Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 1 PART TWO: Planning and Risk

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 2 CHAPTER 5 OVERVIEW OF ELEMENTS OF THE FINANCIAL REPPORT AUDIT PROCESS

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 3 ACCOUNTING AND AUDITING CONTRASTED Fig. 5.1 Relationship between accounting and auditing (p.177)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 4 AREAS OF AUDIT INTEREST Accountable activity of the entity  Collection of original accounting data  Allocation and reclassification of accounting data  Presentation of results Organisation of the entity  External relationships  Internal organisational structure

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 5 FINANCIAL REPORT ASSERTIONS Existence Occurrence Completeness Rights and obligations Valuation Measurement Presentation and disclosure

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 6 ASSERTIONS AND OBJECTIVES FOR INVENTORY Example 5.1Assertions and objectives for the account balance of inventory of a manufacturing company (p. 183) Financial report Illustrative audit objectives assertion Existencen Inventories included in statement of financial position physically exist. n Inventories represent items held for sale in normal course of business. Completeness n Inventory includes all products, materials and supplies owned by the company that are on hand, in transit or stored at outside locations. Rights and n The company has legal title of ownership to the inventories. obligations Valuationn 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. Measurement n Inventory is recorded at the correct amount in the correct period. Presentation andn Inventories are properly classified as current assets with major disclosure categories and their bases of valuation adequately disclosed. Note: Assertion of Occurrence relates to transactions related to inventory, not the balance

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 7 AUDIT EVIDENCE Fig. 5.2 The audit equation (p. 184)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 8 EXAMPLE OF A CASH PURCHASE TRANSACTION Fig. 5.3 A cash purchase transaction (p.184)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 9 AUDIT PROCEDURES Inspection Observation Inquiry Confirmation Computation Analytical procedures

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 10 Transactions traced from initial entry in system to intermediate records, where transactions become components of subtotals, and ultimately to disposition in final records, where subtotals are summarised for presentation in financial report. Direction of tracing can be modified: 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). THE AUDIT TRAIL

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 11 SELECTING AUDIT PROCEDURES Influenced by the following factors: Auditor’s 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

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 12 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. SUFFICIENT APPROPRIATE AUDIT EVIDENCE

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 13 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 structure is 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.

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 14 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.

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 15 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. REDUCING AUDIT RISK

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 16 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. COMPONENTS OF AUDIT RISK (AR)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 17 AR = f (IR, CR, DR) THE AUDIT RISK MODEL

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 18 GRAPHICAL DEPICTION OF AUDIT RISK Fig. 5.4 Audit risk, graphically depicted (p. 192)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 19 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. REDUCING AUDIT RISK I

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 20 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 REDUCING AUDIT RISK II

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 21 INTERRELATIONSHIP OF COMPONENTS OF AUDIT RISK Exhibit 5.1 The interrelationships of the components of audit risk (p. 193)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 22 Defined: Risk that 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. STRATEGIC BUSINESS RISK

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 23 THE RELATIONSHIP OF STRATEGIC BUSINESS RISK TO THE DETERMINATION OF AUDIT RISK

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 24 Tests of control Substantive tests TYPES OF AUDIT TESTS

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 25 To obtain evidence about either: (1)the effectiveness of the design of the policies or procedures in the internal control structure; or (2)the operating effectiveness of those policies or procedures. 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). TESTS OF CONTROL

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 26 To obtain evidence about the validity and the propriety of the accounting treatment of transactions and balances or, conversely, of errors or irregularities therein. These tests reduce detection risk. SUBSTANTIVE TESTS

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 27 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 TYPES OF SUBSTANTIVE TESTS

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 28 USING THE WORK OF AN EXPERT OR ANOTHER AUDITOR Given 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.

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 29 ENSURING THAT WORK BY AN EXPERT IS ADEQUATE An auditor should: Assess skills and competence of expert Assess objectivity and independence of expert Communicate with expert to confirm terms of engagement and ensure expert understands objective and use of work Evaluate work of expert

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 30 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.

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 31 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.

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 32 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 articles of association, continuing contracts) Current working paper file - documentary record of evidence gathered and conclusions reached on this audit. WORKING PAPERS

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 33 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 CURRENT WORKING PAPER FILE

Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 34