Week 3: Elements of the financial report audit process

Tutorial Solutions

A4.2 It is management’s responsibility to adopt sound accounting policies, maintain

adequate internal control and make fair representations in the financial statements. The
auditor’s responsibility is to conduct an audit of the financial statements in accordance with
auditing standards and report the findings of the audit in the auditor’s report.

A4-3 An error is an unintentional misstatement of the financial statements. Fraud

represents intentional misstatements. The auditor is responsible for obtaining reasonable
assurance that material misstatements in the financial statements are detected, whether
those misstatements are due to errors or fraud.

An audit must be designed to provide reasonable assurance of detecting material

misstatements in the financial statements. Further, the audit must be planned and performed
with an attitude of professional scepticism in all aspects of the engagement. Because there
is an attempt at concealment of fraud, material misstatements due to fraud are usually more
difficult to uncover than those due to errors.

The auditor’s best defence when material misstatements (either errors or fraud) are not
uncovered in the audit is that the audit was conducted in accordance with auditing
standards.

A4-6

CHARACTERISTIC AUDIT STEPS

1. Management’s characteristics and Investigate the past history of the firm and
influence over the control environment. its management.

Discuss the possibility of fraudulent

financial reporting with previous auditor and
company solicitors after obtaining
permission to do so from management.
2. Industry conditions. Research current status of industry and
compare industry financial ratios to the
company’s ratios. Investigate any unusual
differences.

Consider the impact of specific risks that

are identified in the conduct of the audit.
 3. Operating characteristics and financial Perform analytical procedures to evaluate
stability. the possibility of business failure.

Investigate whether material transactions

occur close to year-end.

A5-2 The four major audit evidence decisions that must be made on every audit are:

1. Which audit procedures to use.

2. What sample size to select for a given procedure.
3. Which items to select from the population.
4. When to perform the procedure.

A5-5 Auditors should obtain sufficient appropriate audit evidence to be able to draw reasonable
conclusions on which to base the audit opinion (ASA 500). There are two major phrases of the standard:

1. Sufficient appropriate evidence: The auditor must obtain evidence that is relevant,
competent and timely, and there must be a sufficient quantity of that evidence.
2. To be able to draw reasonable conclusions on which to base the audit opinion: The
auditor cannot expect to be completely certain that the financial statements are presented
fairly, but there must be persuasive evidence. The collection of evidence gathered by the
auditor provides the basis for the auditor’s opinion.

Sufficiency deals with the quantity of evidence. Appropriateness is the measure of the quality of
the evidence, its relevance, reliability and timeliness. What is sufficient and appropriate depends on the
circumstances and is affected by assessments of inherent and control risk, materiality, results from
previous audits, results from other procedures, and the source and reliability of information available.

A5-6 There are two primary reasons why the auditor can only be persuaded with a reasonable level
of assurance, rather than be convinced that the financial statements are correct:

1. The cost of accumulating evidence. It would be extremely costly for the auditor to gather
enough evidence to be completely convinced.
2. Evidence is normally not sufficiently reliable to enable the auditor to be completely
convinced. For example, confirmations from customers may come back with erroneous
information, which is the fault of the customer rather than the client.
A5-8 Following are six characteristics that determine reliability and an example of each.

FACTOR EXAMPLE OF
DETERMINING RELIABILITY RELIABLE EVIDENCE

Independence of provider Confirmation of a bank balance

Effectiveness of client’s internal controls Use of duplicate sales invoices for a large,
well-run company

Auditor’s direct knowledge Physical examination of inventory by the

auditor

Qualifications of provider Letter from a solicitor dealing with the client’s

affairs

Degree of objectivity Count of cash on hand by auditor

Timing Observe inventory as of the last day of the

fiscal year
A7-12 The audit risk model is as follows (refer ASA 200 and ASA 315 for ‘technical’
definitions):

PDR = AAR
IR x CR

Where PDR = Planned detection risk

AAR = Acceptable audit risk
IR = Inherent risk
CR = Control risk

Planned detection risk: A measure of the risk that audit evidence for a segment will
fail to detect misstatements that could be material, should such misstatements exist.

Acceptable audit risk: A measure of how willing the auditor is to accept that the
financial statements may be materially misstated after the audit is completed and an
unqualified opinion has been issued.

Inherent risk: A measure of the auditor’s assessment of the likelihood that there are
material misstatements in a segment before considering the effectiveness of internal
control.

Control risk: A measure of the auditor’s assessment of the likelihood that

misstatements exceeding a tolerable amount in a segment will not be prevented or
detected by the client’s internal controls.

A7-13 Planned detection risk (ASA 200) is the risk the auditor is willing to take that the audit
evidence accumulated by the auditor will not detect material misstatements in the financial
statements. When planned detection risk is increased from medium to high, the amount of
evidence the auditor accumulates is reduced. This movement in PDR may result from
assessments of low IR and CR, or a change in AAR. Conversely, an increase in planned
detection risk may be caused by an increase in desired audit risk or a decrease in either
control risk or inherent risk.
A7-14 Inherent risk (ASA 200) is the susceptibility of an account or class of transactions to
material misstatement, before considering the effectiveness of relevant internal controls.
Instructors may refer to ASA 315 Appendix 2 for examples of inherent risks that may arise in
an audit.
Factors affecting assessment of inherent risk include:

 Nature of the client’s business

 Results of previous audits
 Initial v. repeat engagement
 Related parties
 Non-routine transactions
 Judgment required to correctly record transactions and
 Makeup of the population
 Factors related to fraudulent reporting
 Factors related to misappropriation of assets.

A7-17 Acceptable audit risk is a measure of how willing the auditor is to accept that the
financial statements may be materially misstated after the audit is completed and an
unqualified opinion has been issued. Acceptable audit risk has an inverse relationship to
evidence. If acceptable audit risk is reduced, planned evidence should increase.

4.18

Issue Key assertion Justification

(1) Valuation and Items counted were recorded under incorrect, more
allocation expensive, stock codes. This could lead to
inventory being overstated at year end.
(2) Existence Stock items were double counted (i.e. items
transferred from Adelaide were counted there and
also in Melbourne and Sydney, where the items
were transferred to). This could lead to inventory
being overstated at year end.

4.19

Accounts Key assertion at risk Explanation

Sales/ Accuracy/Completeness Sales may be overstated (sales returns
Sales understated) as goods are likely to be
returns returned for a credit.
Inventory Valuation and There may be obsolete stock, as it may be
allocation difficult to sell clothes on hand that were
produced in Korea due to adverse publicity
calling for the products to be boycotted.
Accounts Valuation and Some customers may refuse to pay for their
receivables allocation clothes due to their dissatisfaction with the
company’s alleged behaviour.
4.20 (a) Inspection
(b) Observation
(c) Confirmation
(d) Recalculation
(e) Analytical procedures
(f) Inspection
(g) Enquiries
(h) Re-performance
(i) Inspection

Week 3: Elements of the financial report audit process

Tutorial Solutions

4.23

Situation Component of
audit risk

(a) Technological innovations within the industry have Inherent risk

caused a major product to become obsolete

(b) Cash is more susceptible to theft than an inventory of Inherent risk

cement

(c) Segregation of duties is inadequate Control risk

(d) Cash disbursements have occurred without proper Control risk

approval

(e) A necessary substantive audit procedure is omitted Detection risk

(f) Bank accounts are not reconciled monthly, resulting in a Control risk
client failing to discover employee fraud on a timely
basis

(g) An auditor has complied with the auditing standards on Engagement risk
an audit engagement, but the shareholders have sued the
 auditor for issuing a misleading opinion on the financial
report

(h) Confirmation of receivables by an auditor fails to detect Detection risk

a material misstatement

(i) Notes receivable are susceptible to material Inherent risk

misstatement, assuming there are no related internal
controls

(j) A client, Lemon Ltd, has insufficient working capital to Inherent risk
continue its operations

Week 3: Elements of the financial report audit process

Tutorial Solutions

4.25 (i) There are likely to be public liability claims arising from the problems with the glass
turntables. There is also likely to be an adverse effect on sales and reputation in the
market, resulting in difficulty in selling this product going forward and getting people
to pay for product already sold. This is likely to increase the degree of judgement
required to arrive at materially correct figures for balances such as accounts
receivables, inventories and provision for warranty. This leads to an increase in
inherent risk at the account balance/class of transaction level.
(ii) The move into overseas markets is a positive one as far as increased sales are
concerned. However, there is an apparent lack of expertise in the company in relation
to accounting for foreign currency transactions. The complexity of foreign currency
transactions is likely to lead to an increase in inherent risk at the account balance,
class of transaction and disclosure level.
Given the increased pressure on the accountant, specific control procedures may also
be overlooked, resulting in a possible increase in control risk.
(iii) The fact that a fraud has been committed would increase inherent risk, as there is
a greater possibility of there being a material error in the financial report, as there may
be other frauds.
The fact that the internal control did not detect the fraud, which has occurred over a
prolonged period, would increase control risk.

4.28
Issue Impact on initial Explanation
materiality
1. No independent Decrease The board is now comprised
directors on the solely of the Tam family,
board. who occupy key management
 positions and provide no
independence at the board
level.
2. Commission Decrease The remuneration structure
component of sales might lead Fast Feet’s sale
staff’s remuneration staff to create fictitious
increased. revenues to boost their
commission and salaries.
3. Company to list Decrease Management and the Tams
on ASX. will want the 2015 financial
results to be favourable to
attract investors in the IPO.
Special Question – Materiality
Explain the term ‘materiality’ in the context of financial reporting?

In relation to financial information, materiality means:

“…the information which, if omitted, misstated or not disclosed, has the potential to
adversely affect decisions about the allocation of scarce resources made by users of
the financial report or the discharge of accountability by the management, including the
governing body of the entity.” (AASB 1031)

Financial reporting frameworks often discuss the concept of materiality in the context of the
preparation and presentation of a financial report. Although financial reporting frameworks
may discuss materiality in different terms, they generally explain that:

 Misstatements, including omissions, are considered to be material if they,

individually or in the aggregate, could reasonably be expected to influence the
economic decisions of users taken on the basis of the financial report;
 Judgements about materiality are made in light of surrounding circumstances,
and are affected by the size or nature of a misstatement, or a combination of
both; and
 Judgements about matters that are material to users of the financial report are
based on a consideration of the common financial information needs of users as
a group. The possible effect of misstatements on specific individual users, whose
needs may vary widely, is not considered. (ASA320)

In applying this definition, the auditor is required to consider both:

 the circumstances pertaining to the entity; and
 the information needs of those who will rely on the audited financial report;

When:

(a) Identifying and assessing the risks of material misstatement;

(b) Determining the nature, timing and extent of further audit procedures; and
(c) Evaluating the effect of uncorrected misstatements, if any, on the financial report and in
forming the opinion in the auditor’s report. (ASA320)