Audit Exam revision lecturers wk 5-9 PDF

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Week 5 Lecture 1Materiality (ISA 200) Audit objective “To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion....” In general, “misstatements, including om...

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Week 5 Lecture 1 Materiality (ISA 200) Audit objective “To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion….” In general, “misstatements, including omissions, are considered to be material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements. Judgments about materiality are made in the light of surrounding circumstances, and are affected by the auditor’s perception of the financial information needs of users of the financial statements, and by the size or nature of a misstatement, or a combination of both” (IFAC, ISA 200) Materiality It is a quantitative (amount) assessment and a qualitative (nature) assessment. IAASB has increased the emphasis on disclosure notes – not just the financials Examples from ISA 320 where the auditor may disregard quantitative materiality but qualitative must be considered: 1. When law, regulation or the applicable financial reporting framework affect users’ expectations regarding the measurement or disclosure of certain items e.g. related party transactions, and the remuneration of management 2. The key disclosures in relation to the industry in which the entity operates (for example, research and development costs for a pharmaceutical company). 3. Whether attention is focused on a particular aspect of the entity’s business that is separately disclosed in the financial statements (for example, a newly acquired business). Materiality (ISA 320) Examples from recent annual reports: Tesco Plc – 5% of normalised profits = £50m which represented 0.8% of Net Assets. Performance materiality £25m RBS Plc – 0.5% of Net Assets = £270m (=5% of loss). Couldn’t use profits/losses due to volatility since financial crisis. Low % as new auditors. Performance materiality £135m. Topical see http://blog.frankfurt-school.de/tesco-case-materiality-kicks-back/

Nature of Material items • The amount involved – as noted above, large amounts tend to be treated as material • The nature of the account balance – certain balances are inherently problematic and any misstatement could be treated as material – directors’ salaries or bonuses • The nature of the misstatement – was the misstatement an obvious error or was there a deliberate attempt to deceive? EVALUATION OF MISSTATEMENTS IDENTIFIED DURING THE AUDIT (ISA 450) The auditor shall accumulate misstatements identified during the audit, other than those that are clearly trivial. The auditor may designate an amount below which misstatements would be clearly trivial and would not need to be accumulated because the auditor expects that the accumulation of such amounts clearly would not have a material effect on the financial statements. “Clearly trivial” is not another expression for “not material”.(IFAC, ISA 450) Professional judgement (ISA 200) The application of relevant training, knowledge and experience in making informed decisions such as: Materiality for an audit Audit risk of an audit engagement The nature, timing and extent of audit procedures needed on an audit Evaluating if enough sufficient and appropriate evidence has been obtained Documenting judgements that have been made Professional Scepticism (ISA 200) Have a questioning mind – a requirement of ISA 200 Be critical and be alert to: → Audit evidence contradicting other evidence → Information questioning the reliability of evidence → Indications of fraud → Indications that other audit procedures are required (over and above those required by ISA’s) Don’t overlook unusual circumstances Don’t over-generalise conclusions Don’t use inappropriate assumptions

Need for audit sampling You are shopping in a local supermarket Visualise the contents of your basket How many people are in the store? How many check-outs are operating? How long were you there? How many people went through the store before / after you? What about the other 364 days of the year? How many transactions occur in the year? Need for audit sampling • Auditors can’t test everything • Hence the need for sampling Audit Sampling ISA 530 -Definition ‘The application of audit procedures to less than100% of items within a population of audit relevance such that all sampling units have a chance of selection in order to provide the auditor with a reasonable basis on which to draw conclusions about the entire population..’ ‘The objectives of audit sampling is to provide a reasonable basis for the auditors to draw conclusions about the population from which the sample is selected.’ Sampling Sampling and testing is only one form of gathering sufficient appropriate audit evidence. Could also use: Observation Analytical review Third party verification Use of experts Sampling risk • The risk that the auditor’s conclusion based on a sample may be different from the conclusion if the entire population were subjected to the same audit procedure. • Auditors need to evaluate that risk and decide what level of risk is acceptable – it is a component of detection risk.

• Lowering acceptable detection risk usually means higher sample sizes to achieve the overall desired audit risk Sampling risk is the element of uncertainty that enters into the auditor’s conclusions anytime sampling is used. There are two types of sampling risk. Risk of incorrect rejection (Type I) – in a test of internal controls, it is the risk that the sample supports a conclusion that the control is not operating effectively when, in fact, it is operating effectively. In substantive testing, it is the risk that the sample indicates that the recorded balance is materially misstated when, in fact, it is not. Risk of incorrect acceptance (Type II) – in a test of internal controls, it is the risk that the sample supports a conclusion that the control is operating effectively when, in fact, it is not operating effectively. In substantive testing, it is the risk that the sample supports the recorded balance when it is, in fact, materially misstated. Audit testing ISA 500 ISA 500 gives three ways of selecting items for testing : 1. Selecting all items (100%) → high value items such as land and buildings → directors emoluments and loans → unusual items → high risk items 2. Selecting specific items → High value / key items (items that are suspicious, unusual, particularly risk-prone or that have a history of error) - note this is not sampling 3. Sampling- ISA 530 a representative selection of balances and transactions are audited because of time, cost and practical considerations. Audit testing - Key terms Population - The entire set of data from which a sample is selected and about which the auditor wishes to draw conclusions Statistical sampling – An approach to sampling that has the following characteristics: (i) Random selection of the sample items; and

(ii) The use of probability theory to evaluate sample results, including measurement of sampling risk. A sampling approach that does not have characteristics (i) and (ii) is considered non-statistical sampling. Sampling risk – The risk that the auditor’s conclusion based on a sample may be different from the conclusion if the entire population were subjected to the same audit procedure. Audit testing - Key terms Non-sampling risk – The risk that the auditor reaches an erroneous conclusion for any reason not related to sampling risk. Sampling unit – The individual items constituting a population. Stratification – The process of dividing a population into sub-populations, each of which is a group of sampling units which have similar characteristics (often monetary value). Design and Process of Sampling/Testing • Define errors in advance? What are their size and incidence? • Consider what is the maximum error / tolerable misstatement in the population that you are willing to accept (materiality)? (general rule - the lower the level, the greater the sample size) • Plan the sample. • Why are you doing this test – what is the purpose? • What is the characteristics of the population? (i.e., a receivables listing, sales, sales invoices, supplier statements, and goods received notes) • Can the population be stratified? Can you divide the population into sub-populations with similar characteristics? (i.e., select items, test, and evaluate) Define errors in advance? What are their size and incidence? Consider what is the maximum error / tolerable misstatement in the population that you are willing to accept (materiality)? Tolerable error is the maximum error in the population that auditors would be willing to accept and still conclude that the result from the sample has achieved the audit objective. Tolerable error is considered during the planning stage and, for substantive procedures, is related to the auditors' judgement about materiality. The smaller the tolerable error, the greater the sample size needs to be.

Define errors in advance? What are their size and incidence? Consider what is the maximum error / tolerable misstatement in the population that you are willing to accept (materiality)? Expected error If auditors expect errors to be present in the population, a larger sample than when no error is expected ordinarily needs to be examined to conclude that the actual error in the population is not greater than the planned tolerable error. Smaller sample sizes are justified when the population is expected to be error free. Examples of errors Tests of control - an unsigned despatch note. Substantive tests - items of stock wrong by more than £100. A miss-posting of an invoice to the wrong receivables account - is not an error if it is a test of the value of receivables & it may be an error if it was to verify bad and doubtful debts. Types of sampling • Judgemental Sampling - alternative to statistical based formula (accepted by ISA) whereby you choose a sample subjectively using the auditor’s own judgement. • Haphazard sampling (also not statistical) - no structure to picking the sample but can be used if the sample is representative of population. • Statistical sampling – has to be applied to a homogeneous population (similar in size and the transaction types are similar so that all sampling units have a chance of selection) Statistical Sampling For a sample item to be representative it must: → Equal chance. → Representative. → Not predictably by the client. → Same internal controls. Statistical Sampling Selection methods include: Random selection- i.e. use random number tables Systematic/ Interval selection- use a random start and then have a constant interval between sample points- can be used if there are no patterns in the population Cluster or block sampling- choose a cluster of items e.g. all the GRNs from one depot. May not be representative though.

Monetary Unit Sampling (MUS) or value weighted selection- monetary units, not items, are the population. Monetary Unit Sampling (MUS) Most commonly used technique for substantive testing. MUS takes each £1 of the population as the sampling unit A sample size is arrived at statistically (later) The results are projected to the number of £1s in the population starting from a random generated £ It is very suited to populations where items in the population have very different values. Monetary Unit Sampling (MUS) Larger balances have a greater chance of being selected Individually material items will be selected. It automatically stratifies the population. Sample size takes into account the size of the population It enables conclusions to be drawn on small sample sizes where no or only a few errors are expected. If few errors are expected, a lower sample size will generally be required than if variables sampling was used. Tomorrow! • Sample size • Computer-Assisted Audit Sample sizes Auditors should collect sufficient appropriate audit evidence The bigger the sample size, the greater the confidence that sufficient evidence has been collected Sample sizes depend on judgement: → Level of confidence (from test) → Acceptable error rate:→ Tolerable misstatement - a monetary amount set by the auditor that should not be exceeded by actual misstatement in the population (same or lower than performance materiality) → Tolerable rate of deviation -for control procedures, rate of deviation set by auditor is not exceeded by actual rate in the population (monetary amount irrelevant)

Sample sizes The sample size is determined by: 1. The size of the population/ number of items (populations over 5000 in size do not greatly affect the sample size) 1. The level of confidence or assurance required from the test (normally 95%) → determined by the inherent risk and control risk → and is the reciprocal of risk i.e. if we want 95% assurance, then we are willing to accept a 5% risk that the sample is not representative. 2. The number of high value / material items

Confidence level is the complement of sampling risk. The auditor may set sampling risk for a particular sampling application at 5 per cent, which results in a confidence level of 95 per cent. Sample size • Determine acceptable confidence level • Determine the acceptable / tolerable error rate • Sample size = Reliability factor • Tolerable error rate • Reliability factor (statistically) calculated and it is the amount of assurance the auditor wishes to draw from the test Define errors in advance? What are their size and incidence? Consider what is the maximum error / tolerable misstatement in the population that you are willing to accept (materiality)? Tolerable error is the maximum error in the population that auditors would be willing to accept and still conclude that the result from the sample has achieved the audit objective. Tolerable error is considered during the planning stage and, for substantive procedures, is related to the auditors' judgement about materiality. The smaller the tolerable error, the greater the sample size needs to be. Define errors in advance? What are their size and incidence? Consider what is the maximum error / tolerable misstatement in the population that you are willing to accept (materiality)? Expected error If auditors expect errors to be present in the population, a larger sample than when no error is expected ordinarily needs to be examined

to conclude that the actual error in the population is not greater than the planned tolerable error. Smaller sample sizes are justified when the population is expected to be error free. Sample size Example Max risk auditors prepared to risk 20% therefore confidence level is 80% Expected error rate = 1 Tolerable error rate = 4% (i.e. 4/100) Sample size = Reliability factor Tolerable error rate = 3.00 = 75 items 0.04 Statistical Sampling Advantages → scientific → defendable → mathematically based → efficient → can use lower grade staff → makes auditors explicitly state their judgements on confidence levels, expected error rates and tolerable error rates. Disadvantages → not always understood → audit judgement appears to take second place (but how did we arrive at confidence levels if not using judgement?) → inflexible → Does not incorporate the fact that several attributes of a transaction / balance / document can be tested at the same time → documents have to be held in a manner such that they can be separately identified Evaluating results • Exclude anomalies – must establish if not representative of deviations or misstatements • Identify nature and cause of deviation or misstatement e.g. bank rec not performed one week as accountant on leave. If can corroborate this exception, then control may still be relied on.

• Substantive tests – project misstatements onto population to determine the potential effect on the audit assertion being tested – is that class of transaction or account balance materially misstated?

Week 7 lecture1 Final Audit (ISA 500)  Perform substantive procedures (tests to discover material errors or omissions) • Errors – result can be over or under statement • Omissions – result in understatement  Consider direction of test Error – start with accounting records and trace back to source documents Omission – start with source document and trace to accounting records Statement of Financial Position – Reminder of Assertions COVED – Completeness – Rights and Obligations (ownership) – Valuation – Existence – Disclosure • Property, Plant and Equipment (‘PPE’) – Inherent risks • Technology • Net realisable value if a part of the business is closed • Useful lives • Revaluations • Assets under construction and capitalised costs • Borrowing costs for items constructed • Moveable high value assets • Intangible assets • Non-maintenance Property, Plant and Equipment (‘PPE’) – Controls What are the controls over • Ordering new assets and capital/revenue treatment • Revaluations • Safeguarding assets and recognising impairments

• • • •

Disposals of assets Maintenance and insurance Authorisation and review of depreciation charges Approval of PPE budget

Property, Plant and Equipment (‘PPE’) – Substantive Procedures General • Verify opening balances to last years papers • Reconcile PPE register to general ledger and financial statements • Perform tests from the PPE register • Verify acquisitions/ disposals/ year-end fixed assets Specifically • Completeness – all additions and disposals have been recorded and all assets recorded are in use at year end • Rights and Obligations (Ownership) - entity has rights to assets purchased in year and all assets in the on Financial Statements Property, Plant and Equipment (‘PPE’) – Substantive Procedures Specifically • Valuation - all PPE at Cost or Value less Acc. Dep’n and additions/disposals correctly recorded • Existence - assets in Financial Statements represent those in use at Y/E • Disclosures - are in accordance with accounting standards PPE Completeness • Sample for mis-postings; correct period, correct account (e.g. depreciation) • Review of minutes (which also checks authority for the purchase or disposal) • Verify of all large items in the cash book/ bank statement for completeness of additions and disposals • Review repairs and maintenance account • Compare budget against actual expenditure • Sample of physical assets to PPE register PPE Rights and Obligations (Ownership) • Verify with the land registry for registered land • Inspect title deeds and leases • Inspect motor registration documents • Check with solicitors for title deeds held

• Examine invoices, leases, contracts for purchases PPE Valuation • Check cost against invoices, • Verify any write downs to authorisation, • Obtain third party expert evidence of revaluations – consider reasonableness and in line with accounting standards (IAS 16 and IFRS 13). • Re-perform depreciation calculations and review reasonableness of depreciation policy and agrees with policy. • Consider residual values - appropriate? • Re-perform disposals calculations and verify against documentation. PPE Existence • Perform a physical inspection ,concentrate on high value and additions [they exist, are in use, are in good condition, serial numbers etc.] • Confirm that assets are actually used in the business • Inspect official documents such as title deeds • Obtain supplementary evidence such as property tax/rate demands, insurance premiums. PPE Disclosures • Check consistency with prior years • Check in accordance with accounting policies and standards including FRS 102 or IAS 16 and IFRS 13 • Check with lenders for mortgage agreements, to see if secured or unsecured Intangible Assets Intangible assets include • Development Costs • Patents, Trademarks, licences, concessions etc. • Goodwill – if purchased on an acquisition Intangible Assets - Research and Development costs Research costs – written off Development costs – can be capitalised if • Project technically feasible • End product to be used / sold • There is a market

• The resources exist to complete the project Intangible Assets - Trade marks, patents etc. Capitalise and write off over useful life • Confirm renewal fees have been paid • Confirm still current and in the name of the client • Confirm with Patent Agent (if applicable) Intangible Assets - Goodwill...