 Hello, and welcome to the session in which we will discuss audit planning. Now, why do we need to study about audit planning? Why plan the audit? Well, think about it. If you've taken a vacation, you should plan for it. So let alone if you are auditing a company. Matter of fact, you must plan an audit by the AICPA. Must means you have to. You don't just start the audit. You don't know what you're gonna be starting with. You don't know what steps you're gonna be undertaking, and you don't know when you're gonna end. You have to plan the audit. Proper planning is crucial for the audit engagement for the auditor, at least for three main reasons. One is ensuring sufficient appropriate evidence. Two, managing audit cost. Three, preventing client misunderstanding. Now, we need to discuss each one of these reasons separately, and we will talk about various audit risks. Let's go ahead and get started by discussing ensuring sufficient appropriate evidence. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's gonna help you with your CPA exam preparation, as well as your accounting courses. My CPA material is aligned with your CPA review course, such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses, broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead. Start your free trial today. When we audit, we sample, we don't collect, we don't look at everything. We have limited amount of time. Therefore, we sample. Therefore, we have to determine how are we going to sample? How are we going to sample? Because this sampling will have to give us sufficient evidence to reduce both the audit risk as well as the legal risk. And obviously, as a result, uphold the firm's reputation. We want to do a good job. We want to collect enough evidence. Now, planning would lower both, lower the risk and legal liability. Why? Because when you plan, you want to know which areas would require more attention. Well, as a result, you will spend more time on that. Also, you will not be sued by the client if you are not doing your job properly. Also, managing the audit is important. You want to plan because you have limited amount of resources. And the resources here are time, staff, people and money. You don't have unlimited amount. Therefore, you have to plan where are you going to allocate your money, your time and your staff. Therefore, proper planning is crucial. You need to focus also on high risk areas. For example, how do you know an area is a high risk area? You would use analytical procedures and minimizing your cost will help you as a CPA firm maintain competitiveness. Now, also, proper audit planning will prevent any client misunderstanding. For example, if you promise the client to finish the audit by June 30th and you have to extend it till the end of August. Well, the client will not be happy. That's one thing because you did not have enough staff to complete the audit. But also you could be in breach of contract with the client and that's not good at all. So also clear client communication, faster good relationship and avoid potential legal issues stemming from unmet expectation. And the reason you have to have clear understanding and planning is often time you have to coordinate with the client on certain tasks. For example, if you want to count inventory, you have to let them ahead ahead of time. For example, you're going to be auditing inventory next week or if you want to talk to the staff, you have to let them know ahead of time. Therefore, audit planning is extremely important. And audit planning is important when it comes to managing risk because there are three key concepts of risks that we need to be familiar with. Now, those three concepts that we will discuss here are discussed in other sessions. However, incorporating those risks into the audit planning will help give us the big picture. There are many types of risks, but we're going to be discussing acceptable audit risk or simply put audit risk, client business risk and risk of material misstatement. Now, for one acceptable audit risk and risk of material misstatement, you're going to see later, those are part of the audit risk model, which we will have few sessions about this audit risk model. In this session, these factors impact audit procedures and expenses, and that's why we have to look at them. We have to understand them because you might be given a multiple choice where you have to identify what type of risk am I dealing with. So initial planning largely involved around gathering data to help auditors evaluate those risks because we want to evaluate the audit risk. We want to evaluate the client business risk. We want to evaluate the risk of material misstatement. Since these risks are involved in audit planning, we have to kind of take a look at each one of them briefly in this session, briefly in this session. What is acceptable audit risk? Simply put, let's assume you enter a doctor and they diagnose you with the wrong medical issue. You have cancer, they told you you are good. Well, that's really risky. They told you you are in good shape, but in reality, you are not. And the reason I use cancer just to exaggerate the point is basically giving you the wrong opinion. So it is an acceptable audit risk. An acceptable audit risk measures the auditor willingness to acknowledge the potential for material misstatement and the financial statement, even after completing the audit and providing an unmodified, clean opinion. What does that mean? It means at the end of the day, the auditor is going to give you an opinion and let's assume this opinion is clean. Although they're giving you an opinion, they're taking a risk, they're taking a chance that they could be wrong. How much is that chance? Are they taking a 5% chance, 10% chance? This is the acceptable audit risk. This is the acceptable audit risk. Well, why? Because they can miss, they can miss certain important fraud or errors in the audit. Therefore, they're always taking a risk. So opt-in for a reduced acceptable audit risk signify the auditor's preference for greater assurance. So the lower you go, the more assured you want. So if you say I want, if you choose between 10 and 5, if you say I want to only take a 5% chance of acceptable audit risk, it means you are providing more assurance. So as the audit risk goes down, you need to do more work because you want more assurance. Let me give you two extreme. At a risk level of zero, you want to be 100% correct. If you set acceptable audit risk at zero, which is not possible, it is possible. You could say it's at zero, but you can miss. But if you want to set your acceptable audit risk at zero, it means you have to look at everything. You will not sample, you will not leave any rock unturned. This is what is 0%. Well, obviously 100%, you're okay, you don't care. You might, if you get it wrong. Okay. So this is said by the auditor. And we'll talk about that later on because I told you the acceptable audit risk is the part of the audit risk model. The auditor said this risk at either 5, 10 or 15. So if they set it at 5, it means they only want to take a 5% chance they are wrong. If they set it at 15, they are more comfortable. They want to take a 15% chance they are wrong. Therefore, audit planning plays a role in, I'm sorry, acceptable audit risk plays a role in audit planning. If you want to set it at 5%, you want to do more work. You need more resources, more time, more staff, more money versus 15%, you're going to do less work. You need less resources, less people, less time. Client business risk. What is the client business risk? It refers to the potential that the organization itself, the company itself, may not successfully attains its goal, its business goal or carry its planned approaches, whatever they are trying to do. And risk arises from factors that's beyond your control that you have to take this into account when you're planning the audit. Substantial shift in industry circumstances. The industry is going into IT, it's being more technology driven and your company is not. Occurrence, like alteration, changes in regulation and it's affecting you and you're not being able to keep up with the regulation. Establishing unsuitable aims or strategies. Your goals are not proper. So those are business client risk. As an instance, the auditor could detect downturns and economic conditions that unfavorably impact sales and the ability to generate together outstanding payment. So if that's the case, then what we say, we said the client has a higher business risk than we have to pay more attention to the client risk of material misstatement or RMM. This is also part of the audit risk model RMM. Now, what is RMM? It's the possibility that a material error or fraud in the financial statement exists, the possibility that they do exist after we take into account internal control. It's part of the audit risk model and simply put RMM, the formula for RMM equal to inherent risk times control risk. Now, we need to kind of briefly discuss those two because we discussed them in the audit risk model. Let's talk about inherent risk. Inherent risk means the account itself or the company itself is inherently risky. For example, if you're auditing supplies, supplies is an easy account. You can count the supplies, you know, account for everything and you will be good versus if you are auditing derivatives. Derivatives might involve complex computation, might involve estimation, might involve relying on sources that's not objective. If you are auditing intangible asset, especially with indefinite life, you have to estimate the future cash flow. If you are auditing complex compensation arrangement, those are all inherently risky accounts. If you are auditing a company that's in oil and gas, well, they do a lot of estimates for resources in the ground that's inherently risky. And this inherent risk is intensified if the client lacks strong controls, strong internal control over sales and accounts receivable management as well as other accounts. So inherent risk is the account by itself is risky and if the control risk is bad together, we have a serious problem in RMM. Let's talk about audit planning, wrap it up, evaluating those three risks, audit risk, client business risk and risk of material misstatement is crucial in audit preparation. This evaluation helps in establishing what audit procedures to use, how much evidence to collect and what people to send on that client or to send to that client. Are we going to send senior staff, more experts, specialists? What are we going to send people right out of college? For example, if the auditor recognizes a material misstatement risk and inventory evaluation, then the auditor will involve gathering more data, more evidence, send specialized staff that knows how to audit this inventory specifically to test the account. Let's take a look at this multiple choice question from Farhad Lectures to kind of consolidate our understanding of certain concepts when it comes to audit planning. Which of the following measures an auditor's willingness to accept that the financial statement may be materially misstated upon completing the audit and expressing an unqualified opinion? Simply put, what do we call this risk when the client makes, not the client, when the auditor makes draft an opinion, an issue, an opinion? What risk are they taking? What type of risk is that? Because you could always be wrong. Okay, let's look at A. Is it control risk? Well, what is control risk? Control risk is your internal control procedures may not on a timely basis detect and prevent material misstatement. Remember, we have an accounting information system and we want to protect. We want to protect this accounting information system from errors and fraud. Well, controls, internal control is that protection, protection. Well, that's not what we are discussing in this definition. Is it sampling risk? Sampling risk deals with sampling because the auditor sample. And when you sample, sometimes you might select the wrong sample, the wrong accounts that they are not representative of what you want. Well, that's not really the auditor's willingness to accept, you know, the financial statement are materially misstated. So A and B are out. What is inherent risk? Well, inherent risk refer to the level of risk that exists in the account in the process without considering controls. Basically, by itself, the account is susceptible to risk or the company is more risky than other companies. For example, oil and gas or the account is subject to estimate or complex computation. This is what inherent risk is. And this has nothing to do with the auditor willingness to issue an opinion about the financial statement. By process of elimination, the answer is the acceptable audit risk. And this is acceptable audit risk measures and auditor's willingness. How much are they willing to take of a chance, assuring an opinion that is clean and risk is always when you issue a clean opinion. Because if you don't issue a clean opinion, the client might complain and they ask you to do more work. The risk is when you issue that clean opinion, you are wrong. If you issue a qualified or an adverse opinion, there is a risk, but the risk is not really a problem. Because if the client believes you are wrong, they're going to argue with you. But when you issue unqualified opinion and you are wrong, it's a problem because the users of the financial statement may come back and do what? Sue you. What should you do now? Go to Farhat Lectures, look at additional MCQs, lectures that's going to help you do better. Whether you are an accounting student, taking another course or CPA exam candidate, Farhat Lectures can help. Good luck, study hard and stay safe.