Auditing Final Exam Notes PDF

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Lecture Week 1 Chapter 1 Framework: Assurance Engagement Preparer Preparer can be anyone who prepares financial statements on a subject matter (e.g. a CFO or CEO or management). Subject Matter The subject matter is prepared to be used by the user, and they need to assess the reliability of the subject matter. Practitioner

And so they appoint an assurance service provider, a practitioner, who would have experience in the subject matter and would be completely independent of the entity.

Users

Users want a level of confidence on the subject matter. The practitioner would evaluate the subject matter to see if it complies with the relevant criteria (i.e. accounting standards).

Assurance Report Practitioner will then collect evidence that the criteria is being met and based on this evidence they will provide an assurance report which is provided to the user (not the preparer) and this can be used for decision making. Levels of assurance Two types of levels of assurance, Direct – no claims by client but simply giving an opinion Attest – to verify a claim made by the client that has been measured Level of confidence The report can have 3 different levels of confidence: limited – Have undertaken some procedures and nothing has come to the auditors attention that there are misstatements/errors. It is a negative way of assuring user and emphasizing that only some (not detailed) procedures have been undertaken. This is not possible in final year reports but can be used as a review engagement for interim reports. reasonable – found in any annual report and the message is that users are reasonably assured. Includes complying with all auditing standards, have undertaken auditing on a risk come risk basis, tests undertaken and minimized risk of failing auditing to a very low extent and can reasonably assure users that financial statements are true and fair in their presentation and comply

with accounting standards. This is the only satisfactory level for an audit engagement. absolute – 100% guarantee of no misstatement, fraud, etc. (this is not possible as most financial reporting is based on fair values and so is not 100% accurate, or if checking a sample you can’t be certain there is no error in the whole population, and it is not expected that an auditor can detect some fraud)

Review vel of confidenc Audit

Preparer

Limited Reasonabl e Absolute

User

Direct Assurance

Attest

evidence Subject matter

evaluate

Practitione r

Criteria Independen Expertise

Assurance Engagement - An engagement in which a practitioner aims to obtain sufficient appropriate evidence in order to express a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the measurement or evaluation of an underlying subject matter against criteria.

Non-Assurance Engagement – for an advisory service - includes an agreed upon procedure engagement in which tests and procedures are undertaken and the findings are presented to client. Auditing - To obtain reasonable assurance about whether the financial reports as a whole is free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial report is prepared, in all material respects, in accordance with an applicable financial

reporting framework; and to report on the financial report, and communicate as required by the ASAs, in accordance with the auditor’s findings (ASA 200)

Principles Ethical Principles (APES110 code of ethics ): • integrity Section 110 • objectivity (independent, unbiased) Section 120 • professional competence and due care Section 130 • confidentiality Section 140 • professional behavior Section 150 Fundamental Auditing Principles: • knowledge • responsibility • quality control • rigour and skepticism • evidence • professional judgment • documentation of engagement • communication (with management, BOD, audit committee, ASIC) • association (e.g. with illegal businesses) • reporting Audit Expectation Gap The gap between perceived audit performance by society and society’s expectations of auditors. There are often unreasonable expectations by society of an auditor’s performance. Part of the reason of the gap is due to a deficiency in standards to what is required as opposed to what is expected (reasonableness gap). There is a difference between the auditor’s duty and standards and this is due to deficient performance by auditors in failing to meet standards.

Unreasonable expectations – gap between what society expects auditors to achieve and what they can reasonably be expected to accomplish Deficient Standards – gap between duties that can reasonably be expected of auditors and auditor’s existing duties as defined by law and professional promulgations, Deficient Performance – gap between the expected standard of performance of auditors existing duties and the perceived performance of auditors

Lecture Week 2 Chapter 3 American Accounting Association Model (AAA) 1. Determine the facts 2. Define the ethical issues 3. Identify the major principles, rules and values 4. Specify the alternatives 5. Compare values and alternatives 6. Assess the consequences 7. Make your decisions Threats & Safeguards Section 200.3 Threats fall into one or more of the following categories: (a) Self-interest; (b) Self-review; (c) Advocacy; e.g. firm promoting shares in an audit client (d) Familiarity; and (e) Intimidation Section 200.9 Safeguards that may eliminate or reduce threats to an Acceptable Level fall into two broad categories: (a) Safeguards created by the profession, legislation or regulation; – education and training

– continuing professional development – professional standards – regulatory monitoring and disciplinary process (b) Safeguards in the work environment – discuss with supervisor – dispose off the interest – do not accept the engagement – get an independent review of the work – removing the person from the engagement – separate teams: assurance and non-assurance – no involvement in any decision-making capacity for the client Section 210 – Accepting a new client, requires evaluating a new client to determine if there are any threats under Section 200.3 and apply any safeguards if needed under Section 200.9 Section 240 – Fees and other remuneration should be commensurate with service provided and must not quote too low fees (avoid low-balling where quote low fees then later attempt to recoup fees by increasing fees), make client aware of how they are being charged and should enter into a fee arrangement that may compromise auditor independence. Section 260 – Gifts

Auditor Independence Section 290 – Independence Should be independent in appearance(perception of independence) and of mind (actually be independent) to justify that you have been objective in completing the audit Threats to auditor independence: • Auditor employment relationships – Member of the assurance team cannot be employed by the client. – Two year restriction for a retired/resigned audit partner to join a client – If one former partner is already working for the client, the restriction is 5 years • Financial and business relationships, including: – investments in audit clients (Direct and indirect) – loans to and from clients (Financial institutions vs others) – business relationships (Significant?) – goods and services from clients (Arms-length) • Provision of non-audit services • Fees from clients must be collected promptly (before the issue of a subsequent audit report). Overdue fees may create a selfinterest threat. • Overdue for more than 2 years may be considered a loan to the client

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When total fees generated from a public listed client represent a large proportion of the auditor’s total fees (i.e. more than 15% of the audit firm’s total fees), real or perceived financial dependency on that client may create a self-interest or intimidation threat- apply safeguards. Audit clients must disclose in the financial report the amount of fees paid to the auditor, split between audit and non-audit services.

Lecture Week 3 Chapter 4 Assertions – representations made by management, that are embodied in the financial report, as used by the auditor to consider the different types of potential misstatements that may occur. Audit Procedures (or Audit Tests or Audit Effort) – Methods used by the auditor to gather and evaluate audit evidence – Audit tests can be to test controls or number testing (i.e. test transactions, account balances, presentations and analytical procedure) Audit Evidence – information obtained by the auditor in arriving at the conclusions on which the auditors opinion is biased. When Risk of Material Misstatement (RMM) required until Audit Risk is at a low level

then Audit Effort

When Risk of Material Misstatement (RMM) required until Audit Risk is at a low level

then Audit Effort

Risk of Material Misstatement can be at: Overall Financial Reporting Level OR Individual Assertion Level (Account Level) Inherent Risk Control Risk

OR

Assertions Income statement items/Transactions (e.g. for sales accounts, expenses, income, revenue): • Occurrence – transactions and events that have been recorded have occurred and pertain to the entity • Completeness – all transactions and events that should have been recorded have been recorded • Accuracy – amounts and other data relating to recorded transactions and events have been recorded appropriately • Cut-of – transactions have been recorded in the correct accounting period • Classification – transactions and events have been recorded in the proper accounts Balance sheet items (at period end): • Existence – assets, liabilities and equity interests actually exist • Rights & Obligations - entity holds or controls the rights to assets and liabilities are the obligations of the entity

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Completeness – all assets, liabilities and equity that should have been recorded has been recorded Valuation & Allocation – assets, liabilities and equity interests are included in the financial report at appropriate amounts and any resulting valuation adjustments are appropriately recorded

Presentation & disclosure items: • Occurrence and rights and obligations – disclosed events, transactions and other matters have occurred and pertain to the entity • Completeness – all disclosures that should be included in the financial report have been included. • Classification and understandability – financial information is appropriately presented and described, and disclosures are clearly expressed. • Accuracy and valuation – financial and other information is disclosed fairly and at appropriate amounts Audit Procedures Inspection – examination of documents, records or tangible assets Observation – observing the behavior of operating personnel and the functioning of the business in operation; looking at a process or procedure being performed by someone else External confirmation – audit evidence obtained as a direct written response to the auditor from a third party Recalculation – checking mathematical accuracy of documents or records, proven by recalculating the results. Re-performance - auditor may independently execute procedures or controls that were originally performed as part of the entity’s internal controls; e.g. dummy transaction Analytical Procedures – investigation and analysis of fluctuations and relationships to determine whether there are inconsistencies with other relevant information or deviations from predicted amounts; e.g. sales goes down but profit goes down (analyse this) Enquiry – auditor may ask questions and can include interviewing or obtaining statements from management and employees; e.g. internal control questionnaire. Audit Trail A chain of evidence provided by coding, cross-references and documentation that connects account balances and other summary results with original transaction data. Tracing (e.g. for testing Completeness) Origin Recording

Final

Vouching (e.g. for testing Existence/Occurrence) Audit Evidence

Evidence must be sufficient (i.e. quantity/sample size must be enough) and appropriate (i.e. it is reliable and relevant)

Audit Risk Model Risk that an auditor will give an inappropriate audit opinion when the financial report is materially misstated Audit Risk = Risk of material misstatement + Detection Risk (ASA 200 para A34) Components of Audit Risk Model: Inherent risk – susceptibility of an assertion to material misstatement given inherent and environmental characteristics, but without regard to control procedures; e.g. complexity of underlying transactions Control Risk – function of the effectiveness of the design, implementation and maintenance of internal control by management to address identified risks that threaten the achievement of the entity’s objectives relevant to preparation of the entity’s financial report. Internal controls can only reduce but never eliminate risks of material misstatement - due to possibility of human error. Detection Risk – Risk that auditors’ substantive procedures will lead auditor to conclude no material misstatement exists when, in fact, one does. During planning phase of audit, a planned acceptable level of detection risk is determined. Audit Risk – some misstatements will exist but clean bill of health is given; i.e. a combination of inherent risk, control risk and detection risk. Combined Risk Assessment:

Business Risk – Risk that an entity’s business objectives will not be attained as a result of external and internal factors, pressures and forces brought to bear on the entity. Materiality (ASA 320) is defined as information, individually or in aggregate, that if misstated or omitted from a financial report may adversely affect decisions about the allocation of scarce resources made by financial report users.

Lecture Week 4 Chapter 5 Decide: • Should I accept the client? • Should I continue? – evaluate client on ongoing basis • Prepare engagement letter o contact person o fees structure o using client internal audit or experts o if expertise from outsiders are required Planning: • Understand the client o External o Internal o Financial o Controls • SWOT analysis • Identify Business Risks • Assess the impact of Business Risk (BR) on financial statements o i.e. risk of material misstatement at an, – overall financial report level – assertion level • Determine appropriate audit strategy • Prepare an audit plan Engagement Letter Letter that documents and confirms the auditor’s acceptance of the appointment, – the objective and scope of the audit – the extent of the auditor’s responsibilities to the entity – responsibilities of management – identification of the applicable financial reporting framework – form and contents of any report, and statement that there may be circumstances in which a report may differ from its expected form and content Audit Planning • To develop an efficient and effective audit: – devote attention to important areas – identify areas of potential problems – supervision of staff and review of work, who to contact for consultations – organize and manage audit – select audit team members and assignment of tasks – coordinate with internal auditors, experts or other third parties • Determines the scope of the audit

Audit Planning Risk Assessment Process Understand the entity

Identify Risks

Assess Risks

Respond to risks

Understand the entity EXTERNAL ENVIRONMENT: • Regulatory: o Taxation – subsidies, relief from tax, additional taxes o Import/Export – are channels open, scope available to improve or threats o Government Incentive o Environmental Pressure o Accounting Framework • Industry: o Growth – prospects o Competition – market share of client, monopolistic practices o Barriers to entry – easy to join or many restrictions o Generally accepted norms – not legalized but accepted norm that companies behave in particular manners o Capital or Labour Intensive o Substitute Products – competition with substitutes o Industry developments • External Environment: o Economic growth o Currency, stock market volatility o Fluctuations in prices – is the product reasonably priced o Interest Rates o Consumer sentiment o Availability of finance ENTITY SPECIFIC: • Operations: o Product lines – is risk spread over multiple product lines o Location of facilities – how many, and where are they located, overseas (what is happening overseas if there are any – e.g. civil unrest) o Markets – where o Key customers and suppliers – major suppliers and customers information needs to be known o Internet (online) platform o Employment arrangement, union contracts – if staff is main asset there will be union agreements etc. • Financing and Investment: o Current and future projects – how much is invested in current projects, how much is needed for the future o Use of financial instrument – complexity of valuations and modeling risks o Debt and equity structure – is it highly geared o Investments – long term or short term

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Reporting: o Accounting policies – which assets/liabilities may be problematic depending on the industry, are standards clear or are they able to be manipulated o Unusual or complex transactions o Foreign currency assets, liabilities or transactions o Fair Value Controls: o Tone at the top level management – overall controls o Risk assessment procedures – how does the entity assess their own risks o Internal audit dept. – who do they report to o Data processing system o Control activities

Analytical Procedures • Trend • Operational performance • Relationships between accounts • Compare with industry averages, competitors, previous year performance, budgets, etc. Simple Procedures: Complex Procedures: • ratio analysis • time series modeling • simple comparisons • regression analysis • time series analysis • financial modeling • trend statements Ratios: Short Term Liquidity Ratios: • Current Ratio – high ratio (benchmark 2:1, assets : liabilities) indicates entity’s ability pay current debt obligations; high ratio means there are more current assets over current liabilities . = Current Assets Current Liabilities • Quick Asset Ratio – same as current ratio but does not include inventory and can help identify if there is an inventory account risk = Liquid Assets . Current Liabilities • Operating Cash Flow Ratio – provides a longer term measure of entity’s ability to meet current liabilities by using cash flows instead of current assets to meet current liabilities; higher is better/more able to meet obligations =.Cash flow from operations Current Liabilities Activity Ratios: • Receivables Turnover Ratio – indicates how many times accounts are turned over in a year (can also use days in receivables ratio – how many days it takes to collect sales revenue); higher ratio is more desirable • Inventory Turnover Ratio – indicates how many times inventory is turned over in a year; if it is low it means

inventory is not selling quickly, and could be misstated or valued incorrectly Profitability Ratios: • Gross Profit Ratio – provides an indication of company’s product pricing and product mix (inventory account errors can distort ratio due to COGS) • Net Profit Ratio – measure profitability after all expenses are considered; significant fluctuations of this ratio may indicate misstatement in expense accounts and auditor may need to increase their testing of these accounts. • Solvency Ratios: • Debt to Equity Ratio – higher the ratio, the higher the gearing/debt, this can determine against the industry average whether the entity will be able to acquire more debt in the future or not (i.e. can be a risk) • Times Interest Earned Ratio – higher ratio is better as it means profits are high, and debt can be paid off (compare against D/E Ratio, especially if they don’t follow the same trend) Id...