Advanced Auditing

Advanced Auditing

JOIN KHALID AZIZ COACHING CLASSES ACCA F8 & P7 PIPFA FINAL AUDITING. 0322-3385752

JOIN KHALID AZIZ ICMAP STAGE 1, 2 & 3 COACHING CLASSES. FUNDAMENTALS OF FA & ECONOMICS. COST ACCOUNTING FA & APPRAISAL 0322-3385752

JOIN KHALID AZIZ B.COM COACHING CLASSES. ACCOUNTING, ADVANCED ACCOUNTING, STATISTICS, ECONOMICS & INCOME TAX LAW. 0322-3385752

Topics for discussion today • Preliminary engagement activities • Planning process • Overview • Risk and materiality • Audit strategy & audit plan • Going concern & factual insolvency • Subsequent Events • Fraud, AP Act (if time available) • Reporting (if time available) Advanced Auditing Lecture 1

Preliminary Engagement Activities • References: • ISA 220 – Quality Control for Audits • ISQC 1 – Quality Control for Firms • ISA 210 – Agreeing the terms of audit engagements • Objectives of Preliminary Engagement Activities • Related to client • the acceptability of a new client OR • Consider the ability to continue as auditors for existing clients • Provision of a quality audit • Regulatory and ethical considerations Advanced Auditing

Preliminary Engagement Activities • Why perform Preliminary Engagement Activities ? • Limitation of auditor’s risks by not accepting unsatisfactory clients • Firm’s professional reputation could suffer • Negative publicity (lawsuits; client failures) • Types of risks faced by auditor • Legal liability • Against the firm because of company failures (= audit failures) • Reputational damage • Because of being associated with a particular client Advanced Auditing

Preliminary Engagement Activities • Step 1: Perform a Client Investigation • Consider: Independence of Auditor • Overriding requirement of a statutory audit • Threats to independence • IFAC Code of Ethics • Consider: Integrity of Client • Matters to consider include • Business reputation of owners and management • Nature of operations • Attitude of management regarding interpretation of accounting standards Advanced Auditing

Preliminary Engagement Activities • Step 1: Perform a Client Investigation • Consider: Integrity of Client • Matters to consider include • Attitude towards keeping audit fee as low as possible • Indications of limitations of scope of audit work • Illegal activities of client • Reasons for non-reappointment of previous auditor • Consider: Changes to Existing Client • Refer above Advanced Auditing

Preliminary Engagement Activities • Step 1: Perform a Client Investigation • Consider: Communication with previous auditor • In terms of IFAC Code of Ethics • Informed of intention to replace? • Permission to discuss client? • Has client’s permission been obtained to discuss client? No? • Consider: financial responsibility of client • Ability and willingness to pay audit fee? • Consider: legal procedures in respect of the engagement • Does a vacancy exist? Advanced Auditing

Preliminary Engagement Activities • Step 2: Determine the auditor’s skills and competence requirements • Does the firm has the necessary capabilities, competencies, time, and resources? • Considerations • Knowledge of industry • Experience of relevant regulatory or reporting requirements (or able to obtain such skills) • Sufficient personnel with required skills and competencies • Experts available (if needed) • Able to meet the audit deadline Advanced Auditing

Preliminary Engagement Activities • Step 3: Establish the terms of engagement • Confirmation of relationship • Contractual relationship • Removal of any misunderstanding • Copy of letter to be filed in working papers • Reference: ISA 210 – Engagement Letters • Refer to Appendix 1 for example of an engagement letter Advanced Auditing

Planning: An Overview • Obtaining an understanding of the entity, including internal controls  • Assessing the risk of material misstatement in the financial statements  • Determining materiality  • Establishing the overall audit strategy & • Developing the audit plan Advanced Auditing Lecture 1

Audit Risk and Materiality • AUDITING NOTES: • Chapter 7. Important Elements of the Audit Process- Concept of Materiality and Audit Risk. • SAICA HANDBOOK: • ISA 240: The Auditor’s responsibilities relating to fraud in an audit of financial statements. • ISA 315: Identifying and assessing the risks of material misstatement through understanding the entity and its environment. • ISA 320: Materiality in planning and performing an audit. • ISA 330: The Auditor’s responses to assessed risks. • ISA 450: Evaluation of misstatements identified during the audit • ISA 510: Initial audit engagements – opening balances. • ISA 520: Analytical Procedures. Advanced Auditing

Audit Risk : the auditor’s objective • Identify and assess risks of material misstatement • High, Medium, Low • Risk may be due to • FRAUD (ISA 240) or ERROR • 2 Levels of risk • Financial Statement level AND Assertion level • How? • By obtaining an understanding of entity and its environment, including internal control • Why? • Provides a basis for designing and implementing responses to assessed risks of material misstatement Advanced Auditing

Audit Risk • Definition of Audit Risk • The risk that the auditor expresses an inappropriate audit opinion when the annual financial statements are materially misstated • Audit Risk is a function of the risks of material misstatement (IR & CR), and Detection Risk (Ref: Glossary of Terms) • Risk-based auditing Advanced Auditing

ISA 315 • Identification of risks • Obtaining an understanding of the entity and its environment, including Internal Control • Assessing identified risks • Evaluating whether the risks relate more pervasively to the AFS as a whole • Relating the risks to what can go wrong at the assertion level • Considering the likelihood of misstatement, and possible magnitude of the misstatement Advanced Auditing

ISA 315 • Significant Audit Risks • Risk of fraud • Risk related to significant economic, accounting, or other developments that require specific attention • Complex transactions • Significant transactions with related parties • Degree of subjectivity • Transactions outside normal course of business for entity Advanced Auditing

ISA 315 • Where auditor revises assessment of Audit Risk • Where assessment changes during the audit • Revision of assessment • Modification of audit procedures • Documentation required • Discussions between audit team • Key elements of understanding • Identified risks • FS level • Assertion level Advanced Auditing

ISA 315 • The link between ISA 315 and Audit Risk? • A failure to identify factors that may give rise to the risk of material misstatement (and a failure to respond to such risks) Increase in audit risk • Failure to understand • The entity and its environment • The accounting system and internal control systems Advanced Auditing

The Client Risks • “Inherent Risk” • Built-in risk that exists before internal controls are put in place!!! • Risks related to specific type of industry and type of client • Develop assessment by gaining understanding of entity and its environment (A17 – A41) • Industry, regulatory and external factors • Nature of entity • Objectives and strategies, and related business risks • Financial performance of entity Advanced Auditing

The Client Risks • “Control Risk” • A66 • Evaluation of design of control involves considering whether control is capable of effectively preventing, or detecting and correcting, material misstatements. • Implementation of a control means that the entity is using it • No point in testing a control if it is not designed properly • A67 • Risk assessment procedures • Enquiry of personnel • Observing the applicable controls • Inspecting reports and documentation • Tracing transactions i.e. Walk-through Advanced Auditing

The Client Risks • Control risk • Control activities • Control environment – NB!!! • E.g. Management override • The entity’s risk assessment process • The information system • Control activities • Monitoring of internal controls • Essential to evaluate the effect of the identified weaknesses (in system) on the financial statement assertions Advanced Auditing

The Auditor’s Risk • Detection risk • Risk that the auditor will not detect a misstatement that exists and could be material • Risk that is inherent in the client’s operations and IS NOT addressed by the client’s control system • Detection risk is a function of the effectiveness of the auditor’s audit procedures Advanced Auditing

The Auditor’s Risk • Detection risk • Detection risk may arise because • Inappropriate audit procedure • Misapplication of a procedure • Misinterpretation of the results of a procedure • There is an INVERSE relationship between risk of material misstatement [IR & CR] and Detection Risk Advanced Auditing

Assessing risk at two levels • At financial statement level • Will potentially affect many assertions • Factors that may affect audit risk at the financial statement level • Management's integrity • Manipulation of AFS to meet their own needs • Management’s experience and knowledge • Errors in AFS • Pressure on management • Many business failures in industry • Need to raise loans Advanced Auditing

Assessing risk at two levels • At financial statement level • Factors that may affect audit risk at the financial statement level (cont.) • Nature of entity’s business • Factors affecting the industry (→ going concern problems) • Economic conditions • Consumer demand for company’s products • Need to consider how these factors will impact on the AFS Advanced Auditing

Assessing risk at two levels Advanced Auditing • At financial statement level – responding to risks • Assigning staff with appropriate skills and experience • More supervision of staff • Professional scepticism • Elements of unpredictability in selecting items to test, and in the performance of the work • Adjustment of nature, timing, and extent of audit procedures → more substantive in nature • Use of experts (complex & judgmental areas)

Assessing risk at two levels • At financial statement level – responding to risks • Going concern risks → more discussions with management, audit committee • Focusing procedures on high risk areas • Consideration of whether to continue with the audit Advanced Auditing

Assessing risk at two levels • At assertion level • Risk at financial statement level “trickles” down, and becomes risk at the assertion level • E.g. Poor management integrity • Factors that may affect audit risk at the assertion level • Susceptibility of an account to misstatement • Complexity of transactions • Degree of judgement involved • Susceptibility of assets to loss or misappropriation • Complex and unusual transactions (at year-end) • Transactions not subjected to routine processing Advanced Auditing

Audit Risk • Events and conditions that may indicate risks of material misstatement • Appendix 2 of ISA 315 • Do NOT learn “off by heart” • Understand and be able to identify in a question • Know how to respond to the identified risk Advanced Auditing

ISA 330 – Auditor’s responses to risks • Design and performance of further audit procedures to obtain sufficient, appropriate audit evidence • Nature, timing and extent of further procedures are based on, and are responsive to the assessed risks of material misstatement at assertion level • Tests of controls • Substantive procedures (AR, Tests of Detail) • Ref: ISA 330 Application and Other Explanatory Material Advanced Auditing

ISA 330 – Auditor’s responses to risks • Evaluating the sufficiency and appropriateness of the audit evidence gathered • Based on audit procedures performed, and evidence gathered • Need to conclude on whether assessments of risk of material misstatement at assertion level remain appropriate • Does the evidence corroborate or contradict the assertions in the AFS Advanced Auditing

Risk of Material Misstatement: Fraud • Misstatement of AFS is INTENTIONAL • Responsibility for prevention and detection of fraud • Lies with management and those charged with governance • Commitment to culture of honesty • Consider potential for override of controls • Responsibility of auditor • To obtain reasonable assurance that AFS are free of material misstatement – through error or fraud Advanced Auditing

Risk of Material Misstatement: Fraud • Ability of auditor to detect fraud depends on factors such as • Skill of perpetrator • Frequency and extent of manipulation • Degree of collusion • Size of amounts • Seniority of those involved • More difficult to detect management fraud Advanced Auditing

JOIN KHALID AZIZ • COACHING CLASSES • ICMAP STAGE 1,2,3,4..& CAM • ICAP MODULE A,B,C,D • PIPFA • MA-ECONOMICS • B.COM, BBA & MBA • BA-ECONOMICS • INTER COMMERCE • 0322-3385752 • R1173, ALNOOR SOCIETY BLOCK 19, F.B.AREA, KARACHI.

Risk of Material Misstatement: Fraud • Auditor’s requirements • Professional scepticism • Irrespective of past experience with client • Discussion with audit team • Risk assessment procedures Advanced Auditing

Materiality • References • ISA 320 – Materiality in Planning and Performing an Audit • ISA 450 - Evaluation of Misstatements Identified During an Audit • Audit report • Auditor’s opinion on whether or not the AFS are materially misstated • AFS will contain a margin of uncertainty • Where misstatement > acceptable margin of uncertainty • Affects user’s decisions based on AFS • Misstatement becomes MATERIAL Advanced Auditing

Materiality • The nature of materiality • It is subjective • Professional judgement is required • It is relative • E.g. Coca Cola vs. the corner cafe • The balance sheet vs. the income statement • It is qualitative and quantitative • Qualitative • Where an amount > amount set as material • Quantitative • Judged against a factor other than an amount • E.g. Important disclosure that is omitted Advanced Auditing

Setting of materiality Advanced Auditing • Auditor must consider and set materiality during the Planning stage of the audit • Planning Stage • Assess the risk of materiality misstatement AND consider planning materiality • Formulate an audit plan • Nature, timing, and extent of audit procedures

Planning Materiality Advanced Auditing • The relationship between planning materiality and audit risk • Inverse relationship • Higher audit risk • Set materiality lower in order to compensate for this • Lower audit risk • Set materiality higher • Chance of material misstatement going undetected is lower • Inverse relationship between audit risk and materiality • Impact on nature, timing and extent of audit procedures • The risk of material misstatement will have a direct impact on setting of planning materiality levels

Planning Materiality • It is a benchmark against which to measure quantitative misstatements • Considerations • Amount of misstatement • Quantitative • Nature of misstatement • Qualitative • 2 Levels at which materiality is considered • Overall level • Individual level Advanced Auditing

Planning materiality • Exam technique – when calculating materiality • Stability of indicators – which figures to use • Budget or actual • Budgeted figures – will these figures be achieved? • Un-audited figures of current year – whole year’s figures? • Prior year audited figures • Balance sheet or Income Statement • Consider the nature of the business • Which would be most appropriate ? • Look at “activity” on B/S and I/S. • Who are the users? Would they use the I/S or the B/S mostly? Advanced Auditing

Planning materiality Exam technique – when calculating materiality Calculation E.g. use of DP6 Conclusion Do not leave materiality in a range – need a number!! Where it is a high risk audit – be conservative Examples Incentive to overstate assets and understate liabilities Possible Going Concern Risks related to particular assets, liabilities etc Risks related to the accounting system Advanced Auditing

Planning materiality • Quantitative indicators of materiality • E.g. DP6 • Turnover ½ - 1% • Gross profit 1 – 2% • Net income 5 – 10% • Total assets 1 – 2% • Equity 2 – 5% • Will calculate upper and lower limits of materiality • Using lower limit  more conservative level of materiality  detection of more errors Advanced Auditing

Planning materiality • Qualitative indicators of materiality • Consider when quantifying materiality • Examples include • Control environment • Effectiveness of internal controls • Integrity of management • Appropriateness of accounting policies and the disclosure thereof • Statutory requirements and regulations • Problems and errors – previous years • Results of analytical procedures • Possibility of illegal transactions Advanced Auditing

Final Materiality • Is established at the end of the audit • Is the standard against which identified misstatements are measured, in order to determine the effect on the AFS • Consider responsibilities in terms of reporting responsibilities (ISA 700) • Conclusion required by ISA 700 takes into account auditor’s evaluation of unadjusted audit differences on the AFS (ISA 450) Advanced Auditing

Final Materiality • Planning Stage • Assess the risk of materiality misstatement AND consider planning materiality • Formulate an audit plan • Nature, timing, and extent of audit procedures • Evaluation of misstatements • Selected audit procedures are carried out – on samples of the population e.g. debtors, sales, creditors • Errors in samples • Draw audit conclusions about the populations Advanced Auditing

Final Materiality • Process followed by auditor • Analyse & project sample errors over the population • If the projected misstatement is unacceptable • Perform further tests OR • Client to check population in detail for errors • Discuss the misstatements with management  correction of errors • Refusal o correct errors  unadjusted differences  use of FINAL MATERIALITY to determine materiality of differences • Misstatement is material  more misstatement that acceptable  qualification of audit opinion Advanced Auditing

Final Materiality • Why would the client refuse to correct misstatements • Disagreement over whether is a misstatement • E.g. estimate of inventory obsolescence is too low • Misstatement not regarded as material • I.e. Won’t influence the user • Ulterior motives • E.g. loan covenant – current ratio required • Too much bother to make the changes • Not concerned about receiving a qualified opinion Advanced Auditing

Advanced Auditing