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 7 INHERENT RISK ASSESSMENT AND MATERIALITY

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 INHERENT RISK (IR) Defined: Susceptibility of account balance or class of transactions to material misstatement, given inherent and environmental characteristics, without regard to internal control structure (AUS 402.09/ISA 400.04). Auditor required to assess IR at financial report level for audit plan, with assessment related to assertions at account balance or class of transactions level when developing audit program.

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 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 Factors affecting the industry

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 INHERENT RISK AND COMPUTER INFORMATION SYSTEMS (CIS) As CIS risks can be pervasive to the entity, factors affecting overall IR associated with CIS are: Significant changes in CIS Insufficient CIS skills and resources Lack of entity support and focus High dependence on CIS Reliance on outsourced CIS Reliability and complexity of CIS

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 INHERENT RISK ASSESSMENT AT ACCOUNT BALANCE AND CLASS OF TRANSACTIONS LEVEL Considerations include: 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 transactions not subject to ordinary processing

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 EFFECT OF INHERENT RISK ON AN ACCOUNT BALANCE ASSERTION Figure 7.1 Effect of inherent risk on an account balance assertion (p. 290)

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 CONSIDERATION OF FRAUD AT PLANNING STAGE At planning stage, auditor must 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.

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 AUDIT PROCEDURES FOR FRAUD AT PLANNING STAGE Auditor will use their experience, knowledge and training to determine whether fraud could occur. Auditor needs thorough understanding of client’s business in order to identify opportunities for perpetration of fraud. Auditor will need to consider: Business environment Internal control structure

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 RISK AT RED FLAG INDICATORS OF FRAUD These are listed in Table 7.1 (p. 292) and are grouped under: Management Unusual pressures within an entity Market pressures Unusual transactions Unsatisfactory records CIS environment

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 CONSIDERING EARNINGS MANAGEMENT INCENTIVES Earnings management occurs when judgment in financial reporting and in structuring transactions is used to alter financial reports to influence perceptions of stakeholders of outcomes dependent on reported accounting numbers. 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.

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 BROAD CATEGORIES OF EARNINGS MANAGEMENT International violations of accounting standards and other reporting requirements that are individually immaterial Inappropriate revenue recognition ‘Big bath’ charges under the guise of restructuring Improper accruals and estimation of liabilities in good times

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 CONSIDERING ILLEGAL ACTS AUS 218 provides guidance on auditor’s consideration of illegal acts (noncompliance with laws and regulations): Must understand the legal and regulatory framework applicable to the entity and industry Audit normally does not include procedures designed specifically to detect illegal acts 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

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 RELATED PARTIES The 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. the accounting standards require the 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.

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 PRELIMINARY ASSESSMENT OF GOING CONCERN BASIS I Defined: 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. (AUS 708.03/ISA 570.03) Auditor 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.

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 PRELIMINARY ASSESSMENT OF GOING CONCERN BASIS II Early identification helps focus audit effort on appropriate assertions in financial report, and permits early communication with management. Auditor focuses primarily on anticipated events during the relevant period, approximately 12 months from date of current audit report to expected date of next audit report.

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 EXAMPLES OF INDICATIONS OF GOING CONCERN PROBLEMS Operating indicators include: Lack of strategic direction Concentration of risk in few products Loss of major market Financial indicators include : High gearing, debt/equity ratio Adverse movements in key ratios, falls in profitability, current, cash flow ratios Inability to pay creditors [See Table 7.2 (p. 298)]

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 EXAMPLES OF MITIGATING FACTORS Auditor should consider mitigating factors: 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.299)]

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 MATERIALITY Defined: 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. (AUS 306.03/ISA 320.03) Auditor uses materiality to:  Evaluate presentation of financial data  Determine nature, timing and extent of audit procedures

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 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 statement of financial position items  equity, or the appropriate asset or liability class total Base amount for statement of financial performance items  net profit or loss and appropriate revenue and expense amount, for year or averaged over a number of years

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 RULES OF THUMB FOR PLANNING MATERIALITY Range of percentages Common bases applied to baseRelative advantages Net profit 5–10Relevance Total revenue0.5–1Stability Total assets0.5–1Predictability and stability Equity 1–2Stability Table 7.4 Rules of thumb for planning materiality (p. 303)

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 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 report.

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 ALLOCATION OF MATERIALITY TO ACCOUNT BALANCES AND CLASSES OF TRANSACTIONS 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 auditor should consider: Dollar value of account Expectation of error

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 RELATIONSHIP BETWEEN MATERIALITY AND AUDIT RISK There is an inverse relationship between audit risk and materiality. 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.