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Lecture 3

Lecture 3 - Audit Planning and Understanding Business Risk.docx

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LECTURE 3 – AUDIT PLANNING AND UNDERSTANDING BUSINESS RISK Nature of Risk  Four critical components of risk affect the audit approach and audit outcome: o Enterprise risk: affect the operations and potential outcomes organisation activities o Engagement risk: association with a specific client o Financial reporting risk: relate directly to the recording transactions and the presentation of the financial statements o Audit risk: an auditor may provide an unqualified opinion on financial statements that are materially misstated. Risk Factors Affecting the Audit  Engagement risk o Risk is high whenever there is increased likelihood that:  The auditor is associated with a failed client  Financial statements contain material misstatement that the auditor fails to find.  Increase the likelihood that the auditor will be sued  Client acceptance or retention decision o A decision affected by a range of factors. The most important involve:  The quality of the client’s corporate governance  The client’s financial health. Corporate Governance and Client Acceptance  The key factors an auditor will analyse include: o Management integrity o Independence and competence of the audit committee and board o Quality of ERM and controls o Regulatory and reporting requirements o Participation of key stakeholders o Existence of related party transactions. Accepting New Clients: Minimising the Risk APES 210 and ASA 220.A8  A new auditor should initiate discussions with the predecessor to discuss the reasons for the change in auditors. o Because of the confidentiality rule, the successor must first obtain client permission to talk with predecessor.  The successor is particularly interested in factors that bear on: o Management integrity o Disagreements with management on any substantive auditing or accounting issues o The predecessor’s understanding of the reasons for the change o Any communications between the predecessor and management or audit committee regarding fraud, illegal acts or internal control matters.  When deciding if the company wants to take on this risk you MUST consider all factors The Engagement Letter  The auditor should prepare an engagement letter to clarify the responsibilities and expectations of each party, and to summarise and document this understanding, including the: o Nature of the services to be provided o Timing of those services o Expected fees and basis on which they will be billed (fixed fee, hourly rates) Developing an Understanding of Business and Financial Misstatement Risks  The auditor should o Understand the company, its strategies, and operations in depth o Develop an understanding of the market in which the company operates o Develop an understanding of the economics of client transactions o Develop expectations about financial results or transaction outcomes. The Business Approach to Auditing • Develop understanding of management’s risk management process • Develop understanding of the business and the risks it faces • Use the identified risks to develop expectations about account balances and financial results • Assess quality of control systems to manage risks • Determine residual risk, and update expectations about account balances • Manage remaining risk of account balance misstatement by determining the direct tests of account balances (detection risk) that are necessary Business Risk: Audit Implications  Two approaches – transaction or top-down o Transaction approach looks at the trees, but not the forest. o Firms now follow the top-down approach, referred to as “business risk” auditing  Provides a holistic view – not only of the company but the industry  Helps to ensure you decide which account is at risk Materiality and Audit Risk  The auditor is expected to plan and perform an audit that provides reasonable assurance that material misstatements will be detected  ‘Information is material if its omission, misstatement or non-disclosure has the potential, individually or collectively, to A influence the economic decisions of users taken on the basis of the financial report; or B affect the discharge of accountability by the management or governing body of the entity.’  Materiality has three significant dimensions: o Size of the misstatement (dollar amount) Quantitative o Circumstances – some things are viewed more critically than others Qualitative o User impact – impact on potential users and the type of judgements made. Qualitative Quantitative Guidelines How to Establish a Preliminary Estimate of Materiality 1. Use latest available financial information and knowledge of the client 2. Predict which accounts are likely to be misstated 3. Consider AASB 1031 Material? ___________________________________________________ Amount >10% of Base Amount Yes ___________________________________________________ Amount <5% of Base Amount No ___________________________________________________ Amount Between 5% & 10% (Judgement Required)  When an audit is started, the materiality guideline is set eg. 5 or 10% o Errors under the materiality guideline are not further investigated as their impact on the business is immaterial o However, where the total of the errors is greater than the materiality guideline is it necessary to make all the changes.  Materiality is a relative concept depending on the financial situation of the business at hand  Determination of materiality is situation-specific. o Although this makes determination more difficult, it allows the auditor to adjust the rigour of the audit to refl
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