Assurance (Knowledge Level) 03rd Chapter

Process of Assurance: Planning the assignment

01. What are the function/ objective/ features of Audit Strategy? [P- 40]
The formulation of the general strategy for the audit
Sets the scope, timing and direction of the audit and
Guides the development of the audit plan.

02. What are the differences between audit strategy and audit plan? [P- 40]
Audit Strategy:
The formulation of the general strategy for the audit which sets the scope, timing and direction of the audit
and guides the development of the audit plan.
Audit plan:
An audit plan shows how the overall audit strategy will be implemented. An audit plan is more detailed than
the audit strategy and sets out the nature, timing and extent of audit procedure to be performed by engagement
team members in order to obtain sufficient appropriate audit evidence.

Subject Audit Strategy Audit Plan

Approach The audit strategy is the general approach The audit plan is the detailed approach, the
and general principle. steps that should be followed.
Objective Guides the development of the audit plan. It shows how the overall strategy will be
implemented.
Activities Sets the scope, timing and direction of the Sets the nature, timing and extent of audit
audit. procedures.
Nature General Specific
Outcome Audit Plan Audit Procedures

03. Describe the audit plan procedures? [P- 40]

An audit plan shows how the overall audit strategy will be implemented. Audits are planned to:
i. Attention to important areas- Ensure appropriate attention is devoted to important areas of the audit
ii. Identify potential problems
iii. Resolve the problems- Resolve the problems on a timely basis
iv. Properly organized and managed- Ensure that the audit is properly organized and managed.
v. Assign work to team members- Assign work to engagement team members properly
vi. Direction and supervision- Facilitate direction and supervision of engagement team members
vii. Review of work

04. Describe the structure approached to planning? [P- 40]

A structured approach to planning will include:
i. Ethical requirements continue to be met
ii. Terms of engagement is understood
iii. Establishing the overall audit strategy
iv. Developing audit plan including risk assessment procedures, audit tests and any other procedures
necessary to comply with ISAs.

05. How can you formulate an audit strategy? [P- 41]

i. Relevant characteristics of engagement e.g. Reporting, framework, entitys environment)
ii. Key dates Reporting, other communication.
iii. Materiality, preliminary risk assessment, testing internal control

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06. What are the key contents of an audit strategy. [P- 41]
Key contents of an audit strategy are as given below:
i. Entitys environment- Understanding the entitys environment
ii. Accounting and internal control systems- Understanding the accounting and internal control systems
iii. Risk and materiality
iv. Nature, timing and extent of procedures
v. Co-ordination, direction, supervision and review
vi. Other matters

07. Give some examples of overall audit strategy. [P- 42]

i. The terms of engagement vi. Risk evaluation and audit approach
ii. Understanding the company and its business vii. Other matters
iii. Special audit problems risks) viii. Budget and fee
iv. Results of analytical procedures ix. Timetable
v. Materiality x. Staffing

08. Under BSA 315, what do you mean by understanding of the entity its environment? Why do we it?
[P- 44]
Identify and assess the risks of material misstatement
Design and perform further audit procedure
Provide a frame of reference for exercising audit judgment.

09. What matters are considered in understanding of entity and its environment? [P- 44]
Industry, regulatory and other external factors
Nature of the entity
Internal control
Measurement and review of financial statement
Objective and strategies and relating business risk.

10. How do we understand of an entity and its environment? [P- 44]

Inquires of management and others
Analytical procedures
Observation and inspection
Prior period knowledge
Discussion.

11. What matters are including in the client profile?

1. Shareholder- Information regarding Shareholder
2. Director- Name of Director
3. Operation- Type of operation
4. Customer- Detail of customer
5. Supplier- Number and Name of supplier
6. IT- The accounting system is completely computerized
7. Financial performance- Company formed 20 years ago and has always been profitable
8. Future plan No new plan that we are aware of.

12. What do you mean by Professional scepticism? [P- 48]

An attitude of professional scepticism means
The auditor makes a critical assessment, with a questioning mind, of the validity of audit evidence
Contradicts or bring into question of the reliability of documents.
Not disbelieve everything
Contain questioning attitude.

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13. What is analytical procedure? [P- 48]

Analytical procedures means-
Evaluation of financial information
Study of plausible relationships among both financial and non financial data
Investigation of fluctuation to identify audit risk.

14. According to BSA 520, what matters are included in the analytical procedures? [P- 49]
The BSA state that analytical procedures include-
Comparisons with-
Prior period information
Anticipated results- Budgets, expectation of auditor
Industry information- Ratio of sales to trade receivables
Relationship between:
Elements of financial information- Gross profit to sales
Financial and relevant non-financial information- Payroll cost to number of employees.

15. What is the basis for choosing analytical procedures for audit? [P- 49]
Auditors professional judgement.

16. At the risk assessment stage, what are the possible sources of information about the client? [P- 49]
Possible sources of information about the client include:
i. Interim financial information v. Bank and Cash records
ii. Budgets vi. Vat returns
iii. Management accounts vii. Board minutes
iv. Non- financial information viii. Discussion with the client at the year end.

17. Described certain accounting ratios which may be used as analytical procedures. [P- 50]
Here are the key ratios used:
Heading/ Ratio Formula Purpose
Performance: Profit before interest and tax
Return on capital employed Equity + net debt Effective use of resources

Return on shareholders' funds Net profit for the period

Share capital + reserves Effective use of resources

Gross profit margin
Cost of sales percentage
Operating cost percentage
Net margin=operating margin
Short-term liquidity:
Current ratio
Quick ratio
Gross profit x 100
Revenue
Gross sales x 100
Revenue
Gross costs x 100
Revenue
Profit before interest and tax x 100
Revenue
Current assets : Current liabilities
Receivables + Current investments
+ Cash : Current liabilities
Assess profitability before taking
overheads into account
Assess relationship of costs to
revenue
Assess relationship of costs to
revenue
Assess profitability after taking
overheads into account
Assess ability to pay current
liabilities from reasonably liquid
assets
Assess ability to pay current
liabilities from reasonably liquid
assets

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Long-term solvency: Net debt x 100

Gearing ratio Equity Assess reliance on external finance

Interest cover Profit before interest payable

Interest payable Assess ability to pay interest charges

Efficiency: Revenue Assess revenue generated from asset

Net asset turnover Capital employed base
Inventory turnover Cost of sales
Inventories Assess level of inventory held

Trade receivables collection Trade receivables x 365 Assess ability to turn receivables into
period Revenue cash
Trade payables payment period Trade payables x 365
Credit purchases Assess ability to pay suppliers

18. What do you mean by the terms Materiality? [P- 52]

Level of error that affects the decisions of users. As per BSA Framework, a matter is material if its omission
or misstatement would reasonably influence the economic decisions of users taken on the basis of the
financial statement. Materiality depends on the size of the error in the context of its omission or
misstatement.

19. How materiality is used in the course of an assurance engagement? [P- 53]
Shows how materiality is used in the course of an assurance engagement:
i. Planning materiality- based on draft financial statements and other available information.
ii. Apply planning materiality- to individual audit objectives/ balances
iii. Test all items:
a. Planning materiality, b. Actual errors detected, c. Actual errors projected to population
iv. Sample from remaining items:
a. Tolerable error, b. Actual errors detected, c. Actual errors projected to population
v. Final materiality- based on results obtained and final financial statements
vi. Compare and consider need for additional testing

Planning materiality
based on draft financial statements
and other available information

Apply planning materiality to Compare and consider need

individual audit objectives/balances
for additional testing

Test all items:

Actual Errors
Planning materiality
Detected

Sample from remaining items Actual Errors

Tolerable error Detected

Final materiality Actual Errors Projected

based on results obtained and final to Population
financial statements

Figure: Audit Materiality

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20. According to the BSA320, when should an auditor consider materiality? [P- 53]
BSA 320 Audit Materiality states that materiality should be considered by the auditor when:
i. Determining nature, training & extent of audit procedure.
ii. Evaluating effect of misstatement

21. How does materiality assessment helps the auditor? [P- 53]
How does risk and materiality are closely connected?
Materiality assessment will help the auditors to decide:
How many and what items to examine
Whether to use sampling techniques
What level of error is likely to say the financial statements dont give a true and fair view?
The resulting combination of audit procedures should help to reduce audit risk to an appropriately low level.

22. What do you mean by Tolerable error? [P- 53]

The maximum error that an auditor is prepared to accept in a class of transactions or balances in the financial
statements.

23. How can we determine materiality? [P- 54]

Or, Describe the method of assurance of materiality?
Methods of assess of materiality:
Particulars Maturity Level
Profit before Tax 5%
Profit after Tax 5-10%
Gross profit 0.5-1%
Revenue 0.5-1%
Total assets 1-2%
Net assets 2-5%

24. Why do need review of materiality? [P- 54]

The level of materiality must be reviewed because-
Draft accounts are altered- due to material error and so on
External factors- may cause changes in risk estimates
Such changes are caused by errors found during testing.

25. What is audit Risk? [P- 55]

The risk for which the auditors give an inappropriate opinion on the financial statement,
Audit Risk = Risk of Material Misstatement + Detection Risk

Inherent Risk Control Risk

26. Describe the element of audit risk. [P- 55]

Audit risk has two elements-
a. Risk of material misstatement- The risk that the financial statements contain a material misstatement
b. Risk of detection- The risk that auditors will fail to detect any material misstatement

27. Classify the risk of material misstatement in the financial statements. [P- 56]
a. Inherent Risk:
Inherent risk is the possibility of material misstatement due to nature of the items.
b. Control Risk:
Control risk is the possibility of material misstatement which can not be detected, prevented or
corrected by the accounting and internal control systems.

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28. Give some example that might increase inherent risk. [P- 56]
Example of issues that might increase inherent risk are:
i. Balance includes estimates
ii. Balance is important
iii. Financial statements are liable to misstatement because:
Company is in trouble
Company is seeking to raise finance
Other motivation for directors to misstate the figures
iv. Financial statements contains complex accounting

29. What is Detection Risk? [P- 56]

The risk that the auditors procedures will not detect a misstatement that exists in an account balance or class
of transaction that could be material, either individually or when aggregated with misstatements in other
balances or classes.

30. Which part of audit risk could be controlled by the auditor and how?
Detection risk could be controlled by the auditor. Because:
Inherent and control risk are integral to client
Auditors parts is detection risk
Auditors aim is to reduce overall audit risk, not only one part.

31. Could detection risk be entirely eliminated and why?

No. due to inherent limitations of audit.

32. How can detection be reduced?

By carrying out substantial number of lost. Include high level of audit work.

33. If control risk and inherent risk both are high what effect it has on the audit?
Not rely on the tests of controls
Carry out extended test of details
To reduce detection risk

34. Determine the audit risk would you accept the engagement?
Inherent risk Control risk Detection risk Audit risk
High High High ?
Medium Low Medium ?

Ans: 01. Audit risk = High. Not acceptable (Reduce detection risk to low level)
02. Audit risk = Medium. Acceptable.

35. If control risk is low, would you substantive procedure?

No. because auditor has to reduce detection risk.

36. Discuss the level of identifying and assessing the risks. [P- 58]
Under BSA 315, there are two levels to identify and assess the risks, which are given below:
i. Financial statement level- the auditor should identify and assess the risks of material misstatement
ii. Assertion level- for classes of transactions, account balances, and disclosures.

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37. What are the steps of identifying and assessing the risks? [P- 58]
It requires the auditor to identify and assess the risks, take the following steps:
Step 1: Identify risks at understanding entity level.
Step 2: Identify risk at assertion level. (For example, Directors asserted, inventory is CUx)
Step 3: Magnitude of misstatement.
Step 4: Likelihood of misstatement

38. According to BSA 315, which factor indicate a significant risk? [P- 59]
BSA 315 sets out the following factors which indicate that a risk might be a significant risk:
Risk of fraud
Recent significant economic, accounting or other development
Complexity of transaction
Significant transaction with a related party
Degree of subjectivity in the financial information
Unusual transaction

39. Why do unusual transaction are more likely to give rise to material misstatement than routine and
regular transactions? [P- 60]
Routine, non-complex transactions are less likely to give rise to significant risk than unusual transactions or
matters of director judgement. This is because unusual transactions are likely to have more:
Management intervention
Manual intervention
Complex accounting principles or calculations
Opportunity for control procedures not to be followed

40. What should an auditor do when found significant risk?

Auditor must evaluate the design and implementation of entitys control in that area.

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Interactive question 1: The overall audit strategy [Difficulty level: Exam standard]
Which three of the following would ordinarily be contained in the overall audit strategy?
The contract between the audit firm and the client
The results of audit risk assessment
Calculation of preliminary materiality
Detailed plan of audit procedures to be carried out
List of staff to be involved with the audit

Interactive question 2: Understanding the entity [Difficulty level: Exam standard]

In order to obtain an understanding of the entity, auditors must use a combination of which four of the
following procedures?
Inspection
Observation
Inquiry
Analytical procedures
computation

Interactive question 3: Analytical procedures [Difficulty level: Exam standard]

Here is some budget financial information for Fleming Ltd, contrasted with the management results for the 12
months under review.
Budget 20X6 CU Actual 20X6 CU
Sales 1,350,000 1,339,588
Cost of sales 850,000 994,663
Gross margin 500,000 344,925
Salaries 245,000 243,873
Repairs and renewals 7,500 24,983
Depreciation 7,500 7,551
Motor expenses 25,750 14,678
Other costs 44,000 43,968
Which three of the following areas would you be most likely to investigate further as a result of carrying out
analytical procedures on the above?
Sales
Cost of sales
Sales and cost of sales
Depreciation
Repairs and renewals
Motor expenses

Interactive question 4: Materiality [Difficulty level: Easy]

You have identified the following draft figures in respect of your audit of Fairford Ltd, which is considered to
be a low risk audit. The client is well known to your firm, there have been no substantial changes in the year
that you are aware of, and you have carried out several audits in previous years. Draft figures:
Revenue CU13,089,394
Profit before tax CU 1,403,444
Total assets CU 4,305,538
Based on a standard weighted average approach, preliminary materiality is likely to be set in the range:
A. CU74,000 CU148,000
B. CU1,400,000 CU2,800,000
C. CU4,300,000 CU8,600,000
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D. CU6,500,000 CU13,000,000

Interactive question 5: Audit risk [Difficulty level: Exam standard]

Audit risk can be split into three components: inherent risk, control risk and detection risk.
For each of the following examples, indicate the type of risk illustrated.
1 The organisation has few employees in the accounts department
2 The organisation is highly connected with the building trade
3 The assurance firm may do insufficient work to detect material errors
4 The financial statements contain a number of estimates

Interactive question 6: Identifying risks [Difficulty level: Exam standard]

You are involved with the audit of Tantpro Ltd, a small company. You have been carrying out procedures to
gain an understanding of the entity. The following matters have come to your attention.
The company offers standard credit terms to its customers of 60 days from the date of invoice. Statements are
sent to customers on a monthly basis. However, Tantpro Ltd does not employ a credit controller, and other
than sending the statements on a monthly basis, it does not otherwise communicate with its customers on a
systematic basis. On occasion, the receivables ledger clerk may telephone a customer if the company has not
received a payment for some time. Some customers pay regularly according to the credit terms offered to
them, but others pay on a very haphazard basis and do not provide a remittance advice. Receivables ledger
receipts are entered onto the receivables ledger but not matched to invoices remitted. The company does not
produce an aged list of balances.
Which one of the following is the risk most likely to arise out of the above scenario?
Inventory may be overstated
Inventory may be understated
Purchases may be overstated
Purchases may be understated
Trade receivables may be overstated
Trade receivables may be understated

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