Planning, understanding the entity and assessing business risks - Week 4

Question 1

Before obtaining a new client or managing an existing one, you must…(do 3 main things):

Answer 1

1. Communicate with the previous auditor but you must request permission from the client.
2. Enquire/engage with third parties (e.g. solicitors, bankers, etc…)
3. Review financial information

Question 2

There must be an engagement letter with the client prior to an audit commencing. What is involved/found in the engagement letter?

Answer 2

According to ASA210, an initial engagement letter must outline the objective and scope of the audit. Management’s responsibilities and an auditor’s responsibilities are also outlined in the engagement letter.

Question 3

What does an initial engagement require?

Answer 3

An initial engagement must require that:

• opening balances do not contain any material misstatement
• the previous period’s closing balances have been correctly brought forward to the current period.
• Appropriate accounting policies are consistently applied.

Question 4

What are the five aspects of an entity and its environment that an auditor needs to understand? (answers Q5.6. of textbook)

Answer 4

1, Industry, regulatory and external factors

2. Nature of the entity
3. Accounting policies
4. Objectives, strategies and related business risks
5. Measurement or review of financial performance

Question 5

Knowledge of the entity and its environment can help the auditor:

Answer 5

1. assess risks and identify problems
2. determine materiality
3. evaluate audit evidence
4. identify areas that require special audit consideration.

Question 6

List some techniques for assessing business risks:

Answer 6

• SWOT Analysis
• PESTEL Analysis
• Value-chain Analysis
• Non-financial performance measures

Question 7

List and describe the 2 aspects towards audit planning

Answer 7

1. Audit strategy - sets out the SCOPE, DIRECTION and TIMING of an audit. It has a lower assessed level of control risk and a predominantly substantive approach.
2. Audit plan - sets out the NATURE, TIMING and EXTENT of audit procedures.

Question 8

Interpret Days in Receivables ratio:

Answer 8

> > Days in receivables = 365/receivable turnover «

Days in Receivables indicates how many days it takes,on average, to collect a day’s sales revenue.

Question 9

Interpret Inventory Turnover ratio.

Answer 9

> > Cost of Goods Sold/average inventory «

Indicates how many times inventory is turned over in a year.

Question 10

Interpret Current ratio

Answer 10

> > Current assets/ current liabilities «

Generally, a high current ratio indicates an entity’s better ability to pay off its current obligations.

Question 11

Interpret Debt-to-Equity ratio:

Answer 11

> > Total liabilities/shareholders’ equity «

Indicates what portion of the entity’s capital comes from debt.