Chapter 3 - Process of assurance: planning the assignment

Question 1

What does ISA (UK) 300, Planning an Audit of Financial Statements state about the objective of the auditor?

Answer 1

The objective of the auditor is to plan the audit so that it will be performed in an effective manner.

Question 2

Define audit strategy.

Answer 2

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 3

Define audit plan.

Answer 3

An audit plan shows how the overall audit strategy will be implemented

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 4

What are six things audits are planned to do:

Answer 4

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 5

Do all audit procedures remain the responsibility of the external auditors?

Answer 5

Yes.

All audit procedures remain the responsibility of the external auditors.

Question 6

What are the four steps towards a structured approach to planning?

Answer 6

Ensuring that ethical requirements continue to be met

Ensuring the terms of the engagement are understood

Establishing the overall audit strategy

Developing an audit plan including risk assessment procedures, audit tests and any other procedures necessary to comply with ISAs

Question 7

What are five aspects of establishing the overall audit strategy?

Answer 7

Identifying the relevant characteristics of 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

Consideration of ‘team members’ available, their skills and how and when they are to be used

Question 8

What are six key contents of an overall audit strategy?

Answer 8

Understanding the entity’s environment

Understanding the accounting and internal control
systems

Risk and materiality

Consequent nature, timing and extent of procedures

Coordination, direction, supervision and review

Other matters

Question 9

With respect to ISA (UK) 315, Identifying and Assessing the Risks of Material Misstatement Through Understanding of the Entity and Its Environment, which five procedures must be used in understanding the entity and its environment?

Answer 9

Inquiries of management and others within the entity.

Analytical procedures

Observation and inspection

If recurring audit, information from previous year audits

The audit team is also required by ISA 315 to discuss the susceptibility of the financial statements to material misstatement.

Question 10

Define analytical procedures.

Answer 10

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 11

What does ISA (UK) 520), Analytical Procedures require?

Answer 11

ISA (UK) 520, Analytical Procedures requires auditors to apply analytical procedures in the
overall review at the end of the audit and as substantive procedures, to obtain audit evidence
directly.

Question 12

What do analytical procedures include?

Answer 12

The consideration of comparisons with comparable info for prior periods, anticipated results of the entity and similar industry information.

Consideration of relationships between elements of financial information and financial information and relevant non-financial information.

Question 13

Should analytical procedures be used at the risk assessment stage?

Answer 13

Yes.

Analytical procedures should be used at the risk assessment stage.

Question 14

Regarding analytical procedures, what do possible sources of information about the client include?

Answer 14

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 15

What is the formula for return on capital employed?

Answer 15

(Profit before interest and tax) / (Equity + net debt)

Effective use of resources

Question 16

What is the formula for return on shareholders’ funds?

Answer 16

(Net profit for the period) / (Share capital + reserves)

Effective use of resources

Question 17

What is the formula for gross profit margin?

Answer 17

(Gross profit x 100) / (Revenue)

Assess profitability before taking overheads into account

Question 18

What is the formula for cost of sales percentage?

Answer 18

(Cost of sales x 100) / (Revenue)

Assess the relationship of costs to revenue

Question 19

What is the formula for operating cost percentage?

Answer 19

(Operating costs x 100) / (Revenue)

Assess the relationship of costs to revenue

Question 20

What is the formula for net (operating) margin?

Answer 20

(Profit before interest and tax x 100) / (Revenue)

Assess profitability after taking overheads into account

Question 21

What is the formula for current ratio?

Answer 21

Current assets: Current liabilities

Assess ability to pay current liabilities from reasonably liquid assets

Question 22

What is the formula for quick ratio?

Answer 22

Receivables + Current investments + Cash: Current liabilities

Assess ability to pay current liabilities from reasonably liquid assets

Question 23

What is the formula for gearing ratio?

Answer 23

(Net debt x 100) / (Equity)

Assess reliance on external finance

Question 24

What is the formula for interest cover?

Answer 24

(Profit before interest payable) / (Interest payable)

Assess ability to pay interest charges

Question 25

What is the formula for net asset turnover?

Answer 25

(Revenue) / (Capital employed)

Assess revenue generated from asset base

Question 26

What is the formula for inventory turnover?

Answer 26

(Cost of sales) / (Inventories)

Assess the level of inventory held

Question 27

What is the formula for inventory days?

Answer 27

(Average Inventory x 365) / (Cost of sales)

Assess the average inventory-holding period

Question 28

What is the formula for trade receivables collection period?

Answer 28

(Trade receivables x 365) / (Revenue)

Assess the ability to turn receivables into cash

Question 29

What is the formula for trade payables collection period?

Answer 29

(Trade payables x 365) / (Purchases)

Assess the ability to pay suppliers

Question 30

Define materiality.

Answer 30

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 31

Define performance materiality.

Answer 31

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.

The concept of performance materiality focuses on the difference between the level of tolerable misstatement and the level of actual misstatements detected.

Question 32

When should materiality be calculated during audits?

Answer 32

Materiality must be calculated at the planning stages of all audits.

Materiality must be reviewed during the audit.

Question 33

Define tolerable misstatement.

Answer 33

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

Often expressed as a proportion of its profits.

Question 34

Are transactions relating to directors considered material?

Answer 34

Yes.

Transactions relating to directors are considered material by nature regardless of their value.

Question 35

Define audit risk.

Answer 35

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 36

Define inherent risk.

Answer 36

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.

Question 37

What is the level of inherent risk when no information to assess inherent risk is available?

Answer 37

The auditors must use their professional judgement and all available knowledge to assess inherent risk. If no such information or knowledge is available then the inherent risk is high.

Question 38

Define control risk.

Answer 38

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 39

Define detection risk.

Answer 39

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 40

What is a crude mathematical formula for audt risk?

Answer 40

Audit risk = Inherent risk x Control risk x Detection risk

Question 41

What does ISA (UK) 315 say?

Answer 41

ISA (UK) 315 paragraph 3 says 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…’.

Question 42

What are the four steps that the auditor is required to take when identifying and assessing risks?

Answer 42

Identify risks throughout the process of obtaining an understanding of the entity and its environment

Assess the identified risks and relate them to what can go wrong at the assertion level

Consider whether the risks are of a magnitude that could result in a material misstatement

Consider the likelihood of the risks causing a material misstatement

Question 43

According to ISA 315, which factors indicate that a risk may be a significant risk?

Answer 43

Risk of fraud

Related to recent significant economic, accounting or other development

The complexity of the transaction

It is a significant transaction with a related party

The degree of subjectivity in the financial information

It is an unusual transaction

Question 44

Define fraud

Answer 44

An intentional act by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception to obtain an unjust or illegal advantage.

Question 45

Define error

Answer 45

An unintentional misstatement in financial statements, including the omission of an amount or a disclosure.