Chapter 3 - Process of assurance: Planning the assignment Flashcards
What is the objective of planning an audit, according to ISA 300?
The objective is to plan the audit so it can be performed in an effective (correct opinion) and efficient (make a profit) manner, ensuring that significant areas are properly addressed and managed.
What are the main objectives of audit planning? (6)
- Ensure attention to important areas. Materiality + Risk
- 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
What is an audit strategy?
BIG PICTURE
An audit strategy outlines the scope, timing, and direction of the audit, guiding the development of the audit plan and addressing broad objectives.
What does an audit plan include?
DETAIL
The audit plan is a detailed guide specifying the nature, timing, and extent of audit procedures to be carried out by the team to gather sufficient and appropriate audit evidence.
Audit Strategy MR BICEP
Materiality + Risk
Resources
Business Understanding
Internal
Control
Environment
People
Materiality + Risk - Basis for setting materiality and risk assessment
Resources - Team members involved, budgeted hours, timing and fee
Business Understanding - Locations, structure, management’s integrity.
Internal
Control- Understanding client accounting policy choices & Understand the reliability of clients’ systems for detecting and preventing accounting fraud and error
Environment - Industry and economic conditions.
People
What is the importance of understanding the entity in audit planning?
Understanding the entity helps auditors identify potential risks, business factors, and relevant internal controls, which shape the approach and focus of the audit.
ISA 315 (UK and Ireland) Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and its Environment states that ‘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.
When we are understanding the entity
a. Why do we do this? (3)
b. How is it done? (4)
c. What’s involved? (5)
a.
Identify and assess the rules
Identify and assess the audit approach
Focus attention and effort on appropriate risks
b.
AEIO
Analytical Procedures - MUST be done in planning stage
Enquires - MUST ask employees + directors
Inspection
Observation
c.
Look at:
- Nature of the entity e.g. what type of business, how does it make revenue, what expenses does it have
- Objectives and Strategies e.g. profit, brand awareness, market share, innovation, copyright
- Entity’s financial performance e.g. profit making, share price
- Internal control w.g. security, stock count, IDs , cash accounting, restricted access
- Industry, regulatory & external factors e.g. new laws, geo location, any competitors
What is professional skepticism, and why is it essential in auditing?
Professional skepticism is a questioning mind and critical assessment of evidence, helping auditors remain alert to errors or fraud during the audit process.
Professional scepticism does not mean that auditors should disbelieve everything they are told; however, they must have a questioning attitude.
When are analytical procedures used?
Analytical procedures MUST be used at the risk assessment stage as part of Understanding the Entity and its Environment - when we plan the audit.
Define analytical procedures in audit planning?
Analytical procedures involve evaluating financial and non-financial information relationships to identify inconsistencies or unusual trends that may indicate risk areas
Compare data to
Prior Periods
Budgets
Ratio Analysis (see below)
Non-financial information
Industry information
What are the 5 types of key ratios used in analytical procedures?
- Performance
- Return on capital employed
- Gross profit margin
- COS %
- Operating cost %
- Operating profit margin - Liquidity
- Current ratio
- Quick ratio - Long term solvency
- Gearing
- Interest cover - Efficiency
- Net asset turnover - Working Capital
- Inventory period
- Trade receivable period
- Trade payable period
Analytical Procedure Ratio - Performance - Return on capital employed
Return on capital employed (ROCE) = Profit before interest and tax/ Capital employed
Capital employed = TALCL OR Equity (sc+sp+re) + NCL
TALCL = total assets LESS current liabilities
- Measures how much profit is generated for every £ of assets employed
- Indicates how efficiently the company uses its assets
Want this to be HIGH (depends on industry, age of assets, whether co revalues its PPE etc) e.g. Unilever (manufacture) ~20% but PWC (Services) ~50%
Analytical Procedure Ratio - Performance - Gross profit margin
Gross Profit Margin = Gross Profit / Revenue
Want this to be HIGH
- Usually does not change dramatically from one period to the next, unless the company changes its sales mix (sales mix e.g. new product introduced which has a higher profit margin)
- Increased margin may be due to decreasing costs or increased sales prices
-Changes could result from Improved / reduced purchasing power (economies of scale) e.g. f you buy more from your supplier they will likely give you a better deal. - And increase in GP% could be due to overstated revenue, understated purchases or overstated inventories
Analytical Procedure Ratio - Performance - COS %
COS % = Cost of sales (Op Inv + Purchases - Cl Inv) / Revenue
How well business is controlling its purchase prices or production costs (if manufacturer)
Want this to be LOW
Analytical Procedure Ratio - Performance - Operating cost %
Operating cost % = Operating costs (Distribution + Admin Expenses)/ Revenue
How well business is controlling its distribution and administrative expenses
Want this to be LOW
Analytical Procedure Ratio - Performance - Operating profit margin
Operating Profit Margin = Profit before interest and tax (PBIT) / Revenue
Want this to be HIGH
- Can reflect how efficiently a business is being run, i.e. through controlled overheads
- How well business is operating its core activities and controlling its costs
- A sharp increase or decrease in this ratio is probably due to changes in administrative expenses, e.g. bad debts, restructuring costs, salary increases.
- Note: you need to be careful when calculating PBIT. Most statements of profit or loss only give PBT so you will need to add back the interest charge to arrive at PBIT.
Analytical Procedure Ratio - Liquidity - Current ratio
Current ratio = Current assets / Current liabilities
- CA = (Inventory + Receivables + Cash + Prepayments)
- CL = (Payables + Overdraft)
- How easily business can afford to pay its current liabilities out of its current assets
- Measures how easily a company can meet its current obligations.
- Less than 1 means CL > CA and could be a cause for concern, e.g. how will company pay its creditors?
- “Correct” level depends on the industry:
– Too high indicates too much cash tied up in working capital
– Too low and we cannot meet obligations as they fall due
Ideally ≥ 1 but depends on industry (e.g. supermarkets typically < 1)
Too low = liquidity probs; Too high = holding costs/poor return on assets
Analytical Procedure Ratio - Liquidity - Quick ratio (aka Acid Test)
Quick ratio = Current assets – Inventory / Current liabilities
- How easily business can afford to pay its current liabilities out of its most liquid current assets
- In times of crisis, businesses struggle to sell inventory quickly. What can be turned into cash quickly.
- Quick ratio (or acid test) sometimes seen as better test of liquidity as excludes inventory.
- Value depends on industry
Analytical Procedure Ratio - Long term solvency - Gearing
Gearing ratio = Net debt / Equity
Amount of lending/investment that is tied up in debt as a proportion of the investment from the shareholders (equity)
Net debt = Loan - Cash = Risky Investment
Equity = SC + SP + RE + Other Reserves = Unrisky Investment
- Debt is riskier than equity due to interest having to be paid and risk assets will be seized if repayments are not made
- Composition of business’s long-term finance (money borrowed from lenders versus money sourced from shareholders)
- Can be increased/decreased by: significant asset purchases; repayment of debt, issue of new debt
- Loan agreements (covenants) may require a company not to exceed a particular level of gearing.
- Higher the number the worser the company is to invest in
Too high - risk company won’t be able to service its finance (pay interest & repay capital)
Too low - not taking advantage of cheaper debt finance (interest is tax-deductible & lower risk to investor
Analytical Procedure Ratio - Long term solvency - Interest cover
Interest cover = Profit before interest and tax (PBIT) / Interest payable expense
- Profit before interest and tax (PBIT) = Operating cost
- Interest payable expense = Finance Costs
- This ratio shows how many times the interest expense can be covered by profits. In simple terms, the higher this figure is, the easier the company will find it to pay its interest expense.
Ideally ≥ 1 (bank loan covenants typically require interest cover of around 2.5 - 3.5)
Analytical Procedure Ratio - Efficiency - Net asset turnover
Net asset turnover = Revenue / Capital employed
Capital employed = TALCL OR Equity (sc+sp+re) + NCL
TALCL = total assets LESS current liabilities
- How efficiently business uses its long-term finance to generate revenue
- Measures how much sales revenue is generated for every £ of assets employed
- A significant decrease can be caused by new assets being purchased close to the year end
- An increase could be caused by the purchase of more efficient assets
- Want this to be HIGH (depends on industry, age of assets, whether co revalues its PPE etc)
Analytical Procedure Ratio - Working Capital - Inventory period
Inventory Days = (Inventory/COS) x 365 days
- Shows how long a business takes to sell its inventory
- If increasing there could be a risk of obsolete inventory - we would need to write down cost to NRV
Too low - risk running out of inventory
Too high - high inventory holding costs
Analytical Procedure Ratio - Working Capital - Trade receivable period
Receivables collection period = (Trade receivables / Revenue) × 365 days
- Shows how quickly customers settle their debts
- Depends on credit policy and credit controls
- Increase may be indicative of recognition of fake sales/trade receivable
- Compare to business’s credit terms
- if considerably higher than credit terms = risk of bad debt
- if lower = great, efficient, cash flow
Analytical Procedure Ratio - Working Capital - Trade payable period
Payables Payment Period = (Trade payables / Purchases (or COS)) × 365 days
- Shows how quickly a business pays its suppliers
- A significant decrease could be indicative of unrecorded credit purchases at the year end
Company to supplier’s credit terms - want to take advantage of full credit term (free credit) But if too high, risk of losing supplier’s goodwill & supplier could refuse to supply
Working capital cycle
Working capital cycle = Inventory period + Receivables period - Payables period
Inventory period: Buy inventory to sell inventory
Receivables period: Sell inventory to customer pays
Payables period: Buy inventory to pay suppliers
No. of days of finance required to fund working capital requirement
Want to keep low but depends on industry
What is materiality, and how is it determined in auditing?
Materiality is the level at which an omission (left out) or misstatement (e.g. wrong heading/no.) in financial statements could influence users’ economic decisions. It’s typically calculated based on percentages of RAP - revenue, total assets, or PBT
What does ISA 320 (UK and Ireland) say about the use of materiality in auditing?
ISA 320 states that materiality and audit risk should be considered throughout the audit, especially in identifying risks, determining procedures, and evaluating uncorrected misstatements.
Materiality states that ‘materiality and audit risk are considered throughout the audit, in particular, when: (3)
Materiality states that ‘materiality and audit risk are considered throughout the audit, in particular, when:
Identifying and assessing the risks of material misstatement - giving an opinion that we have reasonable assurance
Determining the nature, timing and extent of further audit procedures - bigger the number the more work
Evaluating the effect of uncorrected misstatements = do the small mistakes add up to be material
How does materiality affect the auditor’s opinion on reasonable assurance?
Materiality helps in assessing whether there are material misstatements, thus affecting the auditor’s opinion on whether there is reasonable assurance that the financial statements are free of material misstatement.
How does materiality influence the nature, timing, and extent of further audit procedures?
Higher materiality allows for less intensive procedures, while lower materiality requires more detailed testing to ensure smaller misstatements are detected.
Why do auditors evaluate the effect of uncorrected misstatements?
Auditors evaluate if small misstatements, when combined, reach a material threshold, impacting the accuracy of the financial statements.
How do auditors determine preliminary materiality levels?
Auditors calculate a range of values, using an average or weighted average of these figures as the preliminary materiality level, though methods may vary by firm.
Does materiality consider qualitative as well as quantitative factors?
Yes, materiality includes both quantitative aspects (such as amounts) and qualitative aspects, like transactions involving directors, which are material by nature.
What is the relationship between risk and materiality in auditing?
High risk requires a lower materiality threshold, meaning more detailed testing, while low risk allows for a higher materiality threshold, focusing only on larger transactions.
Provide an example of calculating materiality for a low-risk client with revenue of £1,000,000. Revenue materiality is set at 1%.
If revenue materiality is set at 1%, then the materiality level is £10,000. Transactions above £10,000 are investigated in detail, while smaller amounts can be reviewed quickly in the nominal or general ledger.
