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Part Two

Planning and Risk

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Chapter 5

Overview of Elements of the Financial Report Audit

Process

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Accounting and Auditing Contrasted

Learning Objective 1:

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Areas of audit interest

• Accountable activity of the entity– Collection of original accounting data;– Allocations and reclassifications of the associated data;

and– Presentation of results in financial report.

• Organisation of the entity– External relationships– Internal organisational structure.

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Financial Report Assertions and Audit Objectives

• Directors and managers make assertions when they present a financial report.

• Auditors use these assertions to assess risks by considering different types of potential misstatements that may occur and designing audit procedures in response to risks.

• There are three categories of assertions:– Classes of transactions and events;– Account balances; and– Presentation and disclosure.

Learning Objective 2:

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Financial Report Assertions and Audit Objectives (cont.)

• Assertions about classes of transactions and events for the period under audit:(a) Occurrence – transactions and events that have been recorded have occurred and pertain to the entity.(b) Completeness – all transactions and events that should have been recorded have been recorded.(c) Accuracy – amounts and other data relating to recorded transactions and events have been recorded

appropriately.(d) Cutoff – transactions and events have been recorded in the correct accounting period.(e) Classification – transactions and events have been

recorded in the proper accounts.

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Financial Report Assertions and Audit Objectives (cont.)

• Assertions about account balances at the period end:(a) Existence – assets, liabilities and equity interests exist.

(b) Rights and obligations – the entity holds or controls the rights to assets, and liabilities are the obligation of the entity.

(c) Completeness – all assets, liabilities and equity interests that should have been recorded have been recorded.

(d) Valuation and allocation – assets, liability and equity interests are included in the financial report at

appropriate amounts and any resulting valuation adjustments are appropriately recorded.

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Financial Report Assertions and Audit Objectives (cont.)

• Assertions about presentation and disclosure:(a) Occurrence and rights and obligations – disclosed

events, transactions and other matters have occurred and pertain to the entity.

(b) Completeness – all disclosures that should have been included in the financial report have been included.

(c) Classification and understandability – financial information is appropriately presented and described, and disclosures are clearly expressed.

(d) Accuracy and valuation – financial and other information is disclosed fairly and at appropriate amounts.

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Assertions and objectives for the account balance of inventory of a manufacturing company

Financial report Illustrative audit objectivesAssertion

Existence Inventories included in the balance sheet physically exist. Inventories represent items held for sale in normal course of

business.Completeness Inventory quantities as per the accounting records include

all products, materials and supplies owned by the company that are on hand.

Inventory quantities include all products, materials and supplies owned by the company that are in transit or stored at outside locations.

Rights and The company has legal title or similar rights or ownership toobligations the inventories.

Inventories exclude items billed to customers or owned by others.

Valuation and Inventories are properly stated at cost (except when theallocation net realisable value is lower).

Slow-moving, excess, defective and obsolete items included in inventories are properly identified and valued.

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Audit Evidence

Learning Objective 3:

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Common Audit Procedures

• Inspection• Observation• Inquiry• Confirmation• Recalculation• Reperformance• Analytical procedures

Learning Objective 4:

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The audit trail

• Transactions are traced from initial entry in the system to intermediate records, where the transactions become components of subtotals, and ultimately to disposition in the final records, where subtotals are summarised for presentation in the financial report.

• Direction of the tracing can be modified: an auditor can trace from point of initiation of transaction to final recording (assertion of completeness), or trace from final record back to point of initiation (assertion of existence or occurrence).

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Selecting audit procedures

• The selection of audit procedures is influenced by the following factors:

– Auditor’s assessment of business risk and 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; and– 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 – evidence relates to the financial report assertion of interest.

– Reliability – influenced by the source and nature of the evidence.

Learning Objective 5:

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Reliability of audit evidence

• Evidence from sources outside an entity is more reliable than evidence obtained solely from within an entity.

• Evidence generated internally is more reliable when the internal control structures are effective.

• Evidence obtained directly by the auditor is more reliable than evidence obtained from the client.

• Evidence in the form of documents or written representations is more reliable than oral representations.

• Evidence provided by original documents is more reliable than evidence provided by photocopies or facsimiles.

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Overview of the Audit Risk Model

• 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 to an acceptable level to ensure the opinion is reliable.

Learning Objective 6:

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Reducing audit risk

• An 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 (and the particular assertions) that are likely to contain material misstatements.

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Components of audit risk (AR)

• There are three components: Refer AUS 202/ASA 200 (ISA 200):

– 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 will auditor to

conclude no material misstatement exists when one indeed does.

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The audit risk model

• AR = f (IR, CR, DR)

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Graphical depiction of audit risk

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Reducing audit risk

• Auditors cannot change inherent risk.• Auditors cannot directly change control risk. An 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, risk assessment process, information system, control activities and monitoring of controls, and testing their effectiveness.

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Reducing audit risk (cont.)

• The level of detection risk is the lever an auditor can pull to reduce audit risk by:

– Appropriate planning, direction, supervision and review;– Decisions on the nature, timing and extent of audit

procedures; and– Effective performance of procedures and evaluation of

results.

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Interrelationship of the components of audit risk

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Business risk

• Business risk is defined as:– The risk that an entity’s 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 entity’s survival and profitability.

• Requires extensive knowledge of client’s business and industry.

• Recent audit methodologies emphasise assessment of strategic business risk.

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The relationship of business risk to the determination of audit risk

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Types of Audit Tests

• Tests of control• Substantive tests

Learning Objective 7:

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Tests of control

• An auditor performs tests of control to obtain evidence about whether the control activities of the internal control system are effective.

• The tests are designed to provide evidence to support an assessment of control risk at a level below high (indicating reliance on the keys controls).

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Substantive tests

• Performed on specific transactions and balances to see whether the dollar amount of account balance is materially misstated.

• These tests reduce detection risk.

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Types of substantive tests

• Analytical procedures — involve the 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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Using the Work of an Expert or Another Auditor

• Given the complexity and highly specialised nature of many client operations, auditors often find they are unable to service clients effectively without specialist knowledge.

• Experts can be internal or external to the audit firm.• Audit firms develop industry specialisations, have

knowledge management systems supporting the specialisations and have employees designated as specialists by industry, function or technical area.

Learning Objective 8:

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Ensuring that work by an expert is adequate

• An auditor should:– Assess skills and competence of the expert;– Assess objectivity and independence of the expert;– Communicate with the expert to confirm terms of

engagement and to ensure the expert understands the objective and utility of work; and

– Evaluate the work of the expert.

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Using the work of another auditor

• Audit work may be undertaken by a number of different auditors. (Consider a consolidated entity with subsidiaries in many countries.)

• The principal auditor retains responsibility for the overall audit opinion and must ensure the procedures used by other auditors are appropriate for the principal auditor’s purpose.

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Assessing the work of another auditor

• AUS 602/ASA 600 (ISA 600) indicates that where an auditor uses the work of another auditor, the principal auditor should:

– Assess the professional competence of the other auditor;– Advise the other auditor of requirements applicable to

engagement; and– Advise the other auditor of the use to be made of their

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; and– Gathering evidence and providing essential support for

the auditor’s opinion.• Two main divisions:

– Permanent file - store of documents relevant to this audit and future years (e.g. copies of company constitution, continuing contracts.)

– Current working paper file - documentary record of evidence gathered and conclusions reached on this audit.

Learning Objective 9:

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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; and

7. Draft of financial report and audit report.

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Legal aspects of working papers

• AUS 208/ASA 230 (ISA 230) states that working papers are the property of the auditor.

• Auditor should not permit access to audit files by client’s staff, who may then become familiar with audit procedures and could facilitate fraud.

• Working papers must be kept for 7 years.