Objective and General Principles

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1 C. PLANNING AND RISK ASSESSMENT 1. Objective and General principles 2. Understanding the entity and its environment 3. Assessing the risks of material misstatement and fraud 4. Analytical procedures 5. Planning an audit 6. Audit documentation 7. The work of others What is Professional Scepticism? Objective and General Principles Professional scepticism is an attitude auditors should have it involves having a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud and a critical assessment of audit evidence. What is Professional Judgement? Professional judgement is the application of relevant training, knowledge and experience in making informed decisions about the courses of action that are appropriate in the circumstances of the audit engagement. Ethical Requirements Ethical requirements found in the ISA states that the auditor must comply with the relevant ethical requirements. Why do auditors plan? It is a requirement of ISAs that all audits are planned properly Auditors can determine the amount of work that needs to be done and allocate the right amount and type of people to the task The work is properly organised and managed A correct fee can be determined Reduces the chances that the work goes over the budget Reduces the chances that deadlines are not met critical or problematic areas are identified and dealt with appropriately What does planning an audit involve? Audit planning involves setting an audit strategy and a detail audit plan.

2 What is involved in doing an audit strategy? The audit strategy covers the scope, timing and direction of the audit. It involves: The client s activities Reporting framework Key reporting dates The audit approach (Control or Substantive) Initial assessment of materiality Timing of the audit work Key audit risks What is involved in doing a detailed audit plan? The audit plan is derived from the audit strategy and is much more detailed and includes a set of instructions and audit procedures to the audit team. It includes: A more detailed description of the client A description of key accounting policies and internal control systems (internal audit department considerations) A more detailed materiality assessment Results of preliminary analytical procedures on the draft financial statements Audit approach for each area of the financial statements Detail description of the high risk areas Specific audit testing issues Timing of specific procedures Details of staffing a budget and a time table Understanding the Entity and its Environment Why do we need an understanding of the entity and its environment? Understanding the entity and its environment, including the entity s internal control auditors are better equip to accomplish their objective of identifying and assessing the risks of material misstatements, auditors are able to design and implement responses to the assessed risk of material misstatement. It is impossible to set the audit strategy, the detailed audit plan and assess the potential audit risk without first ensuring that the auditors have sufficient knowledge of the client. The ISA require that auditors obtain an understanding of the audit client and its environment. What is involved in understanding an Audit Client?

3 The Industry, regulatory and other factors Nature of the entity Entity s selection and application of accounting policies Its objectives strategies and risks Internal control Financial performance What sources can we turn to for an Understanding of the Entity? Information from you firm partners, managers, industry experts, last year s audit team, working papers file. Information from the external sources industry surveys, Companies House, the internet, trade press, credit reference agencies. Information from you past experiences, analytical review Information from the client Discussion, observation, website, brochures What is Audit Risk? Assessing the Risks of Material Misstatement and Fraud Audit risk is the risk that the auditors give the wrong opinion on the financial statements. For example, where the auditors sign off the financial statements as true and fair when in fact, they are materially misstated in some way. LSBF Note: If the examiner asks you to identify issues in a scenario that could give rise to audit risk look for: Things that can cause material errors Things that risk the company s going concern status During the planning stages auditor should try to identify the areas of the financial statements that are at greatest risk of misstatement and devote appropriate attention to these areas. If risk is ignored and the auditors give the wrong opinion they can be sued by shareholders. What is the Audit Risk Model? Audit Risk = Inherent Risk x Control Risk x Detection Risk What is Inherent Risk? Inherent risk is the risk of errors or misstatements dues to the nature of the company and its transactions.

4 For example; the car industry suffers during an economic downturn due to the reluctance of people to spend money or obtain a loan they may struggle to payback; Financial institution that deal with complex financial instruments such as derivatives are inherently risky because these instruments can be incredibly difficult to account for and value; In the fashion industry where trends and taste change rapidly the sales and inventory balance are inherently risky; A company heavily financed by debt is inherently risky as missed interest payments and repayment can lead to insolvency; A company that operates a profit related bonus scheme profits are inherently risky as there is the incentive for management to manipulate the profit to achieve the bonus targets. What is Control Risk? Control risk is the risk that the control s fail to prevent detect material fraud or error. For example, Bank reconciliations not performed and expense claims not authorised by a manager. What is Detection Risk? Detection risk is the risk that the auditor s procedures fail to detect a material misstatement. For example: human error, choosing the wrong sample to test, lack of training, and inexperience. What is the desired Audit Risk and how can Auditor s achieve this? The desire audit risk is a low audit risk. Auditors have little control over inherent and control risk but the overall risk can be managed by manipulating detection risk i.e. the risk they do have control over. What are analytical procedures? Analytical Procedures Analytical procedures involve comparing numbers, ratios or even non financial information in order to identify unexpected trends or unexpected relationships, which may indicate the existence of errors. When are analytic procedures used by auditors? Analytical procedures are use by auditors at many different stages throughout the audit. At the planning stage to help identify risk, when gathering evidence to help substantiate balances and at the completion as a final check on the financial statements. Give examples of analytical procedures? Year on Year comparing this year s revenue with last year Budget or forecast comparing budgeted purchases to actual Predictions by auditor auditors calculation of depreciation compared to client s calculation To industry information client s revenue compared to competitor s revenue

5 Use of ratios in analytic procedures: Gross profit margin: Gross profit/sales x 100%, Gross profit is affect by a change in selling price or a change in purchase price. Return on Capital Employed (ROCE) Profit before interest and Tax / Debt + Equity, ROCE tells us the returns made by the company on every dollar that is invested in the company either debt or equity. Inventory Days Inventory/COGS x 365, Inventory days tell us how long on average it takes for raw materials to be converted into finished goods and sold and it is affected by stock control and obsolescence. Receivable Days Receivables/Revenue x 365, Debtor days tells us how long on average it takes for debtors to pay. It is affected by credit terms, credit control, and the economic environment Payable Days Payables/COGS x 365, Creditor days tell us how long on average it takes to pay trade payables. It is affected by credit terms and available cash. Gearing Debt/Equity, The gearing ratio tells us how reliant the company is on external debt finance in relation to its equity financing. It is affected by borrowings, finance leases and issuing shares. Materiality Guidelines Something is material if it is important enough to affect the decisions of the users of Financial Statements. This could either be the quantity or quality. There is no exact scientific definition so materiality is really a matter of personal judgement however there are some guidelines: Quantitative: ½ 1% of revenue 1 2% of total assets 5 10% of PBT Quality: Its nature So important to shareholders they will not tolerate any error Director s pay and related party transactions All immaterial errors should be noted down and added up at the end of the audit. It could be that several small errors amount overall to a material error.

6 Planning an Audit In order to form their opinion on the Financial Statements, auditors must obtain suitable audit evidence in the form of tests of controls and substantive tests. What characteristics should audit evidence have? Sufficient Reliable Relevant What does sufficient mean? Auditors must obtain enough evidence to form their opinion and sufficient is a matter of quantity. Sufficient is affected by risk, materiality and reliability. The more risky an item is the more evidence the auditor s should obtain. The more material an item is the more evidence the auditors should obtain. The less reliable audit evidence is the more the more evidence is needed. What does reliability mean? Audit evidence must be reliable in terms of its source and its nature. Auditor generated evidence is more reliable than third part evidence and client generated evidence and third party evidence is more reliable that client generated evidence; written evidence is more reliable than oral evidence; and the original documents are more reliable than photocopies and faxes. What does relevance mean? Relevance deals with the logical connection with the purpose of the audit procedure and the assertion under consideration. Audit evidence is relevant if it rests one or more of the assertions we have to learn. What are the assertions in regard to the Statement of Comprehensive Income? Presentation and Disclosure Auditors must devise tests to ensure that the transactions have been presented and disclosed in accordance with the relevant financial reporting framework. Accuracy Auditors must devise tests to ensure that all of the transactions that took place during the accounting period have actually been recorded at the correct amounts. Completeness Auditors must devise tests that ensure all of the transactions that took place during the accounting period have been recorded in the SOCI. Cut off Auditors must devise tests to ensure that the transactions that took place during the year have been recorded in the correct accounting period.

7 Classification Auditors must devise tests to ensure that the transactions have been recorded in the correct account balance. Occurrence Auditors must devise tests to ensure that the transactions in the SOCI actually took place. Logical order is Occurrence, completeness, accuracy, cut off, classification and presentation and disclosure. What are the assertions in regard to the Statement of Financial Position? Presentation and Disclosure Auditors must devise tests to ensure that the transactions have been presented and disclosed in accordance with the relevant financial reporting framework. Records Auditors must devise tests to ensure that all of the items pertaining to the company have been recorded. Ownership Auditors must devise tests to ensure that all of the assets on the balance sheet are owned by the company and all of the liabilities are an obligation of the company Valuation Auditors must devise tests to ensure that the balances are recorded at the correct value Existence Auditors must devise tests to ensure that the items on the SOFP actually exist in real life. How do we gather evidence? In order to gather evidence auditors have to use a number of techniques: Analytical procedures ratios and comparisons Enquire and confirm asking questions Inspect looking at details Observe watching physical object or persons in action Compute recalculate figures Also in gathering evidence we can rely on the work of third parties, such as, experts, internal auditors, and another firm of external auditors. External auditors still retain full responsibility so caution is needed when relying on third parties as to qualification, experience, independence, and quality of work.

8 How should auditors treat the review of estimates? Estimates are a difficult area as they involve considerable judgement and are base on future events as a result they are easy to manipulate so require particular attention. Review and test the process used by management to develop the estimate Use an independent estimate for comparison Review subsequent events to assess reasonableness of the estimate made Audit Documentation Why is it essential that auditors keep documentation? It is an ISA requirement that all audit working papers should be sufficiently complete and detail! What are the benefits of keeping working papers? Proof that the audit work has been carried out Proof that the audit work has been done properly Tangible evidence of the auditor s conclusion should it be called into question (maybe in court) Enables senior staff to review the work of junior staff Lays a pattern for future audit teams to follow What are the characteristics of Working Papers? The working papers contain: The client s name A reference number The Accounting year end The subject matter The aim of the work The procedure perform The sample chose The key audit risks addressed Cross referencing The results and significant findings The conclusions of the work The person who reviewed the working paper The date of review What is the current audit file? The current audit file shows all the work that was done throughout the audit process. For each annual assignment the working papers will be collected together in the current audit file. It contains; a planning

9 section; a section for each area of the financial statement showing what work has been done; a complete section showing the final tasks carried out at the end of the audit including a schedule of point for management and partner attention and for next year s audit. What is the Permanent audit file? The permanent audit file contains information that will be of continuing use to the auditors year after year. The files information is permanent and includes the engagement letter (contract), organisational charts, systems flow charts, company articles and memorandum (F4 stuff), long term agreements. What are the advantages of standardising audit procedures? Used to train junior staff Quick and more efficient as auditors do not have to devise their own tests for each audit Preserves quality of the audit and consistency Makes it easier to review procedures What are the disadvantages of standardising audit procedures? No incentive for auditors to think for themselves May not be tailored to specific clients therefore not addressing specific risk Needs to be updated Mistakes can be perpetuated What are the different types of review procedures performed on working papers? Hot review this is where the working papers are being reviewed by the audit supervisor prior the audit report being signed. The objective is to spot any mistakes in the audit process before the report is signed. Cold review this is where the working papers are being reviewed by another office within the same audit firm after the audit report has been signed. The objective is to provide feedback and recommendations for improvement. Peer review this is where one small audit firm checks the working papers of another small audit firm because of the lack of a second office to carry out a cold review. The objective is to provide feedback and recommendations for improvement. Monitoring Unit review this is where a Recognised Supervisory Body (ACCA) review audit work on a sample basis. The objective is to ensure competence in the profession.

10 The Work of Others Please see above. THE END.

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