P7:Advanced Audit & Assurance (INT)

2 Section D: Audit of Historical Financial Information Designed to give you knowledge and application of: D1. i. Planning, materiality and assessing the risk of misstatement ii. Evidence iii. Evaluation and review D2. Group audits

3  Materiality & performance materiality and its application in financial reporting and auditing. [2]  Business risks for a given assignment. [3]  Audit risks for a given assignment. [3]  Financial statement risks for a given assignment. [3]  Use of analytical procedures in the planning of an assignment. [3] Learning Outcomes D1(i): Planning, materiality and assessing the risk of misstatement

4 Materiality  if its omission / commission could influence economic decisions  depends on size of item / error judged in particular circumstances  auditor needs to consider it throughout the audit process  considered at overall financial information level & in relation to individual account balance & classes of transactions Turnover 0.5% -1% Profit before tax 5%-10% Total assets 1%-2% Material threshold: commonly used for determining materiality

5 Qualitative factors  relative significance  comparison with the previous year’s corresponding figures  transactions of abnormal and non-recurring nature  statutory requirement  regular checks  recurring errors Determinants of materiality Quantitative factors Percentage of:  profit before tax  turnover  total assets  shareholder’s equity  total expenses  net profit

6 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. According to ISA 320, performance materiality should be considered by the auditor when:  determining the nature, timing and extent of audit procedures; and  evaluating the effect of misstatements. Performance materiality for the financial statements as a whole will be lower than:  the materiality of the financial statements as a whole.  the materiality levels of a particular class of transactions, account balances or disclosures.

7 Materiality affects planning of audit procedures assessing risk deciding tolerable error evaluating the results & reporting deciding the sample size Relationship between materiality & level of audit risk Can be adjusted by auditor by Reducing:  assessed risk of material misstatement & supporting the reduced level by carrying out extensive additional test of control  detection risk by modifying nature, timing & extent of planned substantive procedures High materiality level Low audit risk Application of materiality in financial reporting & auditing Continued…

8 Auditor may extend his procedures When aggregate of unadjusted differences is:  material  not material but approaches materiality &  could exceed the material level To reduce risk / ask management to make adjustments to FS Reasons for change in auditor’s assessment of materiality & audit risk determined at planning level Change in:  circumstances  auditor’s knowledge gained from performing audit procedure Continued… Refer to Example (Formax Plc) on (page 228)

9 Business risk  risk resulting from significant conditions, events, circumstances, actions or inactions  could adversely affect an entity’s ability to achieve its objectives & execute its strategies Financial: risk arising from the way in which a business is financed Operational: risks related to entity’s day-to-day operations & associated internal control Compliance: risk arising from non-compliance with applicable laws & regulations Types of Business risk Refer to Test Yourself 2 on (page 233)

10 Financial statement (FS) risk Financial statement risk probability of inaccuracy of FS made available to the public, shareholders & the regulatory authority Non-compliance with any disclosure requirement Errors in amounts recorded in FS Relationship between business risk and financial statement risk refer to example of Esteem Club Plc (page 234)

11 Audit risk Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated Formula: Audit risk = Inherent risk x Control risk x Detection risk Audit Risk Inherent risk Control risk Detection risk Arises due to nature of business Always present Risk due to faulty / insufficient internal control system Risk of detection of existing irregularities / misrepresentation by auditor Refer to Example on (page 236)

12 Analytical procedures Analytical procedure is evaluations of financial information through analysis of plausible relationships among both financial and non-financial data. Steps involved in analytical procedures Develop an ‘Expectation’ through consideration of relations (ratio analysis) & comparisons (trend analysis) Compare actuals (recorded financial information) & expectation Ask management for explanations Explanation obtained? Satisfied Many limits tests of details of transaction & balances to sample checking Consider need to perform extensive procedures Yes No

13 Areas covered by analytical procedures Trend analysis Benchmarking to industry averages, budgets or standards Ratio analysis Relationship between financial & non-financial information Statistical techniques e.g. trend in sales, purchases, profitability, etc. e.g. comparison of average wages of an entity with industry average e.g. financial ratio, such as gross profit ratio, turnover ratio, etc. e.g. relationship of payroll cost to number of units procedures e.g. regression test or correlation test Refer to Test Yourself 4 on (page 241)

14 RECAP  Materiality & performance materiality and application in financial reporting and auditing. [2]  Business risks for a given assignment. [3]  Audit risks for a given assignment. [3]  Financial statement risks for a given assignment. [3]  Use of analytical procedures in the planning of an assignment. [3]