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Chapter Planning, Knowledge of the Business and Evaluating Business Risk Copyright 2006 McGraw-Hill Australia Pty Ltd 6-1 Learning Objective 1: Client Acceptance Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-2 Acceptance and continuance evaluation procedures • Procedures carried out before accepting a new client or continuing with an existing client include: – Reviewing financial information regarding the client; – Making inquiries of third parties such as solicitors and bankers; – Communicating with previous auditor; – Ensuring that the firm has technical expertise to carry out audit; and – Ensuring accepting engagement will not conflict with the profession’s code of professional conduct Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-3 Communication with previous auditor • • • • Communication ensures that the interests of shareholders, the incoming auditor and existing auditor are protected It allows the existing auditor to advise the prospective auditor of any professional matters they should be aware of before accepting the engagement Nominated incoming auditor should request client’s permission to communicate with previous auditor; If client refuses permission, normally decline nomination; and If permission is granted, the nominated auditor asks previous auditor for all information necessary to decide whether nomination should be accepted Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-4 Learning Objective 2: Engagement Letters • These letters are from the auditor to the client that document the arrangements and confirm the auditor’s acceptance of the appointment and should include: – Objectives and scope of audit; – Responsibility of management for financial report; – Form of any reports; – An explanation of the extent to which an audit can be relied upon to detect material misstatement; and – Auditor’s right of unrestricted access to records, documents and other information necessary to complete audit Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-5 Learning Objective 3: Audit Planning • The planning stage is a very important stage of the audit and involves two aspects: – Audit plan - outlines the expected scope and conduct of audit; and – Audit program - directs the nature, timing and extent of audit procedures Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-6 Major steps in the audit process • In every audit of a financial report there are seven identifiable stages These stages are: – Obtaining knowledge of the client’s business; – Understanding internal controls; – Assessing risks of material misstatement; – Responses to assessed risks; – Performing tests of controls; – Performing substantive procedures; and – Completion and review Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-7 Learning Objective 4: Developing an Overall Audit Strategy • • • Overall audit strategy details the general evidence requirements for forming an opinion and initial decision as to the nature, timing and extent of audit procedures Interrelationship between materiality, audit risk and what constitutes sufficient appropriate audit evidence impacts on auditor’s strategy Audit strategies can range from a lower assessed level of control risk approach to a predominantly substantive approach Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-8 Range of audit strategies Lower assessed level of control risk Predominantly substantive approach Audit strategy may be anywhere along this continuum Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-9 Lower assessed level of control risk approach • If internal control is well designed and expected to be highly effective, audit strategy will include: – Low or medium assessed level of control risks; – Extensive understanding of relevant parts of internal control; – Extensive tests of control; and – Reduced level of substantive audit procedures, based on planned acceptable level of detection risk being high or medium Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-10 Techniques for assessing business risk (cont.) – PEST analysis Identifies: P olitical E conomic S ocial T echnological … influences on entity Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-27 Techniques for assessing business risk (cont.) – Value-chain approach • This approach disaggregates an entity into strategically important activities in order to: – Understand client’s strategic advantages; – Understand risks that threaten attainment of business objectives; – Understand key processes and related competencies needed to realise strategic advantages; – Measure and benchmark process performance; and – Document an understanding of the client’s ability to create value and generate future cash flows by using a client business model, process analyses, key performance indicators and a business risk profile Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-28 Response to assessed risks • An auditor should determine overall responses to assessed risks at financial report level, and perform audit procedures at the assertion level Responses at financial report level include: – assigning more experienced staff; – using experts; and – incorporating unpredictability into selection of further audit procedures Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-29 Performing further audit procedures at the assertion level • An auditor must consider: – Significance of the risk – Likelihood of misstatement occurring – Nature of specific controls – Whether auditor expects to obtain evidence to determine if entity’s controls are effective in preventing or detecting and correcting, material misstatement (planned control risk < HIGH) Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-30 Learning Objective 8: Analytical Procedures • • • Analytical procedures involve the use of ratios, trend analysis and operating statistics for comparison with internal and external data Can be used at all stages of the audit: – e.g in planning stage as a form of evidence or as a final review At this stage we concentrate on use of analytical procedures in planning Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-31 Analytical procedures at the planning stage • • A risk analysis approach requires analytical procedures to be used during the planning stage of the audit Allows the auditor to understand the business and identify areas of potential risk, thereby assisting in the determination of the nature, timing and extent of audit procedures Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-32 Analytical procedures used in planning the audit Simple procedures: • • • • • Simple comparisons Ratio analysis Common-size statements Trend statements Time series analysis More complex procedures: • • • Time series modelling Regression analysis Financial modelling Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-33 Analytical procedures most commonly used in planning • • • Comparison of current balances in the financial report with balances of prior periods, and budgeted amounts (simple comparisons); Computation of ratios and percentage relationships for comparison with prior years, budgets and industry averages (ratio analysis); and Significant variations from expectations indicate areas requiring investigation Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-34 Ratios commonly used at the planning stage • Short-term liquidity Current ratio (current assets to current liabilities); – Quick asset ratio (liquid assets to current liabilities); and – Operating cash flow ratio (cash from operations to current liabilities) – • Activity Receivables turnover (net sales to average accounts receivable); and – Inventory turnover (cost of goods sold to average inventory) – • Profitability Gross profit and net profit ratio (gross profit or net profit to net sales); – Return on total assets (net profit to total assets); and – Return on shareholders’ equity (net profit to ordinary shareholders’ equity) – • Solvency Debt equity ratio (long and short term debt to shareholders’ equity); and – Times interest earned (net profit to annual interest expense) – Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-35 Common-size statements • Express balance sheet components as a percentage of total assets and income statement components as a percentage of total revenue Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-36 Trend statements • Each item is expressed as a percentage of its own level from a base year, thus allowing focus on trend rather than absolute magnitude of dollar charge Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-37 Reliability of data used in analytical procedures • • • • • Data from an independent source outside the entity are generally more reliable than internal data Data from a system with effective internal controls are more reliable than data from a poorly controlled system Data audited in the previous year or in the current audit are more reliable than unaudited data Data from a variety of sources that corroborate each other are more reliable than data from only one source Data from the department within the entity that is responsible for the amount being audited are generally less reliable than data from another department Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-38 Plausibility, predictability and precision of analytical relationships • • Relationships in a stable environment are more predictable than relationships in a dynamic, changing environment Relationships involving income statement amounts (transactions over a period of time) tend to be more predictable than relationships involving only balance sheet accounts (amounts at a point in time) Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-39 Plausibility, predictability and precision of analytical relationships (cont.) • • • Direct relationships are more predictable than indirect relationships Disaggregated relationships are more precise and show clearer relationships than combined or aggregated relationships Relationships involving transactions subject to management discretion are less predictable than those not subject to such discretion Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-40 Examination of significant fluctuations of analytical procedures • • • • • Each significant fluctuation (deviation from expected amount) must be investigated; An auditor must also be alert to the possibility that an absence of expected fluctuation might require investigation; Deviations from an expected amount should be discussed with management; Reasonableness of explanations provided by management should be considered; and An auditor might have to consider impact of fluctuations on audit program and other audit tests Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-41 ... in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-13 Purpose of detailed audit programs • Programs should provide: – Evidence of proper planning of work; – Guidance... Roger Simnett Slides prepared by Roger Simnett 6-14 Contents of audit program • An audit program will outline the following characteristics of audit procedures: – Nature - particular audit procedures... Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 6-12 Preparing detailed audit programs • An audit program is a detailed list of audit procedures that need to be applied
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