Chapter 6
Planning, Knowledge of
the Business and
Evaluating Business Risk
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Learning Objective 1:
Client Acceptance
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Acceptance and continuance evaluation
procedures
•
Procedures carried out before accepting a new client or
continuing with an existing client include:
–
–
–
–
–
Reviewing financial information regarding the client;
Making inquiries of third parties such as solicitors and
bankers;
Communicating with previous auditor;
Ensuring that the firm has technical expertise to carry out
audit; and
Ensuring accepting engagement will not conflict with the
profession’s code of professional conduct.
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Communication with previous auditor
•
Communication ensures that the interests of
shareholders, the incoming auditor and existing auditor
are protected. It allows the existing auditor to advise the
prospective auditor of any professional matters they
should be aware of before accepting the engagement.
• Nominated incoming auditor should request client’s
permission to communicate with previous auditor;
• If client refuses permission, normally decline
nomination; and
• If permission is granted, the nominated auditor asks
previous auditor for all information necessary to decide
whether nomination should be accepted.
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6-4
Learning Objective 2:
Engagement Letters
•
These letters are from the auditor to the client that
document the arrangements and confirm the auditor’s
acceptance of the appointment and should include:
–
–
–
–
–
Objectives and scope of audit;
Responsibility of management for financial report;
Form of any reports;
An explanation of the extent to which an audit can be
relied upon to detect material misstatement; and
Auditor’s right of unrestricted access to records,
documents
and other information necessary to
complete audit.
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6-5
Learning Objective 3:
Audit Planning
•
The planning stage is a very important stage of the
audit and involves two aspects:
–
–
Audit plan - outlines the expected scope and conduct of
audit; and
Audit program - directs the nature, timing and extent of
audit procedures.
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6-6
Major steps in the audit process
•
In every audit of a financial report there are seven
identifiable stages. These stages are:
–
–
–
–
–
–
–
Obtaining knowledge of the client’s business;
Understanding internal controls;
Assessing risks of material misstatement;
Responses to assessed risks;
Performing tests of controls;
Performing substantive procedures; and
Completion and review.
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6-7
Learning Objective 4:
Developing an Overall Audit Strategy
•
Overall audit strategy details the general evidence
requirements for forming an opinion and initial decision
as to the nature, timing and extent of audit procedures.
• Interrelationship between materiality, audit risk and
what constitutes sufficient appropriate audit evidence
impacts on auditor’s strategy.
• Audit strategies can range from a lower assessed level
of control risk approach to a predominantly substantive
approach.
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Range of audit strategies
Lower assessed
level of
control risk
Predominantly
substantive
approach
Audit strategy may be anywhere along this continuum
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6-9
Lower assessed level of control risk
approach
•
If internal control is well designed and expected to be
highly effective, audit strategy will include:
–
–
–
–
Low or medium assessed level of control risks;
Extensive understanding of relevant parts of internal
control;
Extensive tests of control; and
Reduced level of substantive audit procedures, based on
planned acceptable level of detection risk being high or
medium.
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6-10
Predominantly substantive approach
•
If the auditor believes adequate controls do not exist or
might be ineffective or testing controls are not cost
effective, audit strategy will be to:
–
–
–
–
Use a planned assessed level of control risk of high;
Plan to obtain a minimum understanding of internal
control;
Plan no tests of control; and
Plan extensive substantive audit procedures based on
planned acceptable level of detection risk of low or
medium.
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6-11
Impact of business risk assessment on
audit strategy
•
Substantial time is spent on the planning stage and on
developing an expectation of what the entity’s financial
report should look like. Audit strategy might include:
–
–
–
–
Increased use of sophisticated analytical procedures;
Undertaking tests of controls for routine transactions;
Increased substantive testing for non-routine transactions;
and
Reduced detailed substantive testing if financial report is
in accordance with auditor’s expectations.
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6-12
Preparing detailed audit programs
•
An audit program is a detailed list of audit procedures
that need to be applied to a particular balance or class
of transactions to implement the audit strategy.
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6-13
Purpose of detailed audit programs
•
Programs should provide:
–
–
–
–
–
Evidence of proper planning of work;
Guidance for inexperienced staff;
Evidence of work performed;
A means of controlling time spent on the engagement;
and
Evidence of consideration of internal control structure in
relation to proposed audit procedures.
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6-14
Contents of audit program
• An audit program will outline the following
characteristics of audit procedures:
–
–
–
Nature - particular audit procedures to use and particular
items to which a procedure will be applied;
Extent - number of items to which procedures will be
applied, and number of different tests to be performed;
and
Timing - appropriate time to perform the procedure.
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6-15
Learning Objective 5:
Assigning and Scheduling Audit Staff
•
Activities entailed include:
–
–
–
Coordinating assistance of client entity personnel;
Determining the extent of involvement of consultants,
specialists and internal auditors; and
Establishing and co-ordinating staffing requirements.
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6-16
Learning Objective 6:
Knowledge of the Client’s Business
•
Purpose – help to assess business risk, assist the
auditor to identify events, transactions, practices and
risks that might have a significant effect on financial
report, particularly on the appropriateness of accounting
policies adopted and the reasonableness of
assumptions and estimates incorporated in client’s
financial report.
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6-17
Procedures for obtaining an
understanding of a client’s business
•
These include:
–
–
–
–
–
Reviewing the auditor’s previous experience with the
client and industry;
Discussion with client personnel, other advisers or
previous auditors of the entity;
Reviewing the industry or government publications and
legislations;
Visiting the client’s premises; and
Reviewing documentation produced by the client.
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6-18
Steps in planning the audit
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6-19
Knowledge obtained by the auditor
•
An auditor should obtain an understanding of:
–
Client’s organisational structure;
–
Client’s operational and legal structure; and
–
Relevant industry and economic conditions.
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6-20
Learning Objective 7:
Business Risk
•
Business risk can be defined as:
–
Risk that an entity’s business objectives will not be
attained as a result of external and internal forces brought
to bear on an entity and, ultimately, the risk associated
with the entity’s profitability and survival.
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6-21
The relationship between client business risk
and the global, local and internal
environments
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6-22
Assessing business risk
• The auditor must obtain a thorough understanding of
the industry, including:
–
–
–
–
Profitability and structure of the industry;
Relationship between the industry and the broad
economic and business environment;
Critical issues facing the industry; and
Significant industry business risks.
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6-23
Assessing business risk (cont.)
•
The auditor must also understand how the entity fits
within the industry, including:
–
–
–
–
–
Entity’s position within the industry in terms of profitability
and market share;
Opportunities and plans the entity has for increasing or
maintaining profitability and market share;
Threats to the entity’s position in the industry;
Ways in which the entity deals with customers and
competitors; and
Methods the entity uses to measure and monitor its
performance.
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Overview of the audit risk standards
Perform risk assessment procedures to understand the See AUS 402.06-99/
entity and its environment.
ASA 315.10-116
(ISA 315.06-99)
Assess the risks of material misstatement at the
financial report level and at assertion level.
See AUS 402.100-119/
ASA 315.117-140
(ISA 315.100-119)
Respond to the risks at the financial report level and
assertion level.
See AUS 406.04-21/
ASA 330.08-28
(ISA 330.04-21)
Perform further audit procedures that are clearly linked
to risks at the assertion level.
See AUS 406.22-65/
ASA 330.29-89
(ISA 330.22-65)
Evaluate whether sufficient and appropriate audit
evidence has been obtained.
See AUS 406.66-72/
ASA 330.90-98
(ISA 330.66-72)
and AUS 502/ ASA 500
(ISA 500)
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Techniques for assessing business risk –
SWOT analysis
S trengths
—
W eaknesses
— Internal aspects, vulnerability to
competitors’ strategic moves.
O pportunities
— Environmental aspects that can
improve entity’s situation relative
to competitors.
T hreats
— Environmental aspects that can
undermine entity’s competitive
situation.
Internal aspects that can improve
competitive situation.
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6-26
Techniques for assessing business risk
(cont.) – PEST analysis
Identifies:
P olitical
E conomic
S ocial
T echnological
…..influences on entity.
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Techniques for assessing business risk
(cont.) – Value-chain approach
•
This approach disaggregates an entity into strategically
important activities in order to:
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–
–
–
–
Understand client’s strategic advantages;
Understand risks that threaten attainment of business
objectives;
Understand key processes and related competencies
needed to realise strategic advantages;
Measure and benchmark process performance; and
Document an understanding of the client’s ability to create
value and generate future cash flows by using a client
business model, process analyses, key performance
indicators and a business risk profile.
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6-28
Response to assessed risks
•
An auditor should determine overall responses to
assessed risks at financial report level, and perform
audit procedures at the assertion level. Responses at
financial report level include:
–
–
–
assigning more experienced staff;
using experts; and
incorporating unpredictability into selection of further audit
procedures.
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6-29
Performing further audit procedures at the
assertion level
•
An auditor must consider:
–
–
–
–
Significance of the risk.
Likelihood of misstatement occurring.
Nature of specific controls.
Whether auditor expects to obtain evidence to determine
if entity’s controls are effective in preventing or detecting
and correcting, material misstatement (planned control
risk < HIGH).
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6-30
Learning Objective 8:
Analytical Procedures
•
Analytical procedures involve the use of ratios, trend
analysis and operating statistics for comparison with
internal and external data.
• Can be used at all stages of the audit:
–
•
e.g. in planning stage as a form of evidence or as a final
review.
At this stage we concentrate on use of analytical
procedures in planning.
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6-31
Analytical procedures at the planning
stage
•
A risk analysis approach requires analytical procedures
to be used during the planning stage of the audit.
• Allows the auditor to understand the business and
identify areas of potential risk, thereby assisting in the
determination of the nature, timing and extent of audit
procedures.
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6-32
Analytical procedures used in planning the
audit
Simple procedures:
More complex procedures:
•
•
•
•
•
•
Simple comparisons
Ratio analysis
Common-size statements
Trend statements
Time series analysis
•
•
Time series modelling
Regression analysis
Financial modelling
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Analytical procedures most commonly
used in planning
•
Comparison of current balances in the financial report
with balances of prior periods, and budgeted amounts
(simple comparisons);
• Computation of ratios and percentage relationships for
comparison with prior years, budgets and industry
averages (ratio analysis); and
• Significant variations from expectations indicate areas
requiring investigation.
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Ratios commonly used at the planning
stage
•
1.
Short-term liquidity
–
Current ratio (current assets to current liabilities);
– Quick asset ratio (liquid assets to current liabilities); and
– Operating cash flow ratio (cash from operations to current liabilities).
•
2.
Activity
–
Receivables turnover (net sales to average accounts receivable); and
– Inventory turnover (cost of goods sold to average inventory).
•
3.
Profitability
–
Gross profit and net profit ratio (gross profit or net profit to net sales);
– Return on total assets (net profit to total assets); and
– Return on shareholders’ equity (net profit to ordinary shareholders’
equity).
•
4.
Solvency
Debt equity ratio (long and short term debt to shareholders’ equity); and
– Times interest earned (net profit to annual interest expense).
–
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Common-size statements
•
Express balance sheet components as a percentage of
total assets and income statement components as a
percentage of total revenue.
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Trend statements
•
Each item is expressed as a percentage of its own level
from a base year, thus allowing focus on trend rather
than absolute magnitude of dollar charge.
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6-37
Reliability of data used in analytical
procedures
•
•
•
•
•
Data from an independent source outside the entity are
generally more reliable than internal data.
Data from a system with effective internal controls are
more reliable than data from a poorly controlled system.
Data audited in the previous year or in the current audit
are more reliable than unaudited data.
Data from a variety of sources that corroborate each
other are more reliable than data from only one source.
Data from the department within the entity that is
responsible for the amount being audited are generally
less reliable than data from another department.
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6-38
Plausibility, predictability and precision of
analytical relationships
•
Relationships in a stable environment are more
predictable than relationships in a dynamic, changing
environment.
• Relationships involving income statement amounts
(transactions over a period of time) tend to be more
predictable than relationships involving only balance
sheet accounts (amounts at a point in time).
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6-39
Plausibility, predictability and precision of
analytical relationships (cont.)
•
Direct relationships are more predictable than indirect
relationships.
• Disaggregated relationships are more precise and show
clearer relationships than combined or aggregated
relationships.
• Relationships involving transactions subject to
management discretion are less predictable than those
not subject to such discretion.
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6-40
Examination of significant fluctuations of
analytical procedures
•
•
•
•
•
Each significant fluctuation (deviation from expected
amount) must be investigated;
An auditor must also be alert to the possibility that an
absence of expected fluctuation might require
investigation;
Deviations from an expected amount should be
discussed with management;
Reasonableness of explanations provided by
management should be considered; and
An auditor might have to consider impact of fluctuations
on audit program and other audit tests.
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6-41