Audit Process & Strategic Risk Evaluation

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ACCOUNTING AND AUDITING CONTRASTED

ACCOUNTING Responsibility of management
Measure and record accounting data in accordance w ith accounting standards

AUDITING Responsibility of auditor

Obtain suf f icient appropriate audit evidence about the propriety and accuracy of the accounting data in accordance w ith auditing standards

Prepare the f inancial report in accordance w ith the identif ied f inancial reporting f ramew ork

Provide an audit opinion on w hether the f inancial report is presented f airly in accordance w ith the identif ied f inancial reporting f ramew ork

Fig. 5.1 Relationship between accounting and auditing (p.177)

Distribute the f inancial report, including the audit report, to the ow ners of the entity

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FINANCIAL REPORT ASSERTIONS

Existence Occurrence Completeness Rights and obligations Valuation Measurement Presentation and disclosure
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ASSERTIONS AND OBJECTIVES FOR INVENTORY

Example 5.1 Assertions and objectives for the account balance of inventory of a manufacturing company (p. 183) Financial report Illustrative audit objectives assertion
Existence Completeness Rights and obligations Valuation n Inventories included in statement of financial position physically exist. n Inventories represent items held for sale in normal course of business. n Inventory includes all products, materials and supplies owned by the company that are on hand, in transit or stored at outside locations. n The company has legal title of ownership to the inventories. n Inventories are properly stated at cost (except when net realisable value is lower). n Slow-moving, defective and obsolete items included in inventories are properly identified and valued. n Inventory is recorded at the correct amount in the correct period. n Inventories are properly classified as current assets with major categories and their bases of valuation adequately disclosed.

Measurement Presentation and disclosure

Note: Assertion of Occurrence relates to transactions related to inventory, not the balance

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AUDIT EVIDENCE
Underlying accounting data Corroborating information

Books or original entry General and subsidiary ledgers

Audit evidence

Documents, such as cheques,

invoic es, contracts and minutes

Related accounting manuals Worksheets supporting cost

allocations, computation and reconciliations, etc.

Confirmations and other written

representations

Information from inquiry,

observations and inspection

Other information developed or

obtained by the auditor

Fig. 5.2 The audit equation (p. 184)

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AUDIT PROCEDURES
Inspection Observation Inquiry Confirmation Computation Analytical procedures
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SELECTING AUDIT PROCEDURES

Influenced by the following factors: Auditors assessment of inherent risk Nature of the internal control structure and assessment of control risk Materiality of particular component of financial report Experience gained from previous audits Results of other audit procedures Source and reliability of information available
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SUFFICIENT APPROPRIATE AUDIT EVIDENCE

Sufficiency quantity of audit evidence
necessary to provide the auditor with a reasonable basis for an opinion on the financial report.

Appropriateness quality of audit evidence. Two

dimensions:
Relevance relates to the financial report assertion of interest. Reliability influenced by its source and nature.

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AUDIT RISK AT THE FINANCIAL REPORT LEVEL

Audit risk is the risk that the auditor will give an inappropriate audit opinion when the financial report is materially misstated.
Before issuing an opinion on the financial report, the auditor needs to reduce audit risk sufficiently to make the opinion reliable.

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REDUCING AUDIT RISK

The auditor reduces audit risk by performing audit procedures until there is sufficient appropriate evidence for each assertion of each significant transaction class or account balance to provide reasonable assurance that the financial reports are not materially misstated.

The audit risk model focuses audit effort on those classes of transactions or balances that are likely to contain material misstatements.

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COMPONENTS OF AUDIT RISK (AR)

Three components: Inherent risk: (IR) susceptibility of an assertion to material misstatement given inherent and environmental characteristics, but without regard to prescribed control procedures. Control risk: (CR) risk that material misstatement might not be prevented or detected by internal control procedures. Detection risk: (DR) risk that auditors substantive procedures lead auditor to conclude no material misstatement when there is one.

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THE AUDIT RISK MODEL AR = f (IR, CR, DR)

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GRAPHICAL DEPICTION OF AUDIT RISK

Fig. 5.4 Audit risk, graphically depicted (p. 192)

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REDUCING AUDIT RISK I

Auditor cannot change inherent risk. Auditor cannot directly change control risk. Auditor can obtain evidence to support an assessed level of control risk less than high (expect to rely on internal control) by examining control environment, information system and control procedures and testing their effectiveness.
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REDUCING AUDIT RISK II

The level of detection risk is the lever the auditor can pull to reduce audit risk by: Appropriate planning, direction, supervision and review Decisions on the nature, timing and extent of audit procedures Effective performance of procedures and evaluation of results

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INTERRELATIONSHIP OF COMPONENTS OF AUDIT RISK

Exhibit 5.1 The interrelationships of the components of audit risk (p. 193)

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STRATEGIC BUSINESS RISK

Defined:
Risk that entitys business objectives will not be obtained as a result of external and internal factors, pressures and forces brought to bear on entity and, ultimately, the risk associated with the entitys survival and profitability. Requires extensive knowledge of clients business and industry. Recent audit methodologies emphasise assessment of strategic business risk.

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THE RELATIONSHIP OF STRATEGIC BUSINESS RISK TO THE DETERMINATION OF AUDIT RISK

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TYPES OF AUDIT TESTS

Tests of control Substantive tests

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TYPES OF SUBSTANTIVE TESTS

Analytical procedures study and comparison of relationships between accounting data and related information Tests of details obtaining evidence on the items (or details) included in an account balance or class of transactions:
Tests of transactions Tests of balances

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ASSESSING THE WORK OF ANOTHER AUDITOR

AUS 602 indicates that where an auditor uses the work of another auditor, the principal auditor should:
Assess professional competence of other auditor Advise other auditor of requirements applicable to engagement Advise other auditor of use to be made of work, areas requiring special attention, and timetable.
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WORKING PAPERS
These are the specific means used to record audit evidence. Working papers aid in:
Planning and performing the audit Supervising and reviewing the audit work Gathering evidence and providing essential support for the auditors opinion Permanent file - store of documents relevant to this audit and future years (e.g. copies of articles of association, continuing contracts) Current working paper file - documentary record of evidence gathered and conclusions reached on this audit.
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Two main divisions:

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CURRENT WORKING PAPER FILE

Includes:
1. Overall audit plan 2. Review of accounting system and related internal controls 3. Audit program, listing the audit procedures undertaken 4. Details of audit testing undertaken 5. Working trial balance - schedule of general ledger accounts 6. Trial balance working paper schedules, including external documents 7. Draft of financial report and audit report

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STEPS IN ACCEPTING AN AUDIT

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QUALITY CONTROL POLICIES AND CLIENT EVALUATION PROCEDURES

Procedures carried out before accepting a new client or continuing with an existing client include:

Reviewing financial information regarding the client Making inquiries of third parties such as solicitors and bankers Communicating with previous auditor Ensuring firm has technical expertise to carry out audit Ensuring accepting engagement will not conflict with the professions code of professional conduct
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COMMUNICATION WITH PREVIOUS AUDITOR

Ensures interests of shareholders, incoming auditor and existing auditor are protected. Allows existing auditor to advise prospective auditor of any professional matters they should be aware of before accepting the engagement. Nominated auditor should request clients permission to communicate with previous auditor. If client refuses permission, normally decline nomination. If permission granted, ask previous auditor for all information necessary to decide whether nomination should be accepted.
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ENGAGEMENT LETTER
A letter from auditor to client that documents and confirms auditors acceptance of the appointment. Should include:
Objective and scope of audit Responsibility of management for financial report Form of any reports An explanation of extent to which an audit can be relied upon to detect material misstatement Auditors right to unrestricted access to records, documents and other information necessary to complete audit

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AUDIT PLANNING
Planning stage a very important stage of the audit Two aspects:
Audit plan - outlines the expected scope and conduct of audit Audit program - directs the nature, timing and extent of audit procedures

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MAJOR STEPS IN THE AUDIT PROCESS

In every audit of a financial report there are five identifiable stages. These stages are: Obtaining knowledge of the clients business Understanding the internal control structure Performing tests of transactions Performing tests of balances Completion and review

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DEVELOPING AN OVERALL AUDIT STRATEGY

Overall audit strategy details the general evidence requirements for forming an opinion and initial choice as to nature, timing and extent of audit procedures. Interrelationship between materiality, audit risk and what constitutes sufficient appropriate audit evidence impacts on auditors strategy. Audit strategies can range from a lower assessed level of control risk approach to a predominantly substantive approach.
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RANGE OF AUDIT STRATEGIES

Lower assessed level of control risk Predominantly substantive approach

Audit strategy may be anywhere along this continuum

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LOWER ASSESSED LEVEL OF CONTROL RISK APPROACH

If the internal control structure is well designed and expected to be highly effective, audit strategy will be:
Assessed level of control risk of low or medium Extensive understanding of relevant parts of the internal control structure Plan extensive tests of control Plan reduced level of substantive audit procedures

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PREDOMINANTLY SUBSTANTIVE APPROACH

If auditor believes adequate controls do not exist or might be ineffective or testing controls are not cost effective, audit strategy will be:
Use a planned assessed level of control risk of high Plan to obtain a minimum understanding of internal control structure Plan no tests of control Plan extensive substantive audit procedures
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IMPACT OF STRATEGIC BUSINESS RISK ASSESSMENT ON AUDIT STRATEGY

More time is spent on planning stage and on developing an expectation of what the entitys financial report should look like. Audit strategy might include:
Increased use of sophisticated analytical procedures Undertaking tests of controls for routine transactions Increased substantive testing for non-routine transactions Reduced detailed substantive testing if financial report in accordance with auditors expectations

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CONTENTS OF AUDIT PROGRAM

Audit program will outline following characteristics of audit procedures:
Nature - particular audit procedures to use and particular items to which a procedure will be applied Extent - number of items to which procedures will be applied, and number of different tests to be performed Timing - appropriate time to perform the procedure
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ASSIGNING AND SCHEDULING AUDIT STAFF

Activities entailed include:
Coordinating assistance of client entity personnel Determining extent of involvement of consultants, specialists and internal auditors

Establishing and coordinating staffing requirements

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KNOWLEDGE OBTAINED BY THE AUDITOR OF CLIENTS BUSINESS

Auditor should obtain an understanding of: Clients organisational structure Operations and legal structure Relevant industry and economic conditions

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PROCEDURES FOR OBTAINING AN UNDERSTANDING OF THE CLIENTS BUSINESS

These include:
Reviewing auditors previous experience with client and industry Discussion with client personnel, other advisers or previous auditors of entity Reviewing industry or government publications and legislation Visiting clients premises Reviewing documentation produced by client
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STRATEGIC BUSINESS RISK

Defined: Risk that an entitys business objectives will not be attained as a result of external and internal forces brought to bear on an entity and, ultimately, the risk associated with the entitys profitability and survival.

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THE RELATIONSHIP BETWEEN STRATEGIC BUSINESS RISK AND THE GLOBAL, LOCAL AND INTERNAL ENVIRONMENTS

Fig. 6.3 The relationship between client business risk and the global, local and internal environments (p. 248)

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ASSESSING CLIENT STRATEGIC BUSINESS RISK I

The auditor must obtain a thorough understanding of the industry, including:

Profitability and structure of the industry Relationship between the industry and the broad economic and business environment Critical issues facing the industry Significant industry business risks
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ASSESSING CLIENT STRATEGIC BUSINESS RISK II

The auditor must understand how entity fits within industry, including:
Entitys position within industry in terms of profitability and market share Opportunities and plans entity has for increasing or maintaining profitability and market share Threats to entitys position in the industry Ways entity deals with customers and competitors Methods entity uses to measure and monitor its performance

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TECHNIQUES FOR ASSESSING CLIENT STRATEGIC BUSINESS RISK - SWOT ANALYSIS

S trengths - internal aspects that can improve competitive situation - internal aspects, vulnerability to competitors strategic moves

Weaknesses

O pportunities - environmental aspects that can improve entitys situation relative to competitors T hreats - environmental aspects that can undermine entitys competitive situation

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TECHNIQUES FOR ASSESSING CLIENT STRATEGIC BUSINESS RISK II - PEST ANALYSIS

Identifies: P olitical E conomic S ocial T echnological influences on entity.
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TECHNIQUES FOR ASSESSING CLIENT STRATEGIC BUSINESS RISK III

Value-chain approach:
Disaggregates entity into strategically important activities in order to:
Understand clients strategic advantages Understand risks that threaten attainment of business objectives Understand key processes and related competencies needed to realise strategic advantages Measure and benchmark process performance Document understanding of the clients ability to create value and generate future cash flows by using a client business model, process analyses, key performance indicators and a business risk profile
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ANALYTICAL PROCEDURES USED IN PLANNING THE AUDIT

Simple procedures: Simple comparisons Ratio analysis Common-size statements Trend statements Time series analysis More complex procedures: Time series modelling Regression analysis Financial modelling

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RATIOS COMMONLY USED AT THE PLANNING STAGE

1.

Short-term liquidity
Current ratio (current assets to current liabilities) Quick asset ratio (liquid assets to current liabilities) Operating cash flow ratio (cash from operations to current liabilities) Inventory turnover (cost of goods sold to average inventory) Receivables turnover (net sales to average accounts receivable)

2.

Activity

3.

Profitability
Gross profit and net profit ratio (gross profit or net profit to sales) Return on total assets (net profit/total assets) Return on shareholders equity (operating profit to ordinary shareholders equity)

4.

Solvency
Debt equity ratio (long-term liabilities to equity) Number of times interest earned (operating profit to annual interest expense)

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EXAMINATION OF SIGNIFICANT FLUCTUATIONS OF APs

Each significant fluctuation (deviation from expected amount) must be investigated. Auditor must also be alert to possibility that absence of expected fluctuation might require investigation. Deviations from expected amount should be discussed with management. Reasonableness of explanations provided by management should be considered. Auditor might have to consider impact of fluctuations on audit program and other audit tests.
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INHERENT RISK & MATERIALITY

Inherent risk
Susceptibility of account balance or class of transactions to material misstatement, given inherent and environmental characteristics,without regard to internal control structure (AUS 402.09/IAS 400.04)

Materiality
Information which misstated, ormitted or not disclosed separately in a financial report may adversely affect either user decisions or the discharge of accountability by management. (AUS 306.03/IAS 320.03)

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