Topic 6- Understanding the client/entity

Question 1

what are the four general categories of knowledge that we need about our client in order to perform the audit

Answer 1

Client’s business
Staff
Systems
Finance structure

Question 2

Why obtaining and understanding of the entity is important

Answer 2

The purpose of acquiring this knowledge is to identify the risks that the business is exposed to and, ultimately how these could lead to a risk of material misstatement in the financial statements whether due to fraud or error, at the financial statement and assertion levels.

 Risks would include inherent risk and control risk. An important objective would be to determine the extent to which the auditor would rely on the internal control system.

 To provide a basis for designing and implementing responses to the assessed risks of material misstatement in the financial statements.

 This would involve the design and performance of the audit procedures required to form an opinion on the truth and fairness of the financial statements. An important objective would be to determine the extent and nature of audit procedures to reduce detection risk, and therefore audit risk, to an acceptable level.

 To set the scene for identifying assertions and collecting sufficient appropriate evidence to prove that the assertions are reasonable.

 To assess the adequacy of the accounting system as a basis for preparing financial statements

 To assess whether competent to perform the audit

 To understand relevant law and regulations impacting the entity

Question 3

Give examples of knowledge collected under each of those 4 categories

Answer 3

• Client’s business

✓ Relevant industry, regulatory and other external factors (legislation e.g. employee law or health and safety)

✓ The nature of the entity, including

• market and it’s competition
• It’s operations
• It’s ownership (Ltd or Plc) and governance structure
• The types of investment it makes
• The way it is structured and financed
• Nature of products/services and markets
• Location of production facilities and factories
• Key customers and suppliers (materiality)

✓ The entity’s selection and application of accounting policies

• Staff
• Systems
• Finance structure
• The entity’s objectives, strategies and related business risk
• Capital investment activities (capital expenditure)
• Financing structure (Debt vs Equity)
• Significant changes in the entity on prior years (e.g. policies, management, strategies)

✓ The measurement and review of the entity’s financial performance

✓ The internal controls relevant to the audit

Question 4

where are the sources of the above information?

name the sources

Answer 4

✓ Prior year audit file
✓ prior year financial statements
✓ accounting system notes
✓ discussion with management
✓ current year budgets and management
✓ permanent audit file
✓ entities' website
✓ Prior year report to management
✓ financial statements of competitors

Question 5

what do you expect to obtain in prior year audit file (cunulative auditor’s knowledge plus experience

Answer 5

Identification of issues that arose in the prior year audit and how these were resolved. Also whether any points brought forward were noted for consideration for this year’s audit.

Question 6

what do you expect to obtain in prior year financial statements

Answer 6

Provides information in relation to the size of the entity as well as the key accounting policies and disclosure notes.

Question 7

what do you expect to obtain in accounting system notes

Answer 7

Provides information on how each of the key accounting systems operates.

Question 8

what do you expect to obtain in discussion with management

Answer 8

Provides information in relation to any important issues which have arisen or changes to the company during the year.

Question 9

what do you expect to obtain in current year budgets and management

Answer 9

Provides relevant financial information for the year to date. The auditor can identify whether there needs to be a change in materially since last year. In addition, this will be useful for preliminary analytical review and risk identification.

Question 10

what do you expect to obtain in permanent audit file (things that don’t change annually i.e. important bank loan agreements or mortgage arrangements)

Answer 10

Provides information in relation to matters of continuing importance for the company and the audit team, such as statutory books information or important agreements.

Question 11

what do you expect to obtain in entities websites

Answer 11

Recent press releases from the company may provide background on changes to the business during the year as this could lead to additional audit risks.

Question 12

what do you expect to obtain in prior year report to management

Answer 12

(i.e. report of weaknesses in the controls and see if they have been addressed.

Provides information on the internal control deficiencies noted in the prior year; if these have not been rectified by management then they could arise in the current year audit as well.

Question 13

what do you expect to obtain in financial statements of competitors

Answer 13

This will provide information about entities competitors, in relation to their financial results and their accounting policies. This will be important in assessing our client’s performance in the year.

Question 14

To understand the entity and it’s environment, ISA 315 (Identifying and assessing the risks of material misstatement) requires the auditors to perform 4 procedures

what are they

Answer 14

AEIOU

✓ Enquiries.. with management and others within and outside entity (both financial and non financial)

✓ Observation…of control procedure or procedure being performed by other

✓ Inspection…examining records/documents/key strategic documents and procedural manuals

✓ Analytical procedures (Mandatory at planning and Completion/Review stage)

Question 15

what is the definition of analytical review?

Answer 15

Analytical procedures consist of 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 16

what can analytical procedures include

Answer 16

✓ Involve calculating ratios, computing trends, proving figures in total and making comparisons

✓ it can be used to corroborate answers to enquiries

✓ it can involve comparisons- an individual ratio is meaningless unless compared to previous year/similar company/actual v budget

Question 17

what kinds of data can comparisons be made against in analytical procedures?

Answer 17

✓ Comparison of comparable information to prior periods to identify unusual changes or fluctuations in amounts.

✓ Comparison of actual or anticipated results of the entity with budgets and/or forecasts, or the expectations of the auditor in order to determine the potential accuracy of those results.

✓ Comparison to industry information either for the industry as a whole or by comparison to entities of similar size to the client to determine whether receivable days, for example, are reasonable.

Question 18

when is analytical procedures/(review) mandatory and what can it also be used for?

Answer 18

Compulsory at the planning stage. Analytical procedures must be used as risk assessment procedures in order to help the auditor to obtain an understanding of the entity and assess the risk of material misstatement (ISA 315)

Compulsory at the final review stage. The auditor must design and perform analytical procedures that assist them when forming an overall conclusion as to whether the financial statements are consistent with the auditor’s understanding of the entity and also to make sure the numbers make sense (ISA 520)

It can also be an efficient and effective source of substantive evidence

Question 19

when can analytical procedures/(review) also be used? (optional)

Answer 19

Field work/(Final audit)- analytical procedures can be used to obtain sufficient appropriate evidence. Substantive procedures can either be tests of detail or substantive analytical procedures.

Question 20

what is ROCE

Answer 20

Operating Profit / Capital Employed

Capital Employed= Equity + Non-Current Liabilities

Question 21

what is gross profit

Answer 21

Rev- Cost of sales

Question 22

what is gross profit margin

Answer 22

(Gross Profit/ Sales Revenue) x 100%

Question 23

what is operating/net profit margin

Answer 23

(Net Profit/ Sales Revenue) x 100%

Question 24

what is inventory holding period

Answer 24

(Inventory /Cost of sale) x 365

Question 25

what is receivables holding period

Answer 25

(Averg Receivable/Credit Sale) x 365

Question 26

what is payables holding period

Answer 26

(Averg Payable/Credit Purchases) x 365

Question 27

what is current ratio

Answer 27

(Current assets/ Current Liabilities) x 100%

Question 28

what is quick ratio

Answer 28

(Current assets- Inventory/ Current Liabilities) x 100%

Question 29

what is gearing

Answer 29

(Debt/Equity) OR (Debt / Equity + Debt)

Question 30

what is interest cover

Answer 30

PBIT / Finance cost

Question 31

what is the definition of risk

Answer 31

the possibility that there are errors and fraud

Question 32

what is the definition of misstatements

Answer 32

A difference between the amount, classification, presentation, or disclosure of a reported financial statement item and the amount, classification, presentation, or disclosure that is required for the item to be in accordance with the applicable financial reporting framework.

Question 33

how can misstatements arise

Answer 33

Misstatements can arise from error or fraud.

Question 34

what is the definition of uncorrected misstatements

Answer 34

Misstatements that the auditor has accumulated during the audit and that have not been corrected.

Question 35

what is the auditors responsibilities for misstatements

Answer 35

✓ The auditor has a responsibility to accumulate misstatements which arise over the course of the audit unless they are very small amounts.

✓ Identified misstatements should be considered during the course of the audit to assess whether the audit strategy and plan should be revised.

✓ The auditor should determine whether uncorrected misstatements are material in aggregate or individually.

✓ All misstatements should be communicated to those charged with governance on a timely basis and request that they make necessary amendments. If this request is refused then the auditor should consider the potential impact on their audit report.

✓ A written representation should be requested from management to confirm that unadjusted misstatements are immaterial.

Question 36

what are the three categories of misstatements

Answer 36

✓ No doubt
✓ Judgemental
✓ Projected

Question 37

what are no doubt misstatements

Answer 37

Factual misstatements are misstatements about which there is no doubt.

e.g. invoice coded to wages

Question 38

what are judgemental misstatements

Answer 38

Judgemental misstatements are differences arising from the judgements of management concerning accounting estimates that the auditor considers unreasonable, or the selection or application of accounting policies that the auditor considers inappropriate.

e.g. accruals/Revenue recognition/ Depreciation

Question 39

what are projected misstatements

Answer 39

Maintaining records of projected misstatements are the auditor’s best estimate of misstatements in populations, involving the projection of misstatements identified in audit samples to the entire populations from which the samples were drawn.

Question 40

what is the definition of materiality

Answer 40

Information is material if it’s omission or misstatement could (either individually or in aggregate) influence the economic decisions of users taken on the basis of the financial statements.

Question 41

what two things should you look assessing/determining materiality

Answer 41

Quantity (Size) of misstatements

Quality (Nature) of misstatements

Question 42

what is the the lower limit and theoretical guidance on the quantity (size)of materiality for the following

Profit before tax
Turnover
Total assets

Answer 42

In the exam, balances will be material if they exceed the lower of each of the below

Profit before tax (5%)-10%
Revenue (0.5%)-1%
Total assets (1%)-2%

Question 43

In assessing materiality , two things are considered:

1) Quantity
2) Quality
3) Combination of both

what does Quality (Nature) of misstatements refer to

Answer 43

The quantity of the misstatement refers to the relative size of it and the quality refers to an amount that might be low in value but due to its prominence could influence the user’s decision,

for example, directors’ transactions/wages

Question 44

what is performance materiality

Answer 44

An amount which reduces the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole

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

PM is lower materiality and links to Tolerable misstatements.

It’s used to capture anything that may not be individually big but could be so when aggregated together

Question 45

what is the significance of materiality

Answer 45

financial statements which are materially misstated will not give a true and fair view.

Auditors must test all material balances

Question 46

what is audit risk

Answer 46

The risk of issuing an inappropriate audit opinion

Question 47

what is audit risk made up of

Answer 47

AR= Inherent Risk x Control Risk x Detection Risk

Question 48

what is control risk

Answer 48

Risk that clients’ controls fail

The risk that the client’s controls fail to prevent and detect misstatement.

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 49

what is an example of control risk and give audit approach to take

Answer 49

✓ Deficiencies in internal control, especially those not addressed by management

✓ Old or ineffective accounting software

✓ Lack of segregation of accounting duties

• -> Increase substantive testing
• -> Recalculate amounts

✓ lack of authorization procedures

• -> Analytical review comparing budget against actual to see if there are any anomalies
• ->Agree a sample of costs in the nominal ledger to the invoices or source documents

✓ changes to or new computer systems in the year / Lack of personnel with appropriate accounting and financial reporting skills.

• ->review management procedure for the transition e.g. parallel run
• -> check closing balances
• -> use test data (CAAT) to interrogate the systems

✓ change in staff or temporary staff used in the year

• ->increase substantive testing/recalculate a sample of work done by new employees
• ->review training policies

✓ lack of passwords/locks/monitoring- easy to go into a computer and change details/amounts

• -> agree transactions to original doc e.g. invoice/contracts
• -> test data to see how easy it is to change details
• ->look at trends (analytical procedure) and information and see if expectations have been met

Question 50

what is inherent risk and what is it affected by

Answer 50

Due to the nature of business/operations

The susceptibility of a balance to misstatement before considerations of control.

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 an entity and factors which can result in an increase include:

Question 51

what is an example of an inherent risk and give audit approach to take

Answer 51

Inherent risk is affected by the nature of an entity and factors which can result in an increase include:

✓ Performance related pay

• -> Review areas in FS where judgement is taken into account
• -> Recalculate the bonus
• -> Review the reasonableness of the results

✓ Foreign exchange transactions

• -> agree the rate of translation and recalculate a sample
• -> Review company policy on how they process overseas transactions

✓ Unusual and complicated transactions (which require provision and R&D)
–> risk of transactions being over/under stated dur to judgement required. Therefore, audit should obtain an understanding of the criteria in arriving at these figures.

✓ A client in a volatile industry

• -> Risk of lack of understanding of how transactions are disclosed in FS- Auditor should ensure they have competent staff with relevant experience for the audit.
• -> Risk of inventory becoming obsolete and therefore inventory being overvalued- Auditor should increase testing of inventory and review after date sales to see if the inventory has been sold for more than what it cost

✓ rapidly changing technology

✓ complex accounting treatment (requiring judgement)
–> obtain an understanding of the criteria in arriving at the figures

Inherent risk is affected by the nature of an entity and factors which can result in an increase include:

 Changes in the industry it operates in.
 Operations that are subject to a high degree of regulation.
 Going concern and liquidity issues including loss of significant customers.
 Developing or offering new products or services, or moving into new lines of business.
 Expanding into new locations.
 Application of new accounting standards.
 Accounting measurements that involve complex processes.
 Events or transactions that involve significant accounting estimates.
 Pending litigation and contingent liabilities.

Question 52

..what is detection risk

Answer 52

Only factor the auditor can control. (Balancing figure)

The risk that the auditor fails to detect misstatement

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.

Detection risk is affected by sampling and non-sampling risk and factors which can result in an increase include:

– Inadequate planning.
 – Inappropriate assignment of personnel to the engagement team.
 – Failing to apply professional scepticism

Question 53

what is an example of a detection risk and give audit approach to take

Answer 53

✓ First year as a client

• -> Place the experienced auditors on the new client.
• -> Obtain understanding of the business and environment
• -> Agree opening balances to closing balance

✓ Tight audit deadline

• ->Perform an interim audit and complete some of the evidence collection at this point
• ->Increase the number of audit staff that are on the audit

✓ using inappropriate procedures

✓ misinterpreting results

Detection risk is affected by sampling and non-sampling risk and factors which can result in an increase include:

 – Inadequate planning.
 – Inappropriate assignment of personnel to the engagement team.
 – Failing to apply professional scepticism
 – Inadequate supervision and review of the audit work performed.
 – Incorrect sampling

Question 54

what is sampling risk

Answer 54

Possibility that the auditors conclusion, based on a sample may be different from the conclusion reached if the entire population were subjected to the same audit procedures

Question 55

what is non-sampling risk

Answer 55

The risk the auditor reaches an inappropriate opinion despite a representative sample being chosen

Question 56

list the importance of assessing risk /

Answer 56

✓ This will ensure that attention is focused early on the area’s most likely to cause material misstatements.

✓ A thorough risk assessment will also help the auditor to fully understand the entity, which is vital for an effective audit.

✓ Any unusual transactions or balances would also be identified early, so that these could be addressed in a timely manner.

✓ The risks need to be assessed early in order for the audit strategy and detailed work programmes to be developed.

✓ Assessing risks early should also result in an efficient audit.

✓ The team will only focus their time and effort on key areas as opposed to balances or transactions that might be immaterial or unlikely to contain errors.

✓ Ensure that the most appropriate team is selected with more experienced staff allocated to higher risk audits and high risk balances.

✓ A thorough risk analysis should ultimately reduce the risk of an inappropriate audit opinion being given. The audit would have focused on the main risk areas and hence all material misstatements should have been identified, resulting in the correct opinion being given.

✓ It should enable the auditor to have a good understanding of the risks of fraud, money laundering, etc.

✓ Assessing risk should enable the auditor to assess whether the client is a going concern.

Question 57

how can auditors lower the detection risk

Answer 57

Inherent & Control risk cannot be influenced by the auditor however the detection risk can. If these two risk are high (i.e. increased risk of material misstatement), they can lower detection risk
through the following means:

✓ Increasing substantive testing
✓ increasing sample sizes
✓ using more experienced staff
✓ increasing levels of supervision
✓ increasing review procedures

By performing a more thorough audit, there is less risk that the auditor fails to detect material misstatement.