On 17th December 2018, the Competition and Markets Authority (CMA) published an update paper outlining serious competition concerns and proposing changes to legislation to improve the audit sector for the benefit of savers and investors alike.

Week3-Auditplanningriskandmateriality.pdf

Home >Business & Finance homework help >Management homework help >On 17th December 2018, the Competition and Markets Authority (CMA) published an update paper outlining serious competition concerns and proposing changes to legislation to improve the audit sector for the benefit of savers and investors alike.

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Week 3

Audit Planning

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Introduction

Planning the audit is an essential part of the audit process.

ISA 300: ‘Planning an audit of financial statements’ states

‘The auditor shall establish an overall audit strategy that sets the scope timing and direction of the audit and that guides the development of the audit plan’

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Reasons for planning the audit

Planning entails

1) developing a general strategy and

2) a detailed approach for the expected nature, timing and extent of the audit.

It is a continuous process as the plan may be amended as the audit progresses

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Reasons for planning

▪ Devote appropriate attention to important areas of audit

▪ Identify an resolve potential problems on timely basis

▪ Organise and manage audit engagement so it is performed in an effective an efficient manner

▪ Assist in staff selection

▪ Facilitate direction and supervision of audit work

▪ Co-ordinate work done by experts and other auditors

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Definitions

internal control environment

the clients system comprising internal controls and control activities and procedures

compliance tests

tests of internal controls and procedures

substantive testing

detailed testing of transactions and balances, including analytical review

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Definitions audit evidence

the information used by the auditor in arriving at the conclusions on which the audit opinion is based

audit risk

the risk that an auditor might give an incorrect or misleading opinion on the truth and fairness of a set of financial statements

assertions

statements about the validity and recording of transactions, balances and disclosures which form the basis of audit testing work

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Accounting systems

All organisations of any size have accounting systems

• Control of business finance

• Assist in planning and budgeting

• Maintain day-to-day records of receivables and payables

• assets can only be safeguarded if a proper record of them is made;

• financial statements which are required for numerous purposes can only be prepared if adequate accounting records exist;

• statutes (e.g. the Companies Act, 2006) have specific requirements on record keeping for specific types of business;

• record keeping for PAYE, National Insurance, VAT, statutory sick pay and statutory maternity pay is a statutory requirement.

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Internal contol

• Made up of 4 components

▪ The control environment

▪ The risk assessment processes

▪ Control activities

▪ Monitoring of controls

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Internal control

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The auditor and internal control

• ISA 315 requires auditors to obtain an understanding of the internal control sufficient to plan the audit and develop an effective audit approach.

This includes:

–using the understanding of internal control to identify types of potential misstatements;

–considering factors that affect the risks of potential misstatements; and

–designing the nature, timing and extent of audit procedures.

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Planning process • Consider the background to the client’s business

• Consider an outline plan of the audit

• Review the previous year’s files

• Consider changes in legislation or accounting practice

• Review management or interim financial statements

• Meet senior management

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Planning process • Consider audit timing

• Consider work to be done by client staff

• Determine the number and grade of audit staff needed

• Discuss possible problems with the audit team

• Prepare a budget

• Liaise with client on dates.

• Prepare Audit Planning Memorandum

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Detailed planning procedures

The auditor should undertake the following detailed planning procedures:

• Consider the Terms of Engagement and reporting timetable

• Consider general Economic and Industry conditions

• Review previous year's audit file for background knowledge of the entity's business, including ‘Points Forward’

• Assess the effect of changes in its – business – principal business strategies – financial performance – reporting requirements – management – operating style

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Audit planning procedures • Consider the impact of changes in legislation or accounting practice

affecting the entity

• Consider the auditors' cumulative knowledge of the Accounting and Internal Control systems, and any changes in accounting procedures

• Consider extent of Internal Audit involvement and need to involve specialists

• Consider preliminary Materiality levels

• Determine audit approach (in terms of the appropriate mix of control testing, substantive testing, use of Analytical Review, etc) and draft the Audit Programme

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Audit planning procedures

• Determine number, experience, specialist skills, etc. requirements of audit staff

• Timing of audit visit

• Prepare Budget and Fee estimate

• Prepare a formal Audit Planning Memorandum

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Tools and techniques

As part of the planning process the auditor should document the client’s system (if it’s the first audit) or review and amend system documentation appropriately

There are two main tools for this

▪ Flow charts

▪ Internal control questionnaires (ICQs)

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Flow charts

Flow charts are a pictorial representation of a client’s system using standardised symbols

They should chart document flows

Advantages

Easy to see flow of documents

Relatively straightforward to update

Disadvantages

Can be complex to draw

Need to be supported with narrative notes

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Internal control questionnaires

These are simple questionnaires designed to elicit information about the system.

They are used to ascertain and record the client’s system

They are asking the Who? What? How? When? type questions and require descriptive answers.

They supplement flow charts and narrative notes which, combined, can be the first indications of possible systems weaknesses.

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Walk through tests

Once the client’s system has been documented the auditor will ‘walk through’ it.

This means the auditor will test a very low number of transactions – say two or three to ensure that a control or procedure which is supposed to exist or operate actually does.

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Audit files

Flow charts and ICQ’s will form part of the documentation on the Permanent File.

Walk through tests and other work related to the current audit will be documented on the Current File.

We will return to audit documentation later.

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Timing of critical phases of the audit The need for pre-planning the audit becomes apparent once

the timing of the various phases of the audit is considered:

_______/\__________/\________________________________________________

| | | | | | | | |

Start of Interim End of | | Directors | Accounts |

Financial Audit Financial | | Sign | Published |

Year Year | | Accounts | |

| | | AGM

Support | Auditors

Schedules | Sign

Available | Accounts

Final

Accounts

Available

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Practical problems necessitating audit planning

• Clients with similar year ends

• Unforeseen problems (e.g. poor internal control environment, fraud)

• Clients fail to produce information when required (support schedules produced late, etc.)

• Audit staff absences through illness, holidays, study leave, etc.

• Requirements for different grades of staff and adequate Supervision on each audit

• Need for specialist help (e.g. computer experts, valuers, etc.)

• Tight reporting deadlines

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Solutions to these problems

• Organise interim work to spread work load with regard to the systems audit (tests of controls, etc.)

• Pre-plan important dates (cut-off, attendance at stock-taking, debtors' circularisation, etc.)

• Pre-booking of holidays, study leave, etc.

• Co-operation with Internal Audit (e.g. in attending stock-taking, visiting branches, etc.)

• close liaison with client on progress of support schedules, etc. to ensure deadlines are met

• Plan to allow extra time for unforeseen events

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Organisation for efficient planning

Ways in which audit planning can be used to secure efficient and cost effective procedures within the audit firm:

• Establish efficient time recording and costing methods within the audit firm

• Prepare detailed time and cost budgets

• Ensure availability of necessary experience, skills, and knowledge, e.g. expertise in taxation, consultancy, computer systems, etc.

• Maintain good and consistent working practices, e.g. audit procedures manuals, standardised working papers/check lists/forms

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The audit planning memorandum

The audit planning memorandum, will typically include:

• Brief Background to the business, Management, Environment, etc.

• The outline audit scope for all major profit and loss and balance sheet headings (i.e. what is to be done, how, why, when, for debtors, wages, sales, stock, plant and machinery, etc.)

• The timing and reporting requirements (i.e. what reports are required and when)

• The timing of critical phases of the audit

• Proposed liaison with Internal Audit, anticipated staffing requirements, a time budget, etc.

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Poor auditing

Poor audit work often arises because

• There was no planning

• The audit has begun before the planning was complete

• The audit was based on a plan which hasn’t changed in years

• The auditors didn’t fully understand the business

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Audit planning and risk

Planning is vital to successful auditing

The planning process, as well as including logistical factors, e.g. staffing, timing, cost, etc. should also include an estimate of audit risk

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Audit risk

Audit risk is, fundamentally, the risk that the financial statements will contain an error or a misstatement that goes undetected, with the result that the audit opinion is incorrect

Audit risk is the risk that the auditor will give an incorrect report

That is that the auditor will certify the accounts as true and fair when they are not

Audit risk is a function of

▪ The risks of a material misstatement

▪ Detection risk - the risk that the auditor’s own procedures will fail to detect a material error or misstatement

The assessment of risk is a matter of professional judgement

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Audit Risk

Group Activity

(15 minutes)

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Audit Risk Components

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Risks of a material misstatement

Assessed at

▪ Overall financial statement level – pervasive risks which affect many of the assumptions underlying financial statements (known as Assertions) and at

▪ Assertion level for classes of transactions, account balances and disclosures

The auditor will make assessment of inherent and control risk combined to assess the risk of a material misstatement

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Inherent risk

▪ Inherent risk is considered both at the company level and at the transaction level.

▪ It includes the business risks inherent in the business by its nature or the environment it operates in, irrespective of the level of internal control, which may affect transactions or balances, e.g. stock values, lack of working capital, declining industry

▪ At assertion or transaction level it includes risks caused by complex transactions, accounting estimates

▪ The auditor should carry out a business risk assessment including all aspects of the client’s activities including political risks, legal risks, environmental risks, etc.

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Inherent risk – business level

Consider:

▪ Nature of the business

▪ Business environment

▪ History of company

▪ Incidence of unusual transactions

▪ Cash situation of company

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Inherent risk – transaction level

Consider

• how easy is it to defraud the business

• how complex are the underlying transactions

• Degree of judgement involved in agreeing values

For example stock is inherently more risky to value than cash

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Control risk

Control risk is the risk that the accounts could contain a material error or misstatement that has gone undetected by the client’s system of internal controls

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Control risk

Factors affecting control risk include

▪ the internal control environment – the attitude of management towards operating financial controls, i.e. the corporate culture

▪ the integrity of the staff operating the controls

▪ the extent of supervisory controls

▪ the competence of the staff and the management

▪ complexity of the systems

▪ amount of IT involved

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Detection risk

Detection risk is the risk that errors or misstatements will not be detected by the auditor’s own procedures

The higher the levels of inherent risk and control risk the more audit work the auditor will have to do to ensure that detection risk is low

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Materiality

Defined in ISA 320 ‘Materiality in Planning and Performing an Audit’

‘Misstatements are material if they, individually or in aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements’

Decisions about Materiality depend on the size and nature of the misstatements

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Materiality

It is a question of judgement. Decisions reflect

▪ Size of misstatement

▪ Its nature

▪ Matters material to users of the financial statements as a group

Applied at the planning stage as well as during the course of the audit and may be revised in the light of circumstances

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Value and materiality

This can be subjective

There are no rules as to what level of error or omission is considered material – it is a matter for the auditor’s skill and judgement

Auditors should consider ▪ the effect on the financial statements as a whole

▪ the disclosure of individual balances and transactions

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Materiality by nature

Any disclosure which is required to be made by the Companies Act or FRS is automatically material, if omitted or misstated, unless its inclusion would be misleading

Example – disclosure of director’s interests in contract with the company

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Calculation of materiality • Not a science. No precise figure available. It is a matter of

professional judgment.

• Most audit firms set criteria for guidance.

• For example: – Between ½ and 1% of turnover

– Between 1 and 2% of total assets

– Between 5 and 10% of net assets

– Between 5 and 10% of profit after tax

• Figure selected will depend on confidence the auditor has in the client’s figures, the intended uses of the financial statements by the client and other factors affecting auditor’s judgment

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ISA 520 analytical procedures

Analytical review may be defined as:

‘the study of relationships between elements of financial

information expected to conform to a predictable pattern based on the organisation’s experience, and between financial and non-financial information’

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ISA 520 analytical procedures

Analytical procedures are used:

At the planning stage to highlight areas where audit attention might be focussed

During the audit as part of the auditors substantive testing procedures

At the final stage as a general check on the financial systems as a whole

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Analytical procedures in audit planning

Objectives are

▪ to improve the auditor’s understanding of the enterprise and

▪ to identify areas of potential risk or significant changes.

Maintain a running schedule of key ratios and compare with ratios disclosed by interim financial statements.

Examples of key ratios include gross profit margin, operating profit margin, asset turnover, liquidity measures, ROCE, external economic/industry indicators.

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When and how used

When

• before audit – for planning

• during – as part of and to confirm work done (a substantive procedure)

• after – to confirm expectations, or indicate areas for further investigation

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When and how used

How

▪ compare information with prior periods

▪ compare with budgets / anticipated results

▪ compare with similar organisations

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Limitations of analytical review

• There must be reliable data for comparison

• Consistency is not necessarily conclusive – that which we are comparing with may all be wrong

• Good control procedures are necessary if we are to rely on AR as a main audit test

• Material items should not be tested using AR alone

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Homework

• Research and draft an audit plan for a small company business of your choice that your firm will be auditing its year-end financial statements.