1. 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 6 PLANNING, KNOWLEDGE OF THE BUSINESS AND EVALUATING STRATEGIC BUSINESS RISK

2. 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 STEPS IN ACCEPTING AN AUDIT

3. 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 QUALITY CONTROL POLICIES AND CLIENT 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 firm has technical expertise to carry out audit Ensuring accepting engagement will not conflict with the profession’s code of professional conduct

4. 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 COMMUNICATION WITH PREVIOUS AUDITOR Ensures interests of shareholders, incoming auditor and existing auditor are protected. Allows existing auditor to advise prospective auditor of any professional matters they should be aware of before accepting the engagement. Nominated auditor should request client’s permission to communicate with previous auditor. If client refuses permission, normally decline nomination. If permission granted, ask previous auditor for all information necessary to decide whether nomination should be accepted.

5. 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 ENGAGEMENT LETTER A letter from auditor to client that documents and confirms auditor’s acceptance of the appointment. Should include: Objective and scope of audit Responsibility of management for financial report Form of any reports An explanation of extent to which an audit can be relied upon to detect material misstatement Auditor’s right to unrestricted access to records, documents and other information necessary to complete audit

6. 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 AUDIT PLANNING Planning stage a very important stage of the audit Two aspects:  Audit plan - outlines the expected scope and conduct of audit  Audit program - directs the nature, timing and extent of audit procedures

7. 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 MAJOR STEPS IN THE AUDIT PROCESS In every audit of a financial report there are five identifiable stages. These stages are: Obtaining knowledge of the client’s business Understanding the internal control structure Performing tests of transactions Performing tests of balances Completion and review

8. 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 DEVELOPING AN OVERALL AUDIT STRATEGY Overall audit strategy details the general evidence requirements for forming an opinion and initial choice as to 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.

9. 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 Lower assessed level of control risk Predominantly substantive approach Audit strategy may be anywhere along this continuum RANGE OF AUDIT STRATEGIES

10. 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 LOWER ASSESSED LEVEL OF CONTROL RISK APPROACH If the internal control structure is well designed and expected to be highly effective, audit strategy will be: Assessed level of control risk of low or medium Extensive understanding of relevant parts of the internal control structure Plan extensive tests of control Plan reduced level of substantive audit procedures

11. 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 PREDOMINANTLY SUBSTANTIVE APPROACH If auditor believes adequate controls do not exist or might be ineffective or testing controls are not cost effective, audit strategy will be: Use a planned assessed level of control risk of high Plan to obtain a minimum understanding of internal control structure Plan no tests of control Plan extensive substantive audit procedures

12. 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 IMPACT OF STRATEGIC BUSINESS RISK ASSESSMENT ON AUDIT STRATEGY More time is spent on 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 Reduced detailed substantive testing if financial report in accordance with auditor’s expectations

13. 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 PREPARING DETAILED AUDIT PROGRAMS 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.

14. 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 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 Evidence of consideration of internal control structure in relation to proposed audit procedures

15. 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 CONTENTS OF AUDIT PROGRAM 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 Timing - appropriate time to perform the procedure Audit program will outline following characteristics of audit procedures:

16. 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 ASSIGNING AND SCHEDULING AUDIT STAFF Activities entailed include: Coordinating assistance of client entity personnel Determining extent of involvement of consultants, specialists and internal auditors Establishing and coordinating staffing requirements

17. 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 KNOWLEDGE OF THE CLIENT’S BUSINESS Purpose — assist the auditor to identify events, transactions, practices and risks that might have a significant effect on financial report, particularly on appropriateness of accounting policies adopted and reasonableness of assumptions and estimates incorporated in client’s financial report.

18. 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 KNOWLEDGE OBTAINED BY THE AUDITOR Auditor should obtain an understanding of: Client’s organisational structure Operations and legal structure Relevant industry and economic conditions

19. 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 PROCEDURES FOR OBTAINING AN UNDERSTANDING OF THE CLIENT’S BUSINESS These include: Reviewing auditor’s previous experience with client and industry Discussion with client personnel, other advisers or previous auditors of entity Reviewing industry or government publications and legislation Visiting client’s premises Reviewing documentation produced by client

20. 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 STRATEGIC BUSINESS RISK Defined: 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.

21. 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 THE RELATIONSHIP BETWEEN STRATEGIC BUSINESS RISK AND THE GLOBAL, LOCAL AND INTERNAL ENVIRONMENTS Fig. 6.3 The relationship between client business risk and the global, local and internal environments (p. 248)

22. 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 ASSESSING CLIENT STRATEGIC BUSINESS RISK I Profitability and structure of the industry Relationship between the industry and the broad economic and business environment Critical issues facing the industry Significant industry business risks The auditor must obtain a thorough understanding of the industry, including:

23. 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 ASSESSING CLIENT STRATEGIC BUSINESS RISK II The auditor must understand how entity fits within industry, including: Entity’s position within industry in terms of profitability and market share Opportunities and plans entity has for increasing or maintaining profitability and market share Threats to entity’s position in the industry Ways entity deals with customers and competitors Methods entity uses to measure and monitor its performance

24. Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 24 TECHNIQUES FOR ASSESSING CLIENT STRATEGIC BUSINESS RISK - SWOT ANALYSIS S trengths-internal aspects that can improve competitive situation Weaknesses-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

25. Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 25 TECHNIQUES FOR ASSESSING CLIENT STRATEGIC BUSINESS RISK II - PEST ANALYSIS Identifies: P olitical E conomic S ocial T echnological influences on entity.

26. Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 26 TECHNIQUES FOR ASSESSING CLIENT STRATEGIC BUSINESS RISK III Value-chain approach: Disaggregates entity into strategically important activities in order to:  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  Document 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

27. Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 27 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 (planning, as a form of evidence, as a final review). At this stage we concentrate on their use in planning.

28. Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 28 ANALYTICAL PROCEDURES AT THE PLANNING STAGE 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.

29. Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 29 ANALYTICAL PROCEDURES USED IN PLANNING THE AUDIT Simple procedures: Simple comparisons Ratio analysis Common-size statements Trend statements Time series analysis More complex procedures: Time series modelling Regression analysis Financial modelling

30. Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 30 APs 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) Common-size statements and trend statements

31. Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 31 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)  Operating cash flow ratio (cash from operations to current liabilities) 2.Activity  Inventory turnover (cost of goods sold to average inventory)  Receivables turnover (net sales to average accounts receivable) 3.Profitability  Gross profit and net profit ratio (gross profit or net profit to sales)  Return on total assets (net profit/total assets)  Return on shareholders’ equity (operating profit to ordinary shareholders’ equity) 4.Solvency  Debt equity ratio (long-term liabilities to equity)  Number of times interest earned (operating profit to annual interest expense)

32. Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 32 COMMON-SIZE STATEMENTS Express statement of financial position as a percentage of total assets and statement of financial performance as a percentage of total revenue.

33. Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 33 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.

34. Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 34 PLAUSIBILITY, PREDICTABILITY AND PRECISION OF ANALYTICAL RELATIONSHIPS I Relationships in a stable environment are more predictable than relationships in a dynamic, changing environment. Relationships involving statement of financial performance amounts (transactions over a period of time) tend to be more predictable than relationships involving only statement of financial position accounts (amounts at a point in time).

35. Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 35 PLAUSIBILITY, PREDICTABILITY AND PRECISION OF ANALYTICAL RELATIONSHIPS II 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.

36. Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett Slides prepared by Roger Simnett 36 EXAMINATION OF SIGNIFICANT FLUCTUATIONS OF APs Each significant fluctuation (deviation from expected amount) must be investigated. Auditor must also be alert to possibility that absence of expected fluctuation might require investigation. Deviations from expected amount should be discussed with management. Reasonableness of explanations provided by management should be considered. Auditor might have to consider impact of fluctuations on audit program and other audit tests.