Topic 3: Overview of assurance concepts and the auditing process

Topic learning outcomes Outline the main steps involved in the audit process Outline the audit risk model Explain the relationship between financial report assertions, audit objectives, procedures and evidence Explain the concept of materiality 3.1 3.2 3.3 3.4 3.5 Describe the general requirements and contents of audit working papers 1

Overview of assurance concepts and the auditing process Learning Outcomes: 3.1 & 3.2

Audit process overview 3.1 Step 1 Assess risks and client potential Step 2 Perform thorough analysis of company, strategy, environment Step 3 Assess company risks Step 4 Assess controls and other processes in place to address risk Step 5 Perform analytical procedures Step 6 Test operation of controls where controls reduce the risk of misstatement Step 7 Assess remaining risk of misstatement Step 8 Design direct tests of account balances Step 9 Formulate opinion, review quality of work 3 footer

Audit process overview 3.1 Step 1 Assess risks and client potential Review broad risks affecting client, assess management integrity, assess long prospects of client Accept client? No Terminate search and engagement Yes Step 2 Perform thorough analysis of company, strategy, environment Thorough understanding of company, strategies, competitors, financial feasibility, etc, as a base to understand future prospects and expected financial results Topics 3 & 4 Step 3 Assess company risks Assessment of broad risks facing the company and the potential effect of these risks on the company’s financial results 4 footer

Audit process overview 3.1 Step 4 Assess controls and other processes in place to address risk Assess whether the control and other processes are adequate to reduce the risk of a material misstatement occurring in the financial statements Topics 4 & 5 Step 5 Perform analytical procedures Corroborate previous assessment and then determine if risk of financial misstatement is reduced to an acceptable level Account balances with little or no risk of material misstatement Account balances with residual risk of material misstatement 5 footer

Audit process overview 3.1 Step 6 Test operation of controls where controls reduce the risk of misstatement To assess/confirm the effectiveness of the controls Topic 6 Step 7 Assess remaining risk of misstatement Topic 7 Step 8 Design direct tests of account balances To reduce the risk of material misstatements occurring in audited financial statements Topics 8 & 9 Step 9 Formulate opinion, review quality of work Communicate opinion to client and users 6 footer

Financial report assertions 3.2 Financial report assertions By signing their statement, Directors are making claims about recognition and measurement of the various elements of the financial report Per ASA 315.A128 there are 2 categories of assertions: Classes of transactions Account balances Auditors restate the assertions as specific audit objectives for each material class of transaction, balance or disclosure involvement in the financial report They then design audit procedures that gather evidence to support those objectives . 7 footer

Transaction assertions 3.2 Occurrence: transactions and events that have been recorded have occurred and pertain to the entity. Completeness: all transactions and events that should have been recorded have been recorded. Accuracy: amounts and other data relating to recorded transactions and events have been recorded appropriately. Cut-off : transactions and events have been recorded in the correct accounting period. Classification: transactions and events have been recorded in the proper accounts. Presentation: transactions and events are appropriately aggregated or disaggregated and clearly described, and related disclosures are relevant and understandable in the context of the requirements of the applicable financial reporting framework. 8 footer

Account balance assertions 3.2 Account balance assertions Existence: assets, liabilities and equity interests exist. Rights and obligations: the entity holds or controls the rights to assets, and liabilities are the obligation of the entity. Completeness: all assets, liabilities and equity interests that should have been recorded have been recorded and all related disclosures that should have been included in the financial reports have been included. Accuracy, valuation and allocation: assets, liability and equity interests are included in the financial report at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded and related disclosures have been appropriately measured and described Presentation: assets, liabilities and equity interests are appropriately aggregated or disaggregated and clearly described, and related disclosures are relevant and understandable in the context of the requirements of the applicable financial reporting framework 9 footer

Assertions to objectives—an example 3.2 Assertions to objectives—an example Assertion Illustrative audit objectives 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 obligations The company has legal title or similar rights or ownership to the inventories Inventories exclude items billed to customers or owned by others. Accuracy, valuation and allocation Inventories are properly stated at cost (except when net realisable value is lower). Slow-moving, excess, defective and obsolete items included in inventories are properly identified and valued. 10 footer

3.2 Audit procedures Therefore, once audit objectives have been established…. audit procedures are used to obtain audit evidence so that…. audit objectives can be met as per ASA 500.A14-25 common audit procedures are: Inspection Observation Inquiry Confirmation Recalculation Re-performance Analytical procedures 11 footer

3.2 The audit trail Transactions can be traced from: initial entry in the system to… intermediate records (where the transactions become components of subtotals) to… the final records (where subtotals are summarised) for… presentation in the financial report. 12 footer

3.2 Direction of tracing Existence (of account balance components) Accounting records Source documents 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). Existence (of account balance components) Occurrence (of transactions in accting records) Completeness (of account balance components) or Completeness (of transactions in accounting records) 13

Assertions to objectives to procedures 3.2 Assertions to objectives to procedures Accuracy, valuation and allocation 14 footer

3.2 Audit evidence Audit evidence is needed to support audit objectives to support our final opinion It needs to be sufficient and appropriate 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. There two dimensions: Relevance — evidence relates to the financial report assertion of interest Reliability — influenced by the source and nature of the evidence. 15 footer

Reliability of audit evidence 3.2 Reliability of audit evidence We can generalise the following (ASA 500.A31):… Evidence from sources outside an entity is more reliable than evidence obtained solely from within the entity. 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. 16 footer

Overview of assurance concepts and the auditing process Learning Outcome: 3.3

Overview of the audit risk model 3.3 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. 18 footer

3.3 Reducing audit risk An auditor reduces audit risk by performing audit procedures until... there is sufficient and 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. 19 footer

Components of audit risk 3.3 Components of audit risk 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. As outlined in ASA 200.A39-46 there are 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 will lead auditor to conclude no material misstatement exists when, in fact, they do. 20 footer

Audit risk (in a funky diagram) 3.3 Audit risk (in a funky diagram) Auditors can’t change this But can obtain evidence to support an assessed level Auditors can’t change this either! This is where the auditor can reduce 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. 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 Effective performance of procedures and evaluation of results 21 footer

The link between audit risk components 3.3 The link between audit risk components Need to make an assessment If High, NO need to test controls Will rely on substantive tests …of transactions and balances instead Make sure this is practical TEST! To assess control risk as high, auditor must expect that substantive procedures alone will provide sufficient appropriate evidence. Areas where substantive procedures alone may not provide sufficient appropriate evidence include routine recording of significant classes of transactions, such as revenue or purchases. These areas often highly automated with little or no manual intervention. IR/CR move in OPPOSITE direction to DR 22 footer

3.3 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 an entity and, ultimately, the risk associated with the entity’s survival and profitability. Requires extensive knowledge of client’s business and industry 23 footer

3.3 Business v audit risk 24 footer

Overview of assurance concepts and the auditing process Learning Outcome: 3.4

3.4 Materiality Can be explained as information which, if misstated, omitted, or not disclosed separately in a financial report, may adversely affect either user decisions or the discharge of accountability by management (ASA 320.2). Auditor must make preliminary assessment of materiality when planning the audit Auditor uses materiality to: Evaluate the presentation of financial data. Determine the nature, timing and extent of audit procedures (sometimes called planning materiality). 26 footer

Materiality guidelines 3.4 Materiality guidelines Material   10% of appropriate base amount Immaterial   5% of appropriate base amount Judgment  5-10% of appropriate base amount Base amount for balance sheet items  equity, or the appropriate asset or liability class total. Base amount for income statement items  net profit or loss, appropriate revenue and expense amount, either for year or, if significantly fluctuates, averaged over a number of years. Methods vary according to the type of entity being audited or whether the auditor is concerned about the stability of profit figures. 27 footer

3.4 Rule of thumb A single amount is normally estimated for materiality because misstatements usually affect both the balance sheet and income statement (though a combination can be used). 5–10% of net profit before tax is the most common for a company with publicly traded securities 28 footer

Materiality: qualitative factors 3.4 Materiality: qualitative factors An auditor should consider qualitative factors as well as quantitative assessment. Qualitative factors include: The significance of the item to the particular entity The pervasiveness of the misstatement (e.g. the misstatement might affect the presentation of numerous items in the financial report) The effect of the misstatement on the financial report as a whole. 29 footer

Materiality and audit risk 3.4 Materiality and audit risk There is an inverse relationship between audit risk and materiality. An auditor sets a lower materiality threshold for accounts that have a higher audit risk. This means the auditor will need to collect more evidence for these riskier accounts. 30 footer

Overview of assurance concepts and the auditing process Learning Outcome: 3.5

3.5 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 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. 32 footer

Current working paper file 3.5 Current working paper file Includes: Overall audit plan Review of accounting system and related internal controls Audit program, listing the audit procedures undertaken Details of audit testing undertaken Working trial balance — schedule of general ledger accounts Trial balance working paper schedules, including external documents Draft of financial report and audit report. 33 footer

Working papers - example 3.5 Working papers - example 34 footer

Legal aspects of working papers 3.5 Legal aspects of working papers ASA 230 requires that working papers be properly prepared and maintained. Courts have determined that working papers are the property of the auditor - Chantry Martin & Co. v Martin (1953) 3 WLR 459 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 per s.307B of Corporations Act AND Sarbanes-Oxley 2002 35 footer