Chapter 3 auditing PDF

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Chapter 3 3.11

Explain the relationship between the risk assessment, risk response and r reporting phases of an audit.

The risk assessment phase is the first stage of an audit. During this phase the auditor adopts a broad view of the client as a whole and the industry in which it operates. The auditor focuses on gaining an understanding of the client during this phase in order to plan the audit. The auditor has to consider the risk of material misstatement in the client’s financial report. Where the risk assessment is higher, the auditor will usually plan to spend more time and/or do more extensive testing. The risk assessment phase includes gaining an understanding of the client, identifying significant accounts and transactions, setting planning materiality, identifying the factors that can go wrong in the audit, gaining an understanding of key internal controls and developing an audit strategy. The risk response phase is when the auditor does the detailed testing work for the audit (based on the results of the risk assessment phase). The reporting phase is when the auditor completes their work and issues the appropriate audit report 3.21

What does it mean when we say that a business is a ‘going concern’ or, alternatively, has ‘going concern issues’? Why must an auditor specifically consider evidence about the going concern assessment for each client?

ASA 570 (ISA 570) states that under the going concern assumption, an entity is viewed as continuing in business for the foreseeable future. It also notes that a general purpose financial report is prepared on the going concern basis, unless management intends to liquidate the entity or to cease operations, or has no realistic alternative but to do so. When the going concern assumption is appropriate, assets and liabilities are recorded on the basis that the entity will be able to realise its assets and discharge its liabilities in the normal course of business. Therefore, if the going concern basis is not appropriate, the management should prepare a special purpose report which reflects that state. ‘Going concern issues’ mean that there is doubt about the going concern assumption’s applicability to the client’s financial report, and if these doubts are serious enough, the entity should prepare a special purpose report. The auditor must consider evidence about the appropriateness of the going concern assumption for the client in order to express the appropriate audit opinion. If there is not sufficient evidence to support the assumption, the auditor cannot issue an unqualified opinion on general purpose reports. If the going concern uncertainty is appropriately disclosed in the financial report by management and those charged with governance, the auditor can issue an unqualified audit opinion with an emphasis of matter paragraph. However, if adequate disclosure is not made in the financial report, the auditor shall express a qualified or adverse opinion.

3.22

What are mitigating factors in the context of the going concern assessment? Give some examples of mitigating factors for a loss-making client.

Mitigating factors are factors that reduce the risk that the going concern assumption may be in doubt. For example, if the client has lost a key customer, this could raise doubt about its ability to continue as a going concern. However, this doubt would be mitigated by ongoing negotiations with a potential new customer. If the client is making a loss, doubt about its ability to continue in business could exist. This doubt could be mitigated by: - plans to introduce new profitable products - management planning to merge with another company - plans and progress towards expansion into another market - financial support from a parent (or any other factor indicating that the losses can be borne for some time without defaulting on debts etc.) - restructuring, retrenchment, downsizing plans (to cut costs) 3.35 (a) Going concern issue factors:    

Hotel occupancy fees are lower due to reduced business, shopping, and sport related travel. Rent from coffee shop has stopped due to the shop’s closure and uncertainty about recovery of penalty fees or prospect of new lease. Short term finance for renovations will not be renewed. Effect of tougher economic conditions on the business

(b) Mitigating factors:   

Hotel occupancy could increase if sport related travel is realised as predicted. If penalty fees are recoverable, this could repay the short term debt. Long term debt is not due, although repayments must be made.

Other, not discussed in question:  Refinance short term debt through seeking a new bank for both the long term and short term debt  Coffee shop could be leased to a new tenant.  Recession could be less severe due to government stimulus package, increasing business related travel.  Renovations are complete and could help boost occupancy.  Consider likely success of sale of property. Auditor should consider evidence for each risk and mitigating factor. For example, review correspondence with the existing and any new bank with respect to both loans, discuss the case against the coffee shop tenant with the client’s solicitor (with the client’s permission), review advance bookings for travel associated with the football games, review correspondence (if any) with potential new coffee shop tenants, read minutes of board of directors where the issues have been discussed, obtain

independent evidence on travel to the city and retain spending, obtain valuations of property (should be higher following the renovations). The auditor’s conclusion should be based on the strength of the evidence supporting the mitigating factors and the going concern issues, and professional judgement about the likelihood of the events occurring. 3.36 (a) The auditor is required as per ASA 315 to understand the aspects of the client’s business risk that increase the likelihood of material misstatement. Pinetree has experienced consistent growth but there are doubts about its ability to continue to grow after the recent changes to the tax laws. There is a risk that these conditions could place financial stress on the company through falling revenue and cash collections from customers and increased costs from adverse currency movements. There could also be difficulty sourcing products from other companies who are experiencing falling sales because of the tax law changes. There is increased risk of doubtful debts, and improper revenue recognition. Senior managers remunerated through bonuses could be under pressure to find ways to increase revenues and cut costs. These pressures could increase the risk of fraudulent financial reporting. Also, the general attitude within the company towards profit targets could be interpreted as a poor attitude towards preventing fraudulent financial reporting. The slower monthly reporting is a concern. It increases the risk that exceptions and performance evaluation are not being dealt with on a timely basis. It also suggests that the reporting system is under pressure for some reason, increasing the risk that the reports are not accurate, particularly with respect to monthly closing entries. The delay is caused by instructions from senior management, which adds weight to the concern that senior managers are concerned about their bonuses. (b) Given the above risk statements, specific focus would be on making sure that revenues are not overstated and expenses are not understated. This means that there would be a search for backdated revenues and post-dated expenses. Documents (invoices, cash receipts and payments) related to sales for the first weeks of the new year and expenses for the last few weeks of the old year would be inspected. The auditor would vouch sales journal entries for the old year and trace expense documents to the journals for the new year. Interim audit procedures would be directed towards investigating monthly closing procedures. Although these monthly closing entries will not impact on the overall profit for the year (except the first and last month entries), they provide a guide to the management’s attitude towards closing entries in general and the adequacy of the closing entry system controls.

Entity level Ma j o rc u s t o me r sa r ei d e n t i fie ds ot h a tt h ea u d i t o rma yc on s i de rwh e t h e rt h o s e c u s t o me r sh a v eag o o dr e p u t a t i on , a r eong o o dt e r mswi t ht h ec l i e n t( t h a ti s , l i k e l yt o r e ma i nac u s t o me ri nf u t u r e )a n da r el i k e l yt op a yt h ec l i e n to nat i me l yb a s i s . Di s s a t i s fie dc u s t ome r sma ywi t h h o l dp a y me n t , wh i c ha ffe c t st h ea l l o wa n c ef or d o u b t f u ld e b t sa n dt h ec l i e n t ’ sc a s hflo w,o rd e c i d en o tt op u r c h a s ef r o mt h ec l i e nti n t h ef u t u r e ,wh i c hc a na ffe c tt h eg o i n gc o n c e r na s s u mp t i o n . Ma j o rs u p p l i e r sa r ei d e nt i fie dt od e t e r mi newh e t he rt h e ya r er e p ut a bl ea n ds u p pl y q ua l i t yg o o d sonat i me l yb a s i s . Con s i de r a t i o ni sgi v e nt owhe t h e rs i g n i fic a n tl e v e l so f g o od sa r er e t u r ne dt os up p l i e r sa sf a u l t y , t h et e r mso fa n yc on t r a c t swi t hs u p p l i e r sa n d t h et e r mso fp a y me n tt os u p pl i e r s . Di s c ou n t:Ana s s e s s me n ti sma d eo ft h ec l i e n t ’ sb a r g a i n i n gp o we rwi t hi t sc u s t ome r s a n ds u p p l i e r st od e t e r mi n ewh e t h e rd i s c o u n t i n gp o l i c i e sa r ep u t t i n gpr o fit ma r g i n sa t r i s k , whi c hma yp l a c et h ef u t ur evi a bi l i t yoft h ec l i e n ta tr i s k . Op e r a t i o n:Th emo r es pr e a do u tt h ec l i e n t ’ so p e r a t i o nsa r e , t heh a r d e ri ti sf o rt h e c l i e n tt oe ffe c t i v e l yc o n t r o la n dc o o r d i na t ei t sop e r a t i o n s , i n c r e a s i n gt h er i s ko fe r r o r s i nt h efin a n c i a lr e p o r t .Th ea u d i t orwi l ln e e dt ov i s i tl o c a t i o n swh e r et her i s ko f ma t e r i a lmi s s t a t e me n ti sg r e a t e s tt oa s s e s st hep r o c e s s e sa ndp r o c e d u r e sa te a c hs i t e . I f t h ec l i e nth a so p e r a t i o n si n t e r s t a t eo ro v e r s e a s , t h ea u di t o rma yp l a nf o rav i s i tt ot h o s e s i t e sb ys t a fff r o ma ffil i a t e do ffic e sa tt h o s el o c a t i o n swh e r er i s ki sgr e a t e s t

Ex a mpl e so fi n c e nt i v e sa ndp r e s s ur e st ha ti nc r e a s et her i s koff r a ud i nc l ude :  t hec l i e nto pe r a t e si nah i ghl yc o mpe t i t i v ei ndus t r y  as i gni fic a ntde c l i nei nde ma ndf ort hec l i e n t ’ spr oduc t so rs e r vi c e s  f a l l i n gpr ofit s  at hr e a to ft a k e o v e r  at hr e a to fba nkr upt c y  on g oi n gl os s e s  r a pi dgr o wt h  poorc a s hflo wsc omb i ne dwi t hhi ghe a r ni n g s  pr e s s ur et ome e tma r k e te x pe c t a t i ons  pl a n ni n gt ol i s tonas t oc ke x c h a n g e  pl a n ni n gt or a i s ede btorr e ne g ot i a t eal oa n  a boutt oe nt e ri n t oas i gni fic a ntn e wc o nt r a c t  as i gni fic a ntpr opor t i onofr e mu ne r a t i on,whi c hi st i e dt oe a r ni n g s ( t ha ti s ,bonus e s ,opt i ons ) .

Ex a mp l e so fo p p o r t u n i t i e st h a ti n c r e a s et h er i s kt h a taf r a u dma y h a v eb e e np e r p e t r a t e di n c l u d e :     

a c c ount st ha tr e l yone s t i ma t e sa ndj udg e me nt ahi ghv ol umeoft r a ns a c t i onsc l os et oy e a r e nd s i gni fic a nta d j us t i n ge nt r i e sa ndr e v e r s a l sa f t e ry e a r e nd s i gni fic a ntr e l a t e dpa r t yt r a ns a c t i ons poorc or por a t eg o v e r na nc eme c ha ni s ms

 poori nt e r na lc o nt r ol s  ahi ght ur no v e rofs t a ff  r e l i a nc eonc ompl e xt r a n s a c t i ons  t r a ns a c t i onsoutofc ha r a c t e rf orabus i ne s s( f ore xa mpl e ,i fac l i e n t l e a s e si t smot orv e hi c l e st he ys houl dnotha v ec a rr e gi s t r a t i on e xpe ns e s ) .

Ex a mp l e so fa t t i t u d e sa n dr a t i o n a l i s a t i o nsu s e dt oj u s t i f ya f r a u di n c l u d e :  apoort onea tt het op( t ha ti s ,f r oms e n i orma na g e me nt )  t hei mpl e me nt a t i onofa ne ffe c t i v ei nt e r na lc ont r ols t r uc t ur ei sn ot s e e na sapr i or i t y  a ne x c e s s i v ef oc usonma xi mi s a t i ono fpr ofit sa nd/ ors ha r epr i c e  apoora t t i t ud et oc ompl i a nc ewi t ha c c ount i n gr e gul a t i ons  r a t i ona l i s a t i ont ha tot he rc ompa ni e sma ket hes a mei na p pr opr i a t e a c c ount i n gc hoi c e s . Th eg o i n gc o n c e r na s s u mp t i oni sma d ewh e ni ti sb e l i e v e dt h a tac o mp a n ywi l lr e ma i n i nbu s i n e s sf ort h ef o r e s e e a b l ef u t ur e( AS A5 7 0, p a r a . 2 ;I SA5 70 , p a r a . 2 ) . Un d e rt hi s a s s u mp t i on , a s s e t sa r ev a l u e do nt heb a s i st h a tt he ywi l lc on t i n u et ob eu s e df o rt h e p u r p o s e so fc o n d u c t i n gab u s i n e s sa n dl i a b i l i t i e sa r er e c o r d e da n dc l a s s i fie da sc u r r e n t a n dn o n c u r r e n to nt h eba s i st h a tt hec l i e n twi l lp a yi t sde b t sa st he yf a l ldu ei nt h e y e a r st oc o me . I ti st h er e s p o ns i bi l i t yo fma na g e me n ta n dt h o s ec h a r g e dwi t h g o v e r n a n c et oa s s e s swh e t he rt h e i rc o mp a n yi sl i k e l yt or e ma i nag o i n gc on c e r n. I ti s t h er e s p o n s i b i l i t yo ft hea u d i t o rt oo b t a i ns u ffic i e nta p p r o p r i a t ee vi d e n c et oa s s e s st h e v a l i d i t yo ft h eg o i n gc o n c e r na s s u mp t i o nma d eb yt he i rc l i e n t ’ sma n a g e me n ta n dt ho s e c h a r g e dwi t hg o v e r n a n c ewh e np r e p a r i n gt h efin a n c i a lr e po r t .

I ft hea udi t orc onc l ude st ha tt heg oi n gc onc e r na s s ump t i oni si ndoubt , f ur t he rpr oc e dur e sa r eunde r t a k e n.ASA570( I SA570)pr o vi de sal i s tof a ppr opr i a t ea u di tpr oc e d ur e s .The yi nc l ude :  a s s e s s me ntofc a s hflo ws  a s s e s s me ntofr e v e nuea nde xpe ns ei t e ms  a s s e s s me ntofi nt e r i mfina nc i a lr e por t s  r e v i e wofde btc ont r a c t s  r e v i e wofboa r da n dot he rme e t i n g s  di s c us s i onswi t hc l i e ntma na g e me nta ndl a wy e r s  i de n t i fic a t i ona nda s s e s s me ntofmi t i g a t i n gf a c t or s . Closing procedures Re v e n uea nde x p e n s ei t e msmu s ti n c l u d ea l lt r a n s a c t i on st ha to c c ur r e dd u r i n gt h e fin a n c i a lp e r i o da n de x c l u det r a n s a c t i on st h a tr e l a t et oo t he rp e r i od s .As s e ta n d l i a b i l i t yb a l a n c e smus t i nc l ud ea l lr e l e v a n ti t e ms , a c c r u a l smu s tb ec o mp l e t ea n d

c o n t i n g e n tl i a b i l i t i e smu s ta c c u r a t e l ya n dc o mp l e t e l yr e fle c tp o t e n t i a lf u t u r e o b l i g a t i o ns t h e r ei sar i s kt h a tr e v e n u e se a r n e da f t e ry e a r e n dwi l lb ei n c l u d e di nt h ec u r r e n ty e a r ’ s i n c o mea n de x p e n s e si n c u r r e db e f o r ey e a r e ndwi l lbee x c l u de d . I ft h ea u di t o rbe l i e v e s t h a tt h e i rc l i e nti su n d e rp r e s s u r et os mo ot hi t si n c omea n dn o tr e p o r t a n yu ne x p e c t e d i n c r e a s e s , t he r ei sar i s kt h a tr e v e n u e se a r n e dj u s tb e f o r ey e a r e ndwi l lb ee x c l u d e d f r o mc u r r e n ti n c o mea n de x p e n s e si n c u r r e da f t e ry e a r e n dwi l lb ei n c l u de d .I nb o t h c a s e st h ea u d i t o rwi l lv o u c ht r a n s a c t i o n sr e c or d e dc l o s et oy e a r e n dt os o u r c e d o c u me n t a t i o na ndc o n fir mt h a ta l lt r a ns a c t i on sa r er e c o r d e di nt hea p p r o p r i a t e a c c ou n t i n gp e r i o d .

Ch a p t e r4 :Au di tr i s kI I I n he r e n tr i s k( I R)i st h er i s kt h a ta na c c o u n to ra s s e r t i o ni sma t e r i a l l ymi s s t a t e d , a s s u mi n gt he r ea r en or e l a t e dc o n t r o l s .Co n t r o lr i s k( CR)i st h er i s kt h a tac l i e n t ’ s s y s t e mo fi n t e r n a lc on t r o l swi l ln o tp r e v e n to rd e t e c ta ma t e r i a lmi s s t a t e me nt . De t e c t i onr i s k( DR)i st h er i s kt h a tt hea u d i t o r ’ st e s t i n gp r o c e d u r e swi l lno tb e e ffe c t i v ei nd e t e c t i n gama t e r i a lmi s s t a t e me n t . I n f o r ma t i o ni sc o n s i d e r e dq u a l i t a t i v e l yma t e r i a li fi ta ffe c t sau s e r ’ sd e c i s i o n ma ki n g p r o c e s sf o rar e a s ono t h e rt ha ni t sma g n i t ud e I n f o r ma t i o ni sc o n s i d e r e dq u a nt i t a t i v e l yma t e r i a li fi te x c e e d sa na u d i t o r ’ sp r e l i mi n a r y ma t e r i a l i t ya s s e s s me n t . Asar u l eoft h u mb , a n yi t e mt h a ti s1 0p e rc e n to rg r e a t e ro fp r o fitb e f o r et a xi s c o n s i d e r e dt ob ema t e r i a l . An yi t e ml e s st ha n5pe rc e n to fp r o fitb e f o r et a xi s c o n s i d e r e dt ob ei mma t e r i a l . Th ema t e r i a l i t yofa n yi t e mb e t we e n5a n d10p e rc e n to f t h ep r o fitb e f o r et a xi sama t t e rf orp r o f e s s i o n a lj u d g e me n t . Wh e nu s i n gt o t a la s s e t so r r e v e nu ea sab a s e , t h ep e r c e n t a g e sf a l lt o0 . 5 –1p e rc e n ta ndwh e ne q u i t yi st heb a s e , t h ep e r c e n t a g e sa r e1 – 2p e rc e n t . Ana u d i t o rwi l li n c r e a s et h e i rl e v e lo fr e l i a n c eo nd e t a i l e ds u b s t a n t i v ep r o c e d u r e s , wh i c hi n v ol v e si nt e ns i v et e s t i n go fy e a r e n da c c ou n tb a l a n c e sa n dt r a n s a c t i on sf r o m t h r o u g h o u tt h ey e a r . Du r i n gt h er i s ka s s e s s me n tp h a s e , a n a l yt i c a lp r o c e dur e sa r eu s e dt oa i di nt h er i s k i d e n t i fic a t i o np r o c e s s .Du r i n gt h er i s kr e s p o n s ep h a s ea n a l y t i c a lpr o c e d u r e sa r ea n e ffic i e n tme t h o do fe s t i ma t i n ga c c o un tb a l a n c e s . Att h efin a lr e v i e ws t a g e , a n a l y t i c a l p r o c e d u r e sa r eu s e dt oa s s e s swhe t he rt h efin a n c i a lr e p or tr e fle c t st h ea u d i t o r ’ s kn o wl e d g eo ft h e i rc l i e n t . An a l y t i c a lp r o c e d u r e sa r ec o n du c t e da tt h er i s ka s s e s s me n tp h a s eo ft h ea u d i tt o : h i g hl i g htun u s ua lflu c t u a t i o n si na c c o u nt s a i di nt h ei de n t i fic a t i o nofr i s k e n h a n c et h eun d e r s t a n d i n go fac l i e n t i d e n t i f yt hea c c o u n t sa tr i s ko fma t e r i a lmi s s t a t e me n t mi n i mi s ea u d i tr i s kb yc on c e n t r a t i n ga u di te ffo r twhe r et her i s kofma t e r i a l mi s s t a t e me n ti sgr e a t e s t . Gr o s sPr o fit Ad e c l i nei nt h i sr a t i oi n d i c a t e st h a tac l i e n tma yb ep a yi n gmor ef o rt h e i r i n v e n t o r i e so rc h a r g i n gl e s st ot h e i rc u s t o me r s . I ft h egr o s sp r o fitma r g i nc o n t i nu e st o

d e c l i n e , t h ec l i e n tma yf a c ema ki n ga no v e r a l ll o s si ft h e ya r en ota b l et oc o v e rt h e i r o p e r a t i n ge x p e ns e s . I ft h ep r o fitma r g i ni ss t e a d i l yf a l l i n g ,t h i sma ya ffe c tt h ef u t u r ev i a b i l i t yo ft h ec l i e n t . I ft h ep r o fitma r g i nv a r i e swi d e l yf r o my e a rt oy e a r , t h i si n d i c a t e sv o l a t i l i t ya nd u n c e r t a i n t y , wh i c hma k e si td i ffic ul tt oa s s e s st h et r u t ha n df a i r ne s so ft h ec u r r e n t r e p or t e de a r n i n g swi t h o u tf u r t h e ri n v e s t i g a t i o n I ft h eROAa n dROEa r ef a l l i n g , i twi l la ffe c tt h ea b i l i t yo ft h e i rc l i e n tt op a yd i v i d e n d s a n di n t e r e s ta n dr e p a yl o a ns , wh i c ha r ea l s od e pe n de n to nt h ec l i e n t ’ sa b i l i t yt o g e ne r a t ec a s h. Wh e nac l i e n t ’ si n v e nt o r i e st u r n o v e rs l o wsb ymo r et h a ne x p e c t e d , a na ud i t orwi l l s p e n dmo r et i met e s t i n ...