inherent risk assessment and materiality · inherent risk and computer information systems ......
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Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 1
CHAPTER 7
INHERENT RISK ASSESSMENT AND
MATERIALITY
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 2
INHERENT RISK (IR)
Defined: Susceptibility of account balance or class of transactions to material misstatement, given inherent and environmental characteristics, without regard to internal control structure (AUS 402.09/ISA 400.04).
Auditor required to assess IR at financial report level for audit plan, with assessment related to assertions at account balance or class of transactions level when developing audit program.
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 3
FACTORS AFFECTING IR AT
FINANCIAL REPORT LEVEL
• Integrity of management
• Management experience, knowledge and changes during the period
• Unusual pressure on management
• Nature of entity’s business
• Factors affecting the industry
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 4
INHERENT RISK AND COMPUTER
INFORMATION SYSTEMS (CIS)
As CIS risks can be pervasive to the entity, factors
affecting overall IR associated with CIS are:
• Significant changes in CIS
• Insufficient CIS skills and resources
• Lack of entity support and focus
• High dependence on CIS
• Reliance on outsourced CIS
• Reliability and complexity of CIS
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 5
INHERENT RISK ASSESSMENT AT
ACCOUNT BALANCE AND CLASS OF
TRANSACTIONS LEVEL
Considerations include:
• Accounts likely to require adjustment
• Complexity of underlying transactions
• Judgment involved in determining account balance
• Susceptibility of assets to loss or misappropriation
• Occurrence of unusual and complex transactions, particularly at or near year-end
• transactions not subject to ordinary processing
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 6
EFFECT OF INHERENT RISK ON AN
ACCOUNT BALANCE ASSERTION
Figure 7.1 Effect of inherent risk on an account balance assertion (p. 290)
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 7
CONSIDERATION OF FRAUD AT
PLANNING STAGE
At planning stage, auditor must consider
the risk that misstatements from fraud or
error will not be detected.
It is easier to miss material misstatements resulting from fraud because fraud involves acts designed to conceal it.
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 8
AUDIT PROCEDURES FOR FRAUD AT
PLANNING STAGE
• Auditor will use their experience, knowledge and training to determine whether fraud could occur.
• Auditor needs thorough understanding of client’s business in order to identify opportunities for perpetration of fraud.
Auditor will need to consider:
• Business environment
• Internal control structure
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 9
RISK AT RED FLAG INDICATORS
OF FRAUD
These are listed in Table 7.1 (p. 292) and are
grouped under:
• Management
• Unusual pressures within an entity
• Market pressures
• Unusual transactions
• Unsatisfactory records
• CIS environment
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 10
CONSIDERING EARNINGS
MANAGEMENT INCENTIVES
• Earnings management occurs when judgment in financial reporting and in structuring transactions is used to alter financial reports to influence perceptions of stakeholders of outcomes dependent on reported accounting numbers.
• Earnings management involves those responsible for preparing the financial report such as the Chief Financial Officer (CFO) and Chief Executive Officer (CEO).
• Incentives to manage earnings can be either behavioural or market-based.
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 11
BROAD CATEGORIES OF
EARNINGS MANAGEMENT
• International violations of accounting standards and other reporting requirements that are individually immaterial
• Inappropriate revenue recognition
• ‘Big bath’ charges under the guise of restructuring
• Improper accruals and estimation of liabilities in good times
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 12
CONSIDERING ILLEGAL ACTS
AUS 218 provides guidance on auditor’s consideration of illegal acts (noncompliance with laws and regulations): • Must understand the legal and regulatory
framework applicable to the entity and industry • Audit normally does not include procedures
designed specifically to detect illegal acts • Auditor must recognise circumstances requiring
special attention (e.g. debenture deed requires a specific current ratio be maintained) and consider these in preparation of audit programs
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 13
RELATED PARTIES
The auditor must identify all related parties when planning the audit because:
• The existence of related parties or related-party transactions can affect the financial information. E.g. the accounting standards require the disclosure of information relating to related parties.
• The reliability of audit evidence is a function of the source of that evidence. Therefore, evidence from related parties and transactions with those parties need to be more carefully evaluated.
• The initiation of a related-party transaction might be motivated by other than ordinary business conditions, such as fraud.
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 14
PRELIMINARY ASSESSMENT OF
GOING CONCERN BASIS I
Defined: Entity expected to pay debts as and when they fall due, and continue to operate without any intention necessarily to liquidate or otherwise wind up operations. (AUS 708.03/ISA 570.03)
• Auditor required by standards to assess going concern at planning stage.
• Imminent business failure might have an effect on appropriateness of presentation of financial report or might motivate management misrepresentations.
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 15
PRELIMINARY ASSESSMENT OF
GOING CONCERN BASIS II
• Early identification helps focus audit effort on appropriate assertions in financial report, and permits early communication with management.
• Auditor focuses primarily on anticipated events during the relevant period, approximately 12 months from date of current audit report to expected date of next audit report.
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 16
EXAMPLES OF INDICATIONS OF
GOING CONCERN PROBLEMS
Operating indicators include:
• Lack of strategic direction
• Concentration of risk in few products
• Loss of major market
Financial indicators include: • High gearing, debt/equity ratio
• Adverse movements in key ratios, falls in profitability, current, cash flow ratios
• Inability to pay creditors
[See Table 7.2 (p. 298)]
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 17
EXAMPLES OF MITIGATING
FACTORS
Auditor should consider mitigating factors:
• Asset factors — sale of assets, with delayed replacement
• Debt factors — unused lines of credit, ability to renew or extend existing loans
• Cost factors — ability to reduce costs
• Equity factors — additional contributions from owners, subsidiaries or associates
[See Table 7.3 (p.299)]
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 18
MATERIALITY
Defined: information which if misstated,
omitted, or not disclosed separately in a
financial report may adversely affect either
user decisions or the discharge of accountability
by management. (AUS 306.03/ISA 320.03)
• Auditor uses materiality to:
Evaluate presentation of financial data
Determine nature, timing and extent of audit procedures
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 19
QUANTITATIVE GUIDELINES —
MATERIALITY
Material 10% of appropriate base amount
Immaterial 5% of appropriate base amount
Judgment 5-10% of appropriate base amount
Base amount for statement of financial position items equity, or the appropriate asset or liability class total
Base amount for statement of financial performance items net profit or loss and appropriate revenue and expense amount, for year or averaged over a number of years
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 20
RULES OF THUMB FOR
PLANNING MATERIALITY
Range of percentages
Common bases applied to base Relative advantages
Net profit 5–10 Relevance
Total revenue 0.5–1 Stability
Total assets 0.5–1 Predictability and stability
Equity 1–2 Stability
Table 7.4 Rules of thumb for planning materiality (p. 303)
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 21
FINANCIAL INFORMATION USED AS
BASE
Can be taken from:
• Financial report to be audited (if available);
• Annualised interim financial information; or
• Previous period’s financial report.
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 22
ALLOCATION OF MATERIALITY TO
ACCOUNT BALANCES AND CLASSES
OF TRANSACTIONS
Auditor needs to allocate planning material to
account balances and classes of transactions for
audit testing.
(Auditing standards are silent on this issue.)
No required or optimal method, but auditor should
consider:
• Dollar value of account
• Expectation of error
Copyright 2003 McGraw-Hill Australia Pty Ltd
PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett
Slides prepared by Roger Simnett 23
RELATIONSHIP BETWEEN
MATERIALITY AND AUDIT
RISK
• There is an inverse relationship between audit risk and materiality.
• Auditor sets a lower materiality threshold for accounts that have a higher audit risk. This means the auditor will need to collect more evidence for these accounts.