-referenced to other documentation.

C. Group Materiality Judgments:

Present a summary of the tolerable misstatement (performance materiality) and lower limit for individually significant items calculations and document group engagement team reasoning for group and component financial statements materiality levels.

D. Group Sampling and Nonsampling Decisions:

Describe the reasons for making decisions to sample or not sample at the group and component levels. If decisions are made to sample, explain the rationale for sample-size calculations.

E. Group Audit Strategies:

Describe the general group audit strategy including detailed substantive tests of balances, risk assessment procedures, tests of controls and/or extensive analytical procedures. Cross-reference this section to other group audit documentation for specific audit strategies at the group and component financial statement classification levels.

F. Nature of Group Audit Procedures:

Summarize the nature and extent of work for significant components and components to be referred to in the group audit report. Describe the nature, extent and timing of tests of balances procedures and analytical procedures for material financial statement classifications or cross-reference to other documentation describing planned procedures for material financial statement classifications at the group and component levels.

G. Group Engagement Team Meeting:

Summarize the significant potential risks of misstatement at the group and component levels due to error or fraud, planned audit responses and other matters discussed at the group engagement team meeting. All group engagement personnel, including partners or sole practitioners, are required to attend this meeting.  Matters discussed affecting the work of component auditors should be communicated to them.

H. Planned Involvement with Component Auditors:

Summarize here, if not present above, the extent of involvement in the work of component auditors when the group engagement team plans to take responsibility for their work and/or when component auditors’ reports will be referred to in the group audit report. This should include both administrative and technical activities similar to those summarized above for the group audit.  This planned involvement should be part of the group engagement team’s communication to component auditors.

Conclusion

To effectively demonstrate the application of professional judgment and professional skepticism on individual or group audits, thorough documentation of planning activities is a must. Sharing documentation related to planning activities with reporting entity personnel, among audit engagement personnel, and with component auditors on group audits is essential to effective and efficient engagement completion. 

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