Chapter 3 Process of assurance: planning the assignment

Question 1

1.1 Overview of the planning process

Answer 1

The audit strategy determines the scope, timing and direction of audit and determines the development of the audit plan. The audit plan shows is in more detail and shows how the overall strategy will be implemented.

Question 2

1.2 Audit strategy

Answer 2

The key components of audit strategy are:
- Understanding the entity and its environment
- Materiality
- Risk assessment
- Nature, extent, and timing of audit procedures
- Direction, supervision, and review of work
- Other matters

Question 3

1.3 Audit plan

Answer 3

An audit plan shows how the strategy will be implemented. The auditor is responsible for carrying out audit procedures to obtain sufficient evidence to support their opinion. Audit planning ensures:
- Attention is paid to the most important areas
- Potential problems are identified
- The audit is organised and managed
- Work is assigned to the appropriate member of the audit team
- Appropriate direction and supervision of audit team members
- Reviews by more senior auditors are facilitated

Question 4

2.1 Understanding the entity – why

Answer 4

ISA 315 requires the auditor to gain an understanding of the entity. This is to assess risk, help design and perform audit procedures and develop the audit strategy and plan.

Question 5

2.2 Understanding the entity – what

Answer 5

ISA 315 details the following aspects as important in gaining an understanding of the business:
- Industry, regulatory and other external factors, including the applicable financial reporting framework
- Nature of the entity, including the entity’s selection and application of accounting policies
- Objectives and strategies and the related business risks that may result in a material misstatement of the financial statements
- Measurement and review of the entity’s financial performance
- Internal controls

Question 6

2.3 Understanding the entity – how

Answer 6

ISA 315 requires the auditor to use the following:
- Enquiries of management and other client staff
- Analytical procedures
- Observation of processes
- Inspection of documents or assets
- Prior knowledge of the client
- Discussions among the audit team

Question 7

3.1 Importance of materiality in the audit

Answer 7

The audit report sets out the scope of an audit stating it involves “reasonable assurance that the financial statements are free from material misstatement”.
Materiality is an expression of the relative significance of a particular matter in the context of the financial statements as a whole. A matter is material if its omission or misstatement could influence the economic decision of users taken on the basis of the financial statements.
Performance materiality – set by the auditor to reduce materiality to an appropriately low level so the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole.

Question 8

3.2 Using materiality

Answer 8

At planning materiality drives the level of work carried out (whether to test a balance). During the audit, materiality influences the evaluation of audit evidence (if material an adjustment to the financial statements should be requested).

Question 9

3.3 Identifying materiality

Answer 9

An item, error or misstatement may be material because of its size or because of its nature (transactions that must be disclosed in the accounts, between the company and directors). At planning stage, a level of planning materiality will be calculated, the rate used are:
- Profit before tax (5-10%)
- Revenue (0.5% - 1%)
- Total assets (1% - 2%)

Question 10

4.1 Importance of risk assessment

Answer 10

Auditors usually adopt a risk-based approach to auditing. Risk is assessed at planning stage and re-assessed throughout the audit. Effective risk assessment should:
- Make the audit more efficient with work directed to problem areas
- Lead to fewer inappropriate opinions
- Result in fewer negligence claims against the auditor

Question 11

4.2 The audit risk model

Answer 11

Audit risk = inherent risk x control risk x detection risk
Audit risk is the risk the auditor arrives at an inappropriate opinion in the financial statements. Such as stating the FS show a true and fair view when there is a material misstatement.
Audit risk has two elements: risk the FS contain a material misstatement (inherent risk is the misstatement occurs in the first place and the control risk is the client controls do not prevent or detect this misstatement) and the risk the auditor fails to detect any material misstatements (the detection risk is that insufficient work or poor judgement occurs).

Question 12

4.3 Inherent risk

Answer 12

This is the susceptibility of a transaction, account balance or disclosure to material misstatement, irrespective of the controls in place. The risk can be considered at three different levels:

Industry level
- Affects the whole industry
- highly regulated industries such as banking

Entity level
- Affects the whole entity
- Company may not be a going concern; management get profit related bonuses

Balance level
- Isolated to a particular account balance
- Items which are complex or subjective

Question 13

4.4 Control risk

Answer 13

The risk that a material misstatement would not be prevented, detected, or corrected by the accounting and internal control systems.

Question 14

4.5 Detection risk

Answer 14

The risk that the auditor’s procedures will not detect a misstatement that exists in an account balance or class of transactions that could be material, either individually or when aggregated with misstatements in other balances or classes.

Question 15

4.6 Significant risks

Answer 15

Significant risks require special consideration. ISA 315 identifies the following indicators of significant risk:
- Fraud
- Significant accounting, economic or other developments
- Complexity
- Related party transactions
- Subjectivity
- Unusual transactions

Question 16

5.1 Fraud and error

Answer 16

Error is an unintentional misstatement in the financial statements, including the omission of amounts or disclosures. Fraud is an intentional act involving the use of deception to obtain an unjust or illegal advantage.

Question 17

5.2 Characteristics of fraud

Answer 17

ISA 240 identified two categories of fraud that are the concern of auditors:
- Misappropriation of assets – theft
- Fraudulent financial reporting – involves intentionally manipulating the accounts to deceive the users

Question 18

5.3 Responsibilities for fraud and error

Answer 18

Management responsibilities – primary responsibility is the prevention and detection of fraud. This should be achieved by design and implementation of an effective internal control system.
Auditor responsibility – provide reasonable assurance that the accounts are free from material misstatement. They must plan, perform, and review audits. There is an unavoidable risk that material misstatements may not be detected. The risk is greater in relation to fraud rather than error, because of the sophisticated nature of organised crime schemes.

Question 19

6.1 Related parties

Answer 19

A related party is an individual or organisation who is influenced by or has influence over the entity. Transactions with related parties can occur for reasons other than the entities normal business. Related parties increases the potential for financial results to be manipulated as transactions may be carried out on a basis other than arm’s length. These transactions should be brought attention of the shareholders.
Problems relating to related parties are:
- Directors may be reluctant to disclose transactions
- Transactions may not be easy to identify from the accounting system
- Transactions may be concealed in whole or part from auditors for fraudulent purposes

Question 20

7.1 Analytical procedures

Answer 20

The procedures involve the evaluation of financial information through analysis of plausible relationships among financial and non-financial data. They encompass investigation of identified fluctuations or relationships which are inconsistent with other relevant information or differ from expected values by a significant amount.

Question 21

7.2 Preliminary analytical procedures

Answer 21

ISAs 315 and 520 cover the use of analytical procedures. ISA 315 must be used at planning to identify risk. ISA 520 states they can be used as a form to gather audit evidence and may be used to assist in forming an overall conclusion.
They are useful at planning stage to get a perspective on the accounts using financial and non-financial data. The limitations are:
- They require knowledge and experience of the entity, which may be limited in a first year audit
- Experienced staff must carry them out
- The quality of analytical procedure depends upon the reliability of source data
How are they performed: understand the business, develop an expectation, compare actual to expectation and unexpected variations equal risk.

Question 22

7.3 Sources of information

Answer 22

The information required to perform analytical procedures from the client include:
- Interim accounts
- Budgets
- Management accounts
- VAT returns
- Board minutes
- Non-financial information like personnel records
- Discussion or correspondence with client
- Industry knowledge

Question 23

7.4 calculations

Answer 23

Analytical procedures involves calculations of amounts that can be compared with prior year, budget, and industry averages. The following accounting ratios are performed:

Ratio Formula Purpose
Return on capital employed (PBT/equity+net debt) x 100 Effective use of resource
Return on shareholders’ funds Net profit for the period × 100 / Share capital + reserves Effective use of resource
Gross profit margin Gross profit × 100/ Revenue Assess profitability before taking overheads into account.
Cost of sales percentage Cost of sales × 100/ Revenue Assess relationship of costs to revenue.
Operating cost percentage Operating costs/ overheads × 100 /Revenue Assess relationship of costs to revenue.
Net margin/operating margin Profit before interest and tax × 100 /Revenue Assess profitability after taking overheads into account.
Short-term liquidity Current ratio Current assets / Current liabilities Assess ability to pay current liabilities from reasonably liquid assets.
Quick ratio Receivables + Current investments + Cash / Current liabilities Assess ability to pay current liabilities from most liquid assets.
Long-term solvency Gearing ratio Net debt / Equity Assess reliance on external finance.
Interest cover Profit before interest payable / Interest payable Assess ability to pay interest charges.
Efficiency Net asset turnover Revenue / Capital employed Assess revenue generated from asset base.
Trade receivables collection period Trade receivables × 365 / Credit revenue Assess average time taken to turn receivables into cash.
Trade payables payment period Trade payables × 365 / Credit purchases Assess average time taken to pay suppliers.
Inventory holding period Inventory × 365 / Cost of sales Assess average time inventory is held.