CHAPTER 3: Process of assurance: planning the assignment

Question 1

Audit strategy:

Answer 1

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.

Question 2

Audit plan:

Answer 2

An audit plan is more detailed than the strategy and sets out the nature, timing and extent of audit procedures (including risk assessment procedures) to be performed by engagement team members in order to obtain sufficient appropriate audit evidence.

Question 3

Audits are planned to:

Answer 3

• ensure appropriate attention is devoted to important areas of the audit
• identify potential problems and resolve them on a timely basis
• ensure that the audit is properly organised and managed
• assign work to engagement team members properly
• facilitate direction and supervision of engagement team members
• facilitate review of work

Question 4

A structured approach to planning will include:

Answer 4

Step 1: Ensuring that ethical requirements continue to be met
Step 2: Ensuring the terms of the engagement are understood

Question 5

Step 3: Establishing the overall audit strategy

Answer 5

• identifying the relevant characteristics of the engagement, such as the reporting framework used as this will set the scope for the engagement
• discovering key dates for reporting and other communications
• determining materiality, preliminary risk assessment, whether internal controls are to be tested
• consideration of when work is to be carried out, for example before or after the year end
• consideration of ‘team members’ available, their skills and how and when they are to be used, for example particular skills for high risk areas. In addition, appropriate levels of staff are required to facilitate direction, supervision and review of more junior team members’ work

Question 6

Step 4:

Answer 6

The audit plan and any significant changes to it during the audit must be documented.

Question 7

Understanding the entity’s environment

Answer 7

General economic factors and industry conditions
Important characteristics of the client:
(a) business
(b) principal business strategies
(c) financial performance
(d) reporting requirements, including changes since the previous audit
The general level of competence of management

Question 8

Understanding the accounting and internal control systems

Answer 8

• The accounting policies adopted by the entity and changes in those policies
• The effect of new accounting or auditing pronouncements
• The auditors’ cumulative knowledge of the accounting and internal control systems, and the relative emphasis expected to be placed on different types of test

Question 9

Risk and materiality

Answer 9

• The expected assessments of risks of fraud or error and identification of significant audit areas
• The setting of materiality for audit planning purposes
• The possibility of material misstatements, including the experience of past periods, or fraud
• The identification of complex accounting areas including those involving estimates

Question 10

Consequent nature, timing and extent of resources

Answer 10

Possible change of emphasis on specific audit areas

The effect of information technology on the audit

Question 11

Coordination, direction, supervision and review

Answer 11

The number of locations
Staffing requirements
Need to attend client premises for inventory count or other year-end procedures

Question 12

Other matters

Answer 12

The possibility that the going concern basis may be subject to question
Conditions requiring special attention
The terms of the engagement and any statutory responsibilities
The nature and timing of reports or other communication with the entity that are expected under the engagement

Question 13

Understanding the entity and its environment

Answer 13

the objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and assertion levels, through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement

Question 14

Obtaining an understanding of the entity and its environment. WHY?

Answer 14

• To identify and assess the risks of material misstatement in the financial statements
• To enable the auditor to design and perform further audit procedures
• To provide a frame of reference for exercising audit judgement, for example, when setting audit materiality

Question 15

Obtaining an understanding of the entity and its environment. WHAT?

Answer 15

• Industry, regulatory and other external factors, including the reporting framework
• Nature of the entity, including selection and application of accounting policies
• Objectives and strategies and relating business risks that might cause material misstatement in the financial statements
• Measurement and review of the entity’s financial performance
• Internal control

Question 16

Obtaining an understanding of the entity and its environment. HOW?

Answer 16

• Inquiries of management and others within the entity
• Analytical procedures
• Observation and inspection
• Prior period knowledge
• Discussion of the susceptibility of the financial statements to material misstatement among the engagement team
  • Inquiries of management and others within the entity. (The auditors will usually obtain most of the information they require from staff in the accounts department, but may also need to make enquiries of other personnel, for example, internal audit, production staff or directors.)

Question 17

Analytical procedures:

Answer 17

Evaluations of financial information through analysis of plausible relationships among both financial and non-financial data. Analytical procedures also encompass such investigation as is necessary of identified fluctuations or relationships that are inconsistent with other relevant information or that differ from expected values by a significant amount.

Question 18

the consideration of comparisons with:

Answer 18

• comparable information for prior periods
• anticipated results of the entity, from budgets or forecasts or expectations of the auditor
• similar industry information, such as a comparison of the client’s ratio of sales to trade receivables with industry averages, or with the ratios relating to other entities of comparable size in the same industry

Question 19

consideration of relationships between:

Answer 19

• elements of financial information that are expected to conform to a predicted pattern based on the entity’s experience, such as the relationship of gross profit to sales
• financial information and relevant non-financial information, such as the relationship of payroll costs to number of employees

Question 20

analytical procedures should be used at the risk assessment stage. Possible sources of information about the client include:

Answer 20

• interim financial information
budgets
• management accounts
• non-financial information
• bank and cash records
• VAT returns
• board minutes
• discussions or correspondence with the client at the year end

Question 21

key ratios used

Answer 21

page 62

Question 22

Materiality:

Answer 22

An expression of the relative significance or importance of a particular matter in the context of financial statements as a whole. The IFRS Conceptual Framework for Financial Reporting states that a matter is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.

Question 23

Performance materiality:

Answer 23

The amount or amounts set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole.

Question 24

materiality and audit risk are considered throughout the audit, in particular, when:

Answer 24

• identifying and assessing the risks of material misstatement;
• determining the nature, timing and extent of further audit procedures; and
• evaluating the effect of uncorrected misstatements, if any, on the financial statements and in forming the opinion in the auditor’s report’.

Question 25

Materiality assessment will help the auditors to decide:

Answer 25

• how many and what items to examine
• whether to use sampling techniques
• what level of misstatement is likely to lead to an auditor to say the financial statements do not give a true and fair view

Question 26

Tolerable misstatement

Answer 26

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

Question 27

Performance materiality

Answer 27

• The concept of performance materiality focuses on the difference between the level of tolerable misstatement and the level of actual misstatements detected.
• The financial statements are not materially misstated, but there is a risk that there may be undetected misstatements which would push over the materiality threshold.
• The auditor needs to think of materiality not just as a whole, but in relation to the specific areas which have been tested.
• Thinking in terms of performance materiality means thinking of what the effect of individual misstatements might be on audit risk for the financial statements as a whole. This provides the auditor with a margin of safety in relation to any undetected misstatements, which are then less likely to exceed materiality as a whole.

Question 28

Performance materiality (2)

Answer 28

Performance materiality therefore entails a prudent approach to materiality, and to determining the procedures that are needed to conclude on whether or not the financial statements are materially misstated. The higher the assessed risk, the lower the performance materiality must be set. This means that the auditor will perform more audit work than if the concept of performance materiality did not exist.

Question 29

Performance materiality (3)

Answer 29

As with overall materiality, setting performance materiality involves the use of professional judgement. This judgement must take into account qualitative aspects, such as the level of risk attached to a particular balance in the financial statements.

Question 30

Review of materiality

Answer 30

• draft financial statements are altered (due to material misstatement and so on) and therefore overall materiality changes;
• external factors may cause changes in risk estimates.

Question 31

Audit risk:

Answer 31

The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a function of the risks of material misstatement and detection risk.

Question 32

Inherent risk

Answer 32

The susceptibility of an assertion about a class of transaction, account balance or disclosure to a misstatement that could be material, either individually or when aggregated with other misstatements, before consideration of any related controls.
• Inherent risk is affected by the nature of the entity

Question 33

Example of issues that might increase inherent risk are:

Answer 33

• Balance is, or includes, an estimate
• Balance is important in the account
• 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 (such as profit targets or profit related bonuses)
• Financial statements contain balances with complex financial accounting requirements or a choice of treatment

Question 34

Control risk:

Answer 34

The risk that a misstatement that could occur in an assertion about a class of transaction, account balance or disclosure and that could be material, either individually or when aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely basis by the entity’s internal control.

Question 35

Detection risk:

Answer 35

The risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a misstatement that exists and that could be material, either individually or when aggregated with other misstatements.

Question 36

Identifying and assessing the risks

Answer 36

Step 1: Identify risks throughout the process of obtaining an understanding of the entity and its environment
Step 2: Assess the identified risks and relate them to what can go wrong at the assertion level (this is the assertions made in the financial statements by the directors, for example, that inventory is £X)
Step 3: Consider whether the risks are of a magnitude that could result in a material misstatement
Step 4: Consider the likelihood of the risks causing a material misstatement