ACCT3708 - Exam Notes PDF

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WEEK 1 – Introduction, Framework, Regulation and Legal Liability INTRODUCTION AGENCY Separation between managers and owners  Managers are the agents of the owners – run the company for owner’s benefit FINANCIAL STATEMENTS  Given to owners to determine performance o Reward/Punish o Investment Decis...

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WEEK 1 – Introduction, Framework, Regulation and Legal Liability INTRODUCTION AGENCY Separation between managers and owners  Managers are the agents of the owners – run the company for owner’s benefit FINANCIAL STATEMENTS  Given to owners to determine performance o Reward/Punish o Investment Decisions INFORMATION ASYMMETRY  Cannot determine financial statements true/fair 1. Fraud – managers can lie for personal gain 2. Incompetence – misrepresent company performance from lack of knowledge OWNER’S RESPONSE  Cannot distinguish between good/bad managers o Under-reward good managers o Under-valuing the share price of good companies AGENCY COSTS  Agency Costs – cost from information asymmetry (for both parties) o Good managers are under-rewarded o Owners cannot distinguish company performance

ASSURANCE ASSURANCE  Agency costs can be reduced through independent third party providing assurance as to whether the financial statements are true and fair.  The third party: o Conducts procedures to determine true/fairness of financial statements o Issues an opinion on their truth and fairness to the shareholders ASSURANCE ENGAGEMENT  Assurance Engagement – engagement whereby practitioner aims to obtain sufficient appropriate evidence in order to enhance the degree of confidence for the intended users. KEY ELEMENTS OF ASSURANCE ENGAGEMENTS 1. Three party relationship – practitioner, responsible party + intended users 2. Appropriate subject matters 3. Suitable Criteria (rules) 4. Sufficient Evidence (gather evidence and evaluation) 5. Written assurance report (appropriate form)

1. ABSOLUTE ASSURANCE Absolute assurance can never be provided because of:  Nature of Accounting o Valuation Issues o Accounting policy choice and judgments o Contingent Terms  Time and cost of evidence collection and evaluation 2.   

REASONABLE ASSURANCE Conclusion is expressed in positive form i.e. statements ARE true/fair An audit engagement provides a reasonable level of assurance The opinion is expressed in an audit report

3. LIMITED ASSURANCE  Conclusion is expressed in a negative form i.e. nothing to suggestion that the statements ARE NOT true/fair  A review engagement provides limited level of assurance  Why? This is affordable

FINANCIAL STATEMENT AUDITS   

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The auditor is appointed by shareholders at the AGM o Most of the time, they accept the recommendation of the board The auditor expressed their audit opinion to the shareholders via auditor’s report, included in the annual report The auditor CANNOT CHANGE any aspect of financial statements o Preparation of financial statements is the responsibility of the directors and the auditor’s report does not absolve them of this The auditor needs to determine if the financial statements: o Comply with accounting standards o Present a “true and fair” view i.e. free from material errors

MATERIAL ERRORS  Material errors arise from three sources: o Legitimate errors o Deliberate misstatement (Fraud) o Errors in accounting judgments  If errors are found o The auditor asks management to change the financial statements o If they wont, auditor changes the report AUDIT OPINIONS 1. Unqualified Opinion – nothing wrong with the financial statements 2. Qualified Opinion – financial statements contain material error

AUDITING STANDARDS LEGAL REQUIREMENTS  Corporation Act 2001 s301(1) - A company, registered scheme or disclosing entity must have the financial report for a financial year audited in accordance with Division 3 and obtain an auditor’s report AUDIT STANDARD S307A  If an individual auditor, or audit company, conducts… the individual audit or audit company must conduct the audit or review in accordance with auditing standards o An audit of the financial report for a financial year or; o An audit or review of the financial report for a half-year AUSTRALIAN AUDITING STANDARDS (ASAs)  ASAs are legally enforceable (307A)  They are set by the Auditing and Assurance Standards Board (AUASB – statutory body)  Compliance with ASAs is monitored by ASIC ASA 101.9  The auditor shall apply the mandatory components of the ASA when conducting an audit or review in accordance with those standards.  Mandatory Components include: o Application o Definitions o Operative Date o Requirements o Objectives ASA 101.10  The auditor shall consider the whole text of an Auditing Standard to understand, interpret and apply the mandatory components.  Explanatory material include: o Conformity with International o Application Standards on Auditing o Introduction o Appendices o Application and Other Explanatory Material AUDIT OPINION s308 (1)  An auditor who audits the financial report for a financial year must report to members on whether the auditor is of the opinion that the financial report is in accordance with this Act, including: o S296: compliance with accounting standards o S297: true and fair view  If not of that opinion, the auditor’s report must say why INTERNATIONAL AUDITING STANDARDS  International Auditing Standards (ISA’s) – issued by the International Auditing and Assurance Standards Board (IAASB) o not legally enforceable in Australia OTHER STANDARDS  There are several other standards that affect assurance engagements: o APES 110 – Australian Code of Ethics for Professional Accountants o ASQCI – Quality Control for Firms that Perform Audit and Reviews of Financial Reports and Other

ASRE’s – cover review engagements on historical financial information ASAE’s – cover assurance engagements other than audits or reviews of history financial information covered by Australian Auditing Standards or Standards on Review Engagements OTHER DOCUMENTS  Two documents – no legal force but designed to explain concepts o Framework for Assurance Engagements o AUASB Glossary  

CORPORATE GOVERNANCE 

The phrase ‘corporate governance’ describes ‘the framework of rules, relationships, systems and processes within and by which authorities is exercised and controlled within corporations.”

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Most medium and large companies – all the listed companies have an audit committee Primary Link between the board of directors and the external auditor The board of a listed entity should have an audit committee which: o Has at least three members, all of whom are non-executive directors and a majority of whom are independent directors; and o Is chaired by an independent director, who is not the chair of the board

AUDIT COMMITTEE

FUNCTIONS  Review and make recommendations to the board in relation to: o Adequacy of the entity’s corporate reporting processes; o If financial statements reflect true and fair view of performance etc. o Appropriateness of accounting judgments o Appointment/Removal of the external auditor o Rotation of audit engagement partner o Proposal for the external auditor to provide non-audit services and whether it might compromise the independence of the external auditor. LEGAL LIABILITY  Auditor’s can be sued for breach of contract/negligence (3rd parties) by the company

NEGLIGENCE  

Any conduct which is careless or unintentional in nature and entails a breach of any contractual duty or duty of care in tort owed to another person or persons Elements the plaintiff must prove: o A duty was owed to plaintiff by defendant o A breach of the duty of care o Loss or damage was suffered by the plaintiff o Casual relationship (defendant + plaintiff)

ESANDA (law case)  The high court held that the auditor did not have a duty of care because their audit reports were not designed to induce a third party to do anything PRIVITY LETTERS  Privity Letter – letter from an auditor to a third party stating that they can rely on the audit report for a specific purpose.

CASES (EXAM) 1. Pacific Acceptance Case 2. AWA 3. Coffee Case

WEEK 2 – Risk, Error and Audit Process AUDIT RISK AUDIT RISK  Audit Risk – risk of giving the wrong audit opinion  Audits provide a reasonable level of assurance o This means that the best auditor cannot guarantee that their opinion is correct o Audit risk cannot be eliminated  The aim of an audit is to reduce audit risk to an acceptance level ENGAGEMENT RISK  Engagement Risk – risk of negative consequences if the wrong audit opinion is given o Legal Action  Damages  Loss of ability to conduct audits o Loss of Reputation  Inability to attract clients  Lower audit fees due to lower reputation RISK AND COST TRADEOFF  Reducing audit risk is a tradeoff o It reduces engagement risk and the costs associated with it o It costs more money because it requires more resources (staff costs) to conduct better audits  When designing an audit strategy, the auditor needs to assess when the benefits of reduced engagement are outweighed by the additional costs of more audit work (c/b analysis) AUDIT EFFICIENCY AND RISK BASED AUDITING  To reduce the audit risk at the lowest costs the auditor should audit as efficiently as possible  Risk Based Auditing Approach o Determine which parts of the financial statements are at most risk of material error o Concentrate the audit effort in those areas  Legally Mandated by the Australian Auditing Standards (ASAs)

AUDIT PROCESS 1. Accept/Decline the audit 2. Assess the risk of the client a. Business Risk – nature of the job b. Internal Controls – their design to prevent error 3. Collect sufficient appropriate audit evidence a. Test of Controls b. Substantive procedures 4. Form and issue an audit opinion

REASONS FOR DECLINING  Too risky – poor reputation for audit firms  Audit client’s competitors  Lack of expertise in area – industry specialization  Lack of staf  Low Fee $ TERMS OF AUDIT ENGAGEMENT  ASA 210 Agreeing the Terms of Audit Engagement  The auditor should only accept an audit engagement if management: o Accept responsibility for preparation of the financial report and for the internal control system of the company o Agrees to given the auditor access to all information and people ENGAGEMENT LETTER  Engagement Letter – where agreed terms of audit engagement are audited o The objective and scope of the audit of the financial report o The responsibilities of the auditor o The responsibilities of management QUALITY CONTROL ON AUDITS  There are three major standards on audit o ASQC Quality Control for Firms that Perform Audits and Reviews of Financial Reports and Others Assurance Engagements o ASA 220 Quality Control for an Audit of a Financial Report and Other Historical Financial Information o ASA 230 Audit Documentations  The AUASB has issued a standard to force firms to establish internal quality control systems o Standard on how to control an audit firm OBJECTIVE OF AUDIT FIRM  The objective of the firm is to establish and maintain a system of quality controls to provide it with a reasonable assurance that: o The firm and its personnel comply with AUASB Standards, relevant ethical requirements, and applicable legal and regulatory requirements; and o Reports issued by the firm or engagement partners are appropriate in the circumstance ELEMENTS OF QUALITY CONTROL  Leadership responsibilities for quality within the firm  Relevant ethical requirements  Acceptance and continuance of client relationships and specific engagements  Human Resources  Engagement Performance  Monitoring REQUIREMENTS  Establish policies and procedures to ensure that the element of control exists  Communicate these policies to all staff  Monitor and report on the effectiveness and compliance with the policies  Document the policies and their communication and enforcement

ENGAGEMENT PARTNER 

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Every audit is run by one engagement partner o Plans the audit o Manages the engagement team o Consults with client management o Forms the opinion o Signs the audit report On large audits, may be assisted by other partners

LEADERSHIP AND ETHICS  Should be responsible for quality on audit engagement  Should remain alert, through observation, and making enquiries for evidence of non-compliance  Should determine appropriate action if engagement team does not comply to ethics ACCEPTANCE AND CONTINUATION  Should be satisfied that appropriate acceptance and continuance procedure of client relationships  Should inform the firm if information arises suggesting that they should decline the firm ENGAGEMENT TEAMS  The engagement team (and auditor’s experts) should have the appropriate competence to: o Perform the audit engagement in accordance with ASA, ethic, legal and regulatory o Enable an auditor’s report that is appropriate in the circumstances to be issued ENGAGEMENT PERFORMANCE  The engagement partner shall take responsibility for: o The direction, supervision and performance of the audit engagement in compliance with ASA, ethical, legal and regulatory o The auditor’s report being appropriate in the circumstances

DOCUMENTATION 

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Auditors need to document their work o Each individual document is called a “workpaper” o The complete set of “workpapers” is called an audit file Documents can be stored on paper or in electronic form

OBJECTIVE OF DOCUMENTATION  Audit documentation that meets the requirements of this Auditing Standard and the specific documentation requirements of other relevant Australian Auditing Standards provides: o Evidence of the auditor’s basis for an conclusion about the achievement of the overall objective of the auditor; and o Evidence that the audit was planned and performed in accordance with Australian Auditing Standards and applicable legal and regulatory requirements REQUIREMENTS  The auditor should prepare ‘easy-to-understand’: o Nature, timing, extent of audit procedures o Results of audit procedures performed o Significant matters arising during audit and professional judgments

AUDIT ASSERTIONS 

Audit assertions are properties of… that must be true, for the account balance, transaction or disclosure to be correctly stated: o An account balance o A set of transactions o A disclosure in the financial statements

ASSERTIONS, RISK AND ERRORS  Every error relates to one or more assertions of a particular account or disclosure  Every risk that can cause an error must relate to one or more assertions  To find all the errors, EVERY assertion must be tested for EVERY account and disclosure. ASSERTIONS: CLASSES OF TRANSACTIONS + EVENTS, RELATED DISCLOSURES: 1. Occurrence – transactions recorded have actually occurred 2. Completeness – transactions that should have been recorded are included 3. Accuracy – amounts/data have been recorded/measured appropriately 4. Cut-of – transactions recorded in correct accounting period 5. Classification – transactions/event recorded in proper accounts 6. Presentation – transactions/events are properly aggregated, clearly described etc. ASSERTIONS: ACCOUNT BALANCES, RELATED DISCLOSURES 1. Existence – assets, liabilities and equity interests exists 2. Rights and Obligations – holds control of right to assets etc. 3. Completeness – transactions that should have been recorded are included 4. Accuracy, valuations and allocation – recorded/measured appropriately 5. Classification – assets/liabilities recorded in proper accounts 6. Presentation – transactions/events are properly aggregated, clearly described etc.

MATERIALITY 

Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonable be expected to influence the economic decision of users taken on the basis of the financial report

REQUIREMENTS  Audit Strategy – determine materiality as a whole PLANNING MATERIALITY  Auditors set a planning materiality threshold for the financial statements as a whole  This is a percentage of the financial statement figure that is most important to the user o Maximum aggregate error that is allowable before the financial statements become materially misstated o Figure is used to decide on the nature and extent of audit evidence that will be collected MATERIALTY AND ERRORS  Material misstatements can be caused in two ways: o An individual error is material by itself o A number of small errors are immaterial by themselves but together result in material misstatement  As a result, auditors need to keep a list of immaterial errors to see if they result in material misstatement

INVERSE RELATIONSHIP  There is an inverse relationship between planning materiality and risk o Higher risk client, Lower planning materiality o Lower risk client, Higher planning materiality 

Low Planning Materiality o Require smaller (aggregate) errors o Require more evidence to be acceptable o More costly audit

PERFORMANCE MATERIALITY  Performance Materiality – amount set by the auditor less than materiality for the financial report to reduce an appropriately low level probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial report as a whole.  Acts as a buffer for misstatements that are not detected  Performance Materiality < Planning Materiality MATERIALITY ISSUES  Materiality is based on judgment o Quantitative materiality estimates are just guidelines  Quantitative figures are useless for evaluating, the materiality of non-numeric disclosures e.g. contingencies  Statutory disclosures are always material  Some items might be material even if they are numerically small e.g. exam

WEEK 3 – BUSINESS RISK LEARNING OBJECTIVES The aims of this lecture are:  To discuss the requirements to perform risk assessment procedures  To discuss business risk and its link to financial statement errors  To discuss the qualitative and quantitative factors that auditors examine when assessing business risk

RISK ASSESSMENT PROCEDURES 

Risk Assessment Procedure provides a basis of identification/assessment of risk of material misstatement and assertion levels. o Risk Assessment does NOT provide sufficient audit evidence for audit opinion

IDENTIFYING AND ASSSESSING RISK  The auditor shall identify and assess the risk of material misstatement at… to provide a basis for designing and performing further audit procedures o Financial Report level o Assertion level for account balances, classes of transactions and disclosures  For this purpose, the auditor shall: o Identify risk – including relevant controls (relate to risk) and consider classes of transactions, account balances and disclosures. o Assess the identified risks – evaluate if they are for the whole report or many assertions o Relate identified risk – what can go wrong at the assertion level o Likelihood of misstatement – possibility of multiple mistake or potential material mistake PROCEDURE 1. Enquiries of Management – Payroll? Employees? 2. Analytical procedures (Quantitative Techniques) – ratios 3. Observation and Inspection – personally inspect factory Note: Auditors must actively collect evidence, use professional judgment and document evidence for proof of opinion and judgment.

BUSINESS RISK 

Business Risk – risk resulting from significant conditions, events, circumstances, actions or inactions that could adversely afect an entity’s ability to achieve its objectives and execute its strategies, or from the setting of inappropriate objectives and strategies.

BUSINESS RISK AND ERROR  Business risks are the sources of error  If you can identify where business risks are, you have a better chance of finding errors o Poor Financial performance – likely to manipulate financial figures o Rapidly changing industry – more likely to have over valuated assets e.g. tech

SOURCES OF BUSINESS RISK  External o Laws and Regulations  Laws, Specific Industry Regulations, Labour Laws, Environmental Laws etc. o Economic Conditions  Interest rates, Inflation, Unemployment, FOREX o Market Conditions  Demand, Competitors, Industry Structure, Technological Changes  Internal o Business Structure and Operations  Nature of Revenue Sources, products ...