ACC3603 Assurance & Attestation Seminar 4: Materiality, Audit Documentation, CAATs and Audit Evidence Ms Chu Mui Kim bizchum@nus.edu.sg 1 Seminar 4: Learning Outcomes 4.1 Explain and apply materiality. 4.2 Understand the purpose of documentation 4.3 Identify and explain the types of Computer-Assisted Audit Techniques (CAATs) 4.4 Understand the nature of audit evidence & explain the sufficiency and appropriateness of evidence. 4.5 Evaluate the reliability of evidence. 4.6 Explain the different types of audit procedures 2 3 4.1 Materiality • 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 statements; • Judgments 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 • • • • The concept of materiality is applied by the auditor in planning performing the audit evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements • forming the opinion in the auditor’s report. 4 Materiality in planning In planning the audit, the auditor makes judgments about the size of misstatements that will be considered material. These judgments provide a basis for: • Determining the nature, timing and extent of risk assessment procedures; • Identifying and assessing the risks of material misstatement; and • Determining the nature, timing and extent of further audit procedures. 5 Determining Materiality during planning Two types of materiality: • Materiality for financial statements as a whole • Performance materiality Determine materiality for FS as a whole Determining materiality involves the exercise of professional judgment. A percentage is often applied to a chosen benchmark as a starting point in determining materiality for the financial statements as a whole 6 Determining Materiality during planning Materiality for financial statements as a whole Examples of benchmarks that may be appropriate, depending on the circumstances of the entity, include categories of reported income such as profit before tax, total revenue, gross profit and total expenses, total equity or net asset value. Profit before tax from continuing operations is often used for profit-oriented entities. When profit before tax from continuing operations is volatile, other benchmarks may be more appropriate, such as gross profit or total revenues. 7 Determining Materiality during planning 8 Materiality by nature Certain items in the accounts require “precision” regardless of their financial value. • Omission of a disclosure required by Companies Act or financial reporting standards; Therefore, any error (however small) in respect of these items would be considered material and must be adjusted. • Items which are misstated in the accounts such as those linked to fraud and illegal acts; • Items which involve the directors or which are legally required such as share capital. 9 Qualitative Materiality Factors 10 Determining Materiality during planning SSA 320 says that as well as setting materiality for the financial statements as a whole, it may be necessary to do so for a particular balance or class of transactions as well. Performance materiality “the amount or amounts set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole.” Performance materiality must be less than materiality for the financial statements as a whole. Some audit firms have set as a guide that performance materiality should be no more than 70-75% of materiality for the financial statements as a whole. It must be a smaller number because auditors must consider the effect of aggregated errors. 11 Determining Materiality during planning Determining performance materiality The determination of performance materiality is not a simple mechanical calculation and involves the exercise of professional judgment. It is affected by the auditor’s understanding of the entity, updated during the performance of the risk assessment procedures; and the nature and extent of misstatements identified in previous audits and thereby the auditor’s expectations in relation to misstatements in the current period. 12 Determining Materiality during planning Another example of performance materiality relates to the testing of director remuneration. Something may be considered material not just because of its value but also because of its nature. Director remuneration is a very sensitive area because any money that the directors choose to pay themselves reduces distributable profits. Therefore performance materiality may be set as $1 so that every transaction, no matter how low in value, would be tested by the auditors. 13 Activity 4.1 Your firm is the auditor of four companies. Required: (a) For the audit of each of the company described below: (i) Suggest and explain a suitable benchmark; and (ii) Calculate the materiality for the financial statements as a whole. (16 marks) (b) During the year, you discovered that Beta had taken up a significant bank loan and one of the terms in the loan covenant requires Beta’s debt to equity ratio to be below 1:1 at all times. (i) Describe how your materiality for the financial statements as a whole would be changed. (3 marks) (ii) Explain what your assessment of financial statements assertions at risk of Beta for the year ended 31 March 20x6 would be. (6 marks) 14 Activity 4.1 Alpha Alpha is an established family-owned business with no external borrowings and its business is in property investment. Over the years, its investment portfolio has grown to include a sizeable amount of assets. Due to government’s measures to stabilize the property market, its earnings have been flat in the past three years. For the 12 months ended 31 December 20x5, its financial information is as follows: Revenue $96m Profit before tax $12m Profit after tax $7.2m Net assets $96m Total assets $120m 15 Activity 4.1 Beta Beta is a small listed company with significant amount of bank borrowings. It operates a fleet of private yachts for corporate charter and business has been brisk for the company as demand for private sea-charter had been increasing steadily over the past few years. For the 9 months ended 31 December 20x5, its financial information is as follows: Revenue $40m Profit before tax $8m Profit after tax $5m Net assets $15m Total assets $30m 16 Activity 4.1 Gamma Gamma specialises in providing food catering services and is owned by a husband and wife team with no external borrowings. For the 12 months ended 31 December 20x5, the owners, Mr. and Mrs Lim, had withdrawn an amount of $1.2 million from the business earnings in the form of salary, instead of dividends. For the 12 months ended 31 December 20x5, its financial information is as follows: Revenue $3.8m Profit before tax $200k Profit after tax $160k Net assets $2m Total assets $2m 17 Activity 4.1 Omega Omega is a large family-owned business providing marine services to the oil and gas companies. Due to the significant decline in oil prices, Omega faced a series of cancelled and postponed contracts so earnings have been on the decline over the past three years. It is in desperate need for capital injection from venture capitalists. For the 12 months ended 31 December 20x5, its financial information is as follows: Revenue $280m Profit before tax $1.1m Profit after tax $1m Net assets $18m Total assets $30m 18 19 4.2 Audit Documentation Audit documentation that meets the requirements of SSA 230 and the specific documentation requirements of other relevant SSAs provides: • Evidence of the auditor’s basis for a conclusion about the achievement of the overall objectives of the auditor; and • Evidence that the audit was planned and performed in accordance with SSAs and applicable legal and regulatory requirements. 20 Purposes of Audit Documentation Audit documentation serves a number of additional purposes, including the following: • Assisting the engagement team to plan and perform the audit. • Assisting members of the engagement team responsible for supervision to direct and supervise the audit work, and to discharge their review responsibilities. • Enabling the engagement team to be accountable for its work. • Retaining a record of matters of continuing significance to future audits. • Enabling the conduct of quality control reviews and inspections. • Enabling the conduct of external inspections in accordance with applicable legal, regulatory or other requirements. 21 Types of Audit Documentation Audit working papers are collected in the current audit file and the permanent audit files. Current audit file For each annual audit assignment, the working papers are collected in the current audit file. The file shows all of the work that was done throughout the audit process and includes: • a planning section; • sections for each area of financial statements showing the work that was done; for example, audit procedures performed on inventory, bank balances etc; • a completion section showing the final task carried out at the end of the audit, including a schedule of points for manager’s and partner’s attention and a schedule of points for next year’s audit. 22 Types of Audit Documentation Permanent audit file Information that is of continuing use to the audit year-on-year is kept on the permanent file and includes the following items: • the engagement letter; • organisational charts that show the company’s organizational structure and key employees; • system flow charts; • company’s Articles of Association and Memorandum; and • long term agreements such as loan agreements, lease agreements 23 Types of Audit Documentation Good documentation includes: • Enough details to allow reader to understand audit process & reperform tests • Initials of audit staff who performed work & of review by team leader, manager & partner • Use of appropriate tick marks & legends • Index to identify location of work done on specific accounts & procedures • Proper cross-referencing of related data & transactions 24 25 4.3 CAATs Many of the concepts applicable to manual systems hold for computerised systems. The auditor will want to: • Gain assurance that the processes and computer programs are working correctly • Trace transactions through the processing system to determine that transactions have been correctly processed • Select transactions for more detailed testing and analysis Types of commonly used CAATs: • Integrated test facility • Tagging and tracing (tracing transactions through the system) • Generalized audit software 26 Integrated Test Facility Test the application controls in the client’s computer programs by creating a set of simulated data (includes both valid and invalid data) for processing. Test data are developed to determine whether: • Control procedures built into the applications are functioning effectively • The computer application is processing transactions correctly • All transactions and master files are fully and correctly updated • Only test application controls and do not test if the company has adequate controls to prevent submission of unauthorised or incorrect data. 27 Tagging and testing: Tracing transactions through the system • A transaction is selected at the input stage and is electronically "marked“. • The transaction is then electronically tracked through processing • This allows the auditor to determine whether the transaction has been properly recorded and that the correct files have been updated Advantages: – Works concurrently with client's processing of regular transactions – Flexible: auditor is able to select transactions to "mark" – Can be used to track transactions through distributed processing networks 28 Generalised audit software Designed to read existing computer files and perform function such as: • Footing a file • Selecting a sample ‐ either statistically or judgmentally • Extracting, sorting, and summarizing data • Obtaining file statistics • Evaluating statistical sample results • Perform analytical procedures • Finding how many transactions or population items meet specified criteria • Checking for gaps in processing sequences • Checking for duplicates • Performing arithmetic calculations • Analyzing data files for unusual patterns 29 Generalised audit software The most widely used of all computerized audit techniques Allows auditors to perform a variety of procedures including: – Analyzing files – Selecting transactions based on logical identifiers – Scanning accounts for unusual entries – Selecting statistical samples – Performing basic and advanced numerical analysis – Creating reports 30 Audit approaches for E-commerce Audit of entity using E‐Commerce follows basic audit approach; auditor must understand business processes, important applications, control environment, and risks Risk analysis • Risks in common with traditional information systems: o Unauthorized access o Unauthorized changes to programs or data files o Misstatements caused by processing or logic errors o Lack of physical security 31 Audit approaches for E-commerce Risk analysis • Risks unique to E‐Commerce systems o Security of system and protection against penetration by outsiders o Integrity of processing may be threatened by many different sources o Integrity of data communications o Trading partner agreements o Systems interdependencies o Paperless systems coupled with "soft" controls 32 Audit approaches for E-commerce Process and Control Audit • Audits of E‐Commerce will focus on tests of controls and processes • Auditor develops understanding of controls and approach to determine that controls are working effectively Tagging and Tracing • Tagging is more complicated than process identified earlier in chapter • Auditor must work with IT to develop logic 33 Activity 4.2 Select the audit procedures from the following list and enter it in the appropriate place on the grid. Audit procedures: 1. Test data method 2. Custom audit software 3. Auditing around the computer 4. Generalized audit software Description of audit technique a. program written by the auditor to compute the depreciation charge for a particular client Audit procedure b. audit the inputs and outputs of the system without verification of the processing of data c. process fictitious and real data through the client’s IT system d. select receivables with balances that exceed a certain criteria and prepare confirmation letters. 34 35 4.4 Audit evidence: Nature SSA 500 Audit evidence Information used by the auditor in arriving at the conclusions on which the auditor’s opinion is based. Audit evidence includes both information contained in the accounting records underlying the financial statements and other information. The auditor gathers evidence to evaluate the management assertions underlying the financial statements. 36 4.4 Audit evidence: sufficiency and appropriateness The auditor should obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base the audit opinion. Sufficiency of audit evidence refers to the measure of the quantity of audit evidence to be obtained by the auditor to meet audit objectives. It is affected by • the auditor’s assessment of the risks of misstatement (the higher the assessed risks, the more audit evidence is likely to be required) and • the quality of such audit evidence (the higher the quality, the less may be required). 37 Audit evidence: sufficiency and appropriateness Appropriateness of audit evidence is the measure of the quality of audit evidence; that is, its relevance and its reliability in providing support for the conclusions on which the auditor’s opinion is based. • The reliability of evidence means that the evidence must be trustworthy • The relevance of evidence means that the evidence must be related to assertion tested.. Auditors often rely on persuasive rather than convincing evidence, because: – Audit must be completed within reasonable time/cost, hence only test on sample basis. – Evidence obtained may not be perfectly reliable. 38 4.5 Factors affecting reliability of evidence • Audit evidence from independent external sources is more reliable than that obtained from the entity’s records. • Audit evidence obtained from the entity’s records is more reliable when the related accounting and internal control system operates effectively. • Evidence obtained by auditors is more reliable than that obtained by or from entity. • Evidence in the form of documents and written representations is more reliable than oral representations. • Original documents are more reliable than photocopies, telexes or facsimiles. • Evidence created in the normal course of business is better than evidence specially created to satisfy the auditor. • Evidence about the future is particularly difficult to obtain and is less reliable than evidence about past events 39 Paper vs Electronic documentation Major challenge for auditors to determine which electronic data is reliable. Computer systems can be designed to provide safeguards similar to paper‐based systems. If auditor is going to rely on electronic data, he/she must develop an understanding of the – Client's computer system – Controls used to safeguard electronic data from manipulation or destruction 40 4.6 Audit procedures to obtain audit evidence • Inspection of records refers to examination of records or documents that provide evidence of varying degree of reliability depending on the source of audit evidence and the internal controls over their processing. • Inspection of tangible assets refers to examination of tangible assets that provide evidence on the existence and condition of the assets. • Reperformance requires the auditor to carry out the process or procedures being performed by others. • Recalculation is performed when the auditor checks the arithmetical accuracy of source documents and accounting records, and investigate unusual items or fluctuations. 41 Audit procedures to obtain audit evidence • Inquiry refers to seeking information from knowledgeable persons inside or outside the entity, such as enquiring about sale of old inventories from sales managers; enquiring about store operations from store supervisor. • Observation requires the auditor to look at the process or procedures being performed by others., such as attending wages payout, attending stock takes. • Confirmation requires the auditor to obtain a written response to an audit inquiry from persons outside or within the entity to support information contained in accounting records. • Analytical procedure (refer to Seminar 3) • Scanning 42 Activity 4.3 For each of the following specific audit procedures, indicate the type of audit procedure it represents: (1) inspection of records or documents; (2) inspection of tangible assets; (3) reperformance; (4) recalculation; (5) scanning; (6) inquiry; (7) observation; (8) confirmation; and (9) analytical procedures. a. Sending a written request to the client’s customers requesting that they report the amount owed to the client. b. Examining large sales invoices for a period of two days before and after year-end to determine if sales are recorded in the proper period. c. Agreeing the total of the accounts receivable subsidiary ledger to the accounts receivable general ledger account. d. Discussing the adequacy of the allowance for doubtful accounts with the credit manager. 43 Activity 4.3 e. Comparing the current-year gross profit percentage with the gross profit percentage for the last four years. f. Examining a new plastic extrusion machine to ensure that this major acquisition was received. g. Watching the client’s warehouse personnel count the raw materials inventory. h. Performing test counts of the warehouse personnel’s count of the raw material. i. Obtaining a letter from the client’s attorney indicating that there were no lawsuits in progress against the client. j. Tracing the prices used by the client’s billing programme for pricing sales invoices to the client’s approved price list. k. Review the general ledger for unusual adjusting entries. 44 Reliability of Audit procedures (general guidelines) 45 Activity 4.4 Q1. Which of the following would be the most persuasive type of evidence? a. Check register b. Bank statement c. Observation of assets d. Inquiry with the in-house attorney Q2. Which of the following would be the least persuasive type of evidence? a. Confirmation returned by bank directly to the auditor b. Letters of communication from the Securities Exchange Commission c. Physical examination of inventory d. General ledger in a newly developed information system 46 Activity 4.4 Q3. An audit junior assigned to the audit of accounts receivable balances of Recall Pte Ltd has obtained the following audit evidence: i. Aged receivable report performed by the accounts receivable staff. ii. Accounts receivable confirmation. iii. Verbal confirmation from the Chief Finance Officer that all transactions relating to accounts receivable balances have been recorded. iv. Comparison of accounts payable turnover days with prior year done by audit senior. Rank the order of reliability of the audit evidence starting with the most reliable first. a. ii, iv, i, iii. b. iv, ii, i, iii. c. ii, i, iv, iii. 47 d. i, iii, ii, iv.
