1. 7-1 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Chapter 7 Assessing Specific Business Risks and Materiality

2. 7-2 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Assessing risk of material misstatement AUS 406/ASA 330 (ISA 330) points out that when considering assessment of risk of material misstatement at assertion level, an auditor must relate these back to account balances/classes of transactions/disclosures. Needs to consider both the particular characteristics of each class of transaction, account balance or disclosure (inherent risks) and whether the auditor’s assessment takes account of the entity’s controls (control risk).

3. 7-3 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Inherent Risk (IR) Inherent risk: – Susceptibility of account balance or class of transactions to material misstatement, given inherent and environmental characteristics, without regard to internal control structure. An assessment of IR and Control Risk (CR) can be combined or separate. Irrespective of this, an auditor is required to: – assess IR at financial report level for audit plan, – assess related to assertions at account balance or class of transactions level when developing audit program. Learning Objective 1:

4. 7-4 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Business Risk (BR) and IR Entity’s business strategy and associated risks will affect an auditor’s assessment of IR at the financial report level. Where an auditor can trace BRs to areas of a financial report which are likely to be misstated, this gives rise to a higher IR assessment for that area.

5. 7-5 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 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; and Factors affecting the industry.

6. 7-6 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Inherent risk and computer Information Technology (IT) As IT risks can be pervasive to the entity, factors affecting overall IR associated with IT are: – Significant changes in IT; – Insufficient IT skills and resources; – Lack of entity support and focus; – High dependence on IT; – Reliance on external IT; and – Reliability and complexity of IT.

7. 7-7 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Inherent risk assessment at assertion level IR is greater for some assertions and related classes of transactions than for others. Auditors will normally focus on: – 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; and – Transactions not subject to ordinary processing.

8. 7-8 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Effect of inherent risk on account balance assertion

9. 7-9 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Special Areas of Audit Risk: FRAUD At the planning stage, an auditor should 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. Learning Objective 2:

10. 7-10 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Audit procedures for fraud at planning stage An auditor will use their experience, knowledge and training to determine whether fraud could occur. An auditor needs a thorough understanding of a client’s business in order to identify opportunities for the perpetration of fraud.

11. 7-11 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Increased attention to fraud Since June 2004, auditors have been required to pay greater attention to fraud. Auditors need to specifically consider risks of material misstatement in financial report due to fraud; Auditors must discuss an entity’s susceptibility to fraud with other members of the audit team; and Auditors must make more extensive inquiries of management with respect to fraud. Auditors are now specifically required to consider the risk of fraud in revenue recognition, and the possibility of management override of controls.

12. 7-12 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Red flag indicators of fraud An auditor commonly uses a checklist to identify increased risks of fraud. Where risk is high, it is called a “red flag”. These are listed in Table 7.1 (p. 304) and are grouped under: – Management; – Unusual pressures within an entity; – Market pressures; – Unusual transactions; – Unsatisfactory records; and – IT environment.

13. 7-13 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Earnings management Earnings management occurs when judgment in financial reporting and in structuring transactions is used to alter financial reports to influence the perceptions of stakeholders. 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.

14. 7-14 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Broad categories of earnings management Earnings management by clients may fall into the following categories Intentional violations of accounting standards and other reporting requirements that are individually immaterial; Inappropriate revenue recognition; ‘Big bath’ charges under the guise of restructuring; and Improper accruals and estimation of liabilities in good times.

15. 7-15 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Considering illegal acts AUS 218/ASA 250 (ISA 250) provides guidance on an auditor’s consideration of illegal acts (noncompliance with laws and regulations): – An auditor must understand the legal and regulatory framework applicable to the entity and industry; – An audit normally does not include procedures specifically designed to detect illegal acts; and – An 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.

16. 7-16 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Related Parties An 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. accounting standards require 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. Learning Objective 3:

17. 7-17 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Procedures for identifying related parties Review the previous period’s working papers for known related parties; make inquiries of management concerning the names of all related parties; review the entity’s procedures for identifying related parties; inquire about management’s and directors’ affiliations with other entities; review minutes of meetings; and inquire of other auditors involved in the audit.

18. 7-18 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Preliminary Assessment of Going Concern Basis Going Concern: – 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. Refer AUS 708.03/ASA 570.06 (ISA 570.03) – Auditors are 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. Learning Objective 4:

19. 7-19 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Preliminary Assessment of Going Concern Basis (cont.) Early identification helps focus audit effort on appropriate assertions in the financial report, and permits early communication with management. An auditor focuses primarily on anticipated events during the relevant period, approximately 12 months from the date of the current audit report to the expected date of the next audit report.

20. 7-20 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Examples of indications of going concern problems Operating indicators include: – Lack of strategic direction; – Deficiencies in the governing body; – Lack of management expertise; – Concentration of risk in few products; – Loss of major market; – Prolonged industrial action; – Shortages of important supplies; – Deficiencies in management information systems; – Rapid or unplanned development of business; and – Uninsured or underinsured disasters. See Table 7.2 (p. 311)

21. 7-21 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Examples of indications of going concern problems (cont.) Financial indicators: – High gearing; – Fixed-term borrowings; – Reliance on short-term borrowings; – Adverse key financial ratios; – Lack of sustainable operating profits; – Dividend arrears; – Inability to pay; – Difficulty in complying with terms of loan agreements; – Denial of trade credit; and – Inability to obtain necessary financing. See Table 7.2 (p. 311)

22. 7-22 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Examples of indications of going concern problems (cont.) Other indications: – Non-compliance with capital requirements; – Undue influence of market-dominant competitor; – Legal proceedings against the entity; – Technical developments making key product obsolete; – Adverse changes in legislation; and – Failure of other entities in industry. See Table 7.2 (p. 311)

23. 7-23 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Mitigating factors Auditor should consider mitigating factors. These include: – 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.312)

24. 7-24 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Materiality Materiality: – 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. Refer AUS 306.03/ASA 320.06 (ISA 320.03) Auditor uses materiality to: – Evaluate the presentation of financial data. – Determine the nature, timing and extent of audit procedures (sometimes called planning materiality). Learning Objective 5:

25. 7-25 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 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 balance sheet items  equity, or the appropriate asset or liability class total. Base amount for income statement items  net profit or loss and appropriate revenue and expense amount, for year or averaged over a number of years.

26. 7-26 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Setting the preliminary materiality judgment When planning the audit, an auditor makes a preliminary estimate of the amount to be considered material for audit purposes. Conceptually encompasses: – Known misstatements; – Likely misstatements; and – Potential undetected misstatements. A single amount is normally estimated for materiality because misstatements usually affect both balance sheet and income statement.

27. 7-27 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Rules of thumb for planning materiality

28. 7-28 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 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 reports.

29. 7-29 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Consideration of qualitative factors in materiality An auditor should consider qualitative factors as well as quantitative assessment. Qualitative factors include: – The significance of the item of the particular entity; – The pervasiveness of the misstatement (for example the misstatement might affect the presentation of numerous items in the financial report); and – The effect of misstatement on the financial report as a whole.

30. 7-30 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Allocation of materiality to account balances and classes of transactions An 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 an auditor should consider: Dollar value of account Expectation of error.

31. 7-31 Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett Relationship between materiality and audit risk There is an inverse relationship between audit risk and materiality. An 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.