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(May or June)

Interim Audit Meeting Audit progress
(October or November)

Completion of field Post-Audit Meeting Review/approve drafts of
work January 20, 2004 (early February) 10-K annual report

March 15, 2004 Follow-up Meeting Recommendations in
Date of annual meeting (late February or early March) management letter
and proxy statements (Hold prior to mailing proxy
solicitation materials.)

Note: The dates in the auditing cycle would be adjusted for the SEC rule on accelerated filers for the
three-year phase-in of the new requirements.

In SAS No. 61, the Auditing Standards Board stated, “This statement requires
the auditor to ensure that the audit committee receives additional information re-
garding the scope and results of the audit that may assist the audit committee in
overseeing the financial reporting and disclosure process for which management
is responsible.”8 For example, the independent auditors will discuss such matters
as the audit approach and related threshold of materiality and levels of audit risk,
anticipated changes in accounting policies and new accounting pronouncements,
and special areas that need attention.
With respect to audit risk, the independent auditors attempt to minimize the
risk that they have possibly issued an unqualified auditor™s report with respect to
financial statements that are materially misstated. In addition to following the
guidance in SAS No. 47, “Audit Risk and Materiality,” in conducting an audit, the
auditors have to be aware of intentional misstatements or omissions of information
in the financial statements. To assist them in this area of audit risk, the Auditing
Standards Board has issued SAS No. 99, “Consideration of Fraud in a Financial
Statement Audit.” The Board has identified warning signals, or “red flags,” for the
auditors in assessing the risk of materially misstated financial statements due to
fraud. The fraud risk factors considered in assessing this type of risk during the

Statement on Auditing Standards No. 61, “Communication with Audit Committees” (New York:
AICPA, 1988), par. 2.
Analysis of Audit Planning and the Committee 203

planning phase and other conditions that may indicate evidence of fraud during the
audit are presented in Exhibits 6.3 and 6.4.9
In addition to the guidance for the independent auditor™s assessment of audit
risk, the Auditing Standards Board has issued SAS No. 56, “Analytical Proce-
dures.” This statement “requires the use of analytical procedures in the planning
and overall review stages of all audits.”10 The Board states:

Analytical procedures involve comparisons of recorded amounts, or ratios developed
from recorded amounts, to expectations developed by the auditor. The auditor de-
velops such expectations by identifying and using plausible relationships that are
reasonably expected to exist based on the auditor™s understanding of the client and
of the industry in which the client operates. Following are examples of sources of in-
formation for developing expectations:
Financial information for comparable prior period(s) giving consideration to
known changes
Anticipated results”for example, budgets, or forecasts including extrapolations
from interim or annual data
Relationships among elements of financial information within the period
Information regarding the industry in which the client operates”for example,
gross margin information
Relationships of financial information with relevant nonfinancial information11

Given the accrued benefits from the use of analytical procedures by indepen-
dent auditors, the results of comparative financial statement balances and financial
ratios should alert the audit committee to high-risk areas that may have a signifi-
cant impact on the financial statements. Recall the discussion in Chapter 4 with re-
spect to “cooked books” and “cute accounting,” which produce fraudulent
financial statements. For example, the audit committee should be alert to improper
revenue recognition methods, such as a “bill and hold” arrangement between the
company and a customer. Here the company records a sale that increases earnings,
but the customer is not obligated to take delivery of the products.12
Furthermore, the audit committee will be discussing other aspects of the audit
with the senior management representatives”for example, the chief financial

For a further discussion of fraud risk factors, see Howard Groveman, “How Auditors Can Detect Fi-
nancial Statement Misstatement,” Journal of Accountancy 180, No. 4 (October 1995), pp. 83“86;
Vicky B. Heiman-Hoffman, Kimberly P. Morgan, and James M. Patton, “The Warning Signs of Fraud-
ulent Financial Reporting,” Journal of Accounting 182, No. 10 (October 1996), pp. 75“77. Also visit
www.aicpa.org/antifraud/management for Management Antifraud Programs and Controls (New York:
AICPA, 2002).
Statement on Auditing Standards No. 56, “Analytical Procedures” (New York: AICPA, 1988), par. 1.
Ibid., par. 5. Also see Patrick S. Callahan, Henry R. Jaenicke, and Donald L. Neebes, “SAS 56 and
57: Increasing Audit Effectiveness,” Journal of Accountancy 165, No. 10 (October 1988), pp. 56“68;
and Walter K. Kunitake, Andrew D. Luzi, and William G. Glezen, “Analytical Review in Audit and
Review Engagements,” CPA Journal 55, No. 4 (April 1985), pp. 18“26.
For additional reading, see SEC v. Barry J. Minkow, Litigation Release No. 12579 (August 15,
1990), 46 SEC Docket 1777, and SEC v. Donald D. Sheelen et al., Accounting and Auditing Enforce-
ment Release No. 215 (February 8, 1989), 42 SEC Docket 1562.
204 An Overview of Audit Planning

Exhibit 6.3 Risk Factors Relating to Misstatements Arising from Fraudulent
Financial Reporting

Risk factors that relate to misstatements arising from fraudulent financial reporting may
be grouped in the following three categories:

A. Financial stability or profitability is threatened by economic, industry, or entity
operating conditions, such as (or as indicated by):
• High degree of competition or market saturation, accompanied by declining
• High vulnerability to rapid changes, such as changes in technology, product
obsolescence, or interest rates
• Significant declines in customer demand and increasing business failures in either
the industry or overall economy
• Operating losses making the threat of bankruptcy, foreclosure, or hostile imminent
• Recurring negative cash flows from operations or an inability to generate cash
flows from operations while reporting earnings and earnings growth
• Rapid growth or unusual profitability, especially compared to that of other
companies in the same industry
• New accounting, statutory, or regulatory requirements
B. Excessive pressure exists for management to meet the requirements or expectations
of third parties due to the following:
• Profitability or trend level expectations of investment analysts, institutional
investors, significant creditors, or other external parties (particularly expectations
that are unduly aggressive or unrealistic), including expectations created by
management in, for example, overly optimistic press releases or annual report
• Need to obtain additional debt or equity financing to stay competitive”including
financing of major research and development or capital expenditures
• Marginal ability to meet exchange listing requirements or debt repayment or other
debt covenant requirements
• Perceived or real adverse effects of reporting poor financial results on significant
pending transactions, such as business combinations or contract awards
C. Information available indicates that management or the board of directors™ personal
financial situation is threatened by the entity™s financial performance arising from the
• Significant financial interest in the entity
• Significant portions of their compensation (for example, bonuses, stock options,
and earn-out arrangements) being contingent upon achieving aggressive targets for
stock price, operating results, financial position, or cash flow
• Personal guarantees of debts of the entity
D. There is excessive pressure on management or operating personnel to meet financial
targets set up by the board of directors or management, including sales or
profitability incentive goals.

A. The nature of the industry or the entity™s operation provides opportunities to engage
in fraudulent financial reporting that can arise from the following:
• Significant related-party transactions not in the ordinary course of business or with
related entities not audited or audited by another firm
Analysis of Audit Planning and the Committee 205

• A strong financial presence or ability to dominate a certain industry sector that
allows the entity to dictate terms or conditions to suppliers or customers that may
result in inappropriate or non-arm™s-length transaction
• Assets, liabilities, revenues, or expenses based on significant estimates that involve
subjective judgments or uncertainties that are difficult to corroborate
• Significant, unusual or highly complex transactions, especially those close to
period end that pose difficult “substance over form” questions
• Significant operations located or conducted across international borders in
jurisdictions where differing business environments and cultures exist
• Significant bank accounts or subsidiary or branch operations in tax-haven
jurisdictions for which there appears to be no clear business justification
B. There is ineffective monitoring of management as a result of the following:
• Domination of management by a single person or small group (in a nonowner-
managed business) without compensating controls
• Ineffective board of directors or audit committee ovesight over the financial
reporting process and internal control
C. There is a complex or unstable organizational structure, as evidenced by the
• Difficulty in determining the organization or individuals that have controlling
interest in the entity
• Overly complex organizational structure involving unusual legal entities or
managerial lines of authority
• High turnover of senior management, counsel, or board members
D. Internal control components are deficient as a result of the following:
• Inadequate monitoring of controls, including automated controls and controls over
interim financial reporting (where external reporting is required)
• High turnover rates or employment of ineffective accounting, internal audit, or
information technology staff
• Ineffective accounting and information systems, including situations involving
reportable conditions

Risk factors reflective of attitudes/rationalizations by board members, management, or
employees, that allow them to engage in and/or justify fraudulent financial reporting,
may not be susceptible to observation by the auditor. Nevertheless, the auditor who
becomes aware of the existence of such information should consider it in identifying the
risks of material misstatement arising from fraudulent financial reporting. For example,
auditors may become aware of the following information that may indicate a risk factor:
• Ineffective communication, implementation, support, or enforcement of the
entity™s values or ethical standards by management or the communication of
inappropriate values or ethical standards
• Nonfinancial management™s excessive participation in or preoccupation with the
selection of accounting principles or the determination of significant estimates
• Known history of violations of securities laws or other laws and regulations, or
claims against the entity, its senior management, or board members alleging fraud
or violations of laws and regulations
• Excessive interest by management in maintaining or increasing the entity™s stock
price or earnings trend
• A practice by management of committing to analysts, creditors, and other third
parties to achieve aggressive or unrealistic forecasts
• Management failing to correct known reportable conditions on a timely basis

206 An Overview of Audit Planning

Exhibit 6.3 (Continued)

• An interest by management in employing inappropriate means to minimize
reported earnings for tax motivated reasons
• Recurring attempts by management to justify marginal or inappropriate accounting
on the basis of materiality
• The relationship between management and the current or predecessor auditor is
strained, as exhibited by the following:
• Frequent disputes with the current predecessor auditor on accounting, auditing,
or reporting matters
• Unreasonable demands on the auditor, such as unreasonable time constraints
regarding the completion of the audit or the issuance of the auditor™s report
• Formal or informal restrictions on the auditor that inappropriately limit access to
people or information or the ability to communicate effectively with the board of
directors or audit committee
• Domineering management behavior in dealing with the auditor, especially
involving attempts to influence the scope of the auditor™s work or the selection or
continuance of personnel assigned to or consulted on the audit engagement

Source: Reprinted with permission from Statement on Auditing Standards No. 99, “Consideration of
Fraud in a Financial Statement Audit” (New York: AICPA, 2002, Appendix to SAS No. 99.

officer and the director of internal auditing. Thus the overall planning strategy of
the directors will be based on their conference with these parties.
More specifically, these steps provide a framework for the committee™s strategy:

1. Develop an understanding of the entity™s business and its industry.13 This step
is particularly important because the audit committee should understand the
external and internal environment within which the entity must operate. Such
an understanding of the environmental characteristics will provide all members
of the committee with the knowledge to assess the overall audit plan effec-
tively. To accomplish this step, the audit directors should develop a macroap-
proach supplemented with the suggested professional development course as
discussed in Chapter 7.
2. Review the following with respect to each segment of the corporate audit plan
as discussed in the succeeding section of this chapter:
a. Purpose and objectives of each audit plan

The AICPA publishes Audit and Accounting Guides and Industry Risk Alerts. The audit committee
may wish to consult these publications (e.g., Consideration of the Internal Control Structure in a Fi-
nancial Statement Audit) to obtain an orientation to the entity™s industry. Also see Robert Walker,
“Know Your Client™s Business,” CA Magazine 124, No. 6 (June 1991), pp. 49“52; John P. McAllister
and Mark W. Dirsmith, “How the Client™s Business Environment Affects the Audit,” Journal of Ac-
countancy 59, No. 2 (February 1982), pp. 68“74; Donald N. Wolfe and Gerald Smith, “Planning the
Audit in a Distressed Industry,” CPA Journal 58, No. 10 (October 1988), pp. 46“50; and John W.
Hardy and Larry A. Deppe, “Client Acceptance: What to Look For and Why,” CPA Journal 62, No. 5
(May 1992), pp. 20“27.


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