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Chapter 3

MGAD10H3 Chapter Notes - Chapter 3: Business Process, Financial Statement, Dividend Policy

Financial Accounting
Course Code
Kevin Ha

of 7
MGTD60H3 Chapter 3 Audit Planning I
Audit Process in Focus
- Different stages/phases of the audit:
o Planning stage
o Performing stage (where detailed work is scheduled)
o Reporting stage (where the audit opinion is formed)
- An understanding of the client is gained in the early stages of each audit which drives the planning phase
- During the planning stage, an assessment is made of the risk that a material misstatement (significant error or
fraud) could occur in the client’s financial statements
- During the planning stage, auditor will gain an understanding of their client, the client’s internal controls, their IT
environment, their client’s corporate governance environment, and their client’s closing procedures
- An auditor will also identify any related parties that may affect the client’s going concern status
- Corporate Governance Rules, systems, and processes within companies used to guide and control
- During the planning stage, an auditor will assess the adequacy of their client’s corporate governance in assessing
the risk that the financial statements are materially misstated
- A client’s IT system is used to capture, process, and report on the accounting records
- Closing procedures aim to ensure that transactions are recorded in the appropriate accounting period
3-1 Stages of an Audit
- Main stages of audit: planning, performing and reporting
- Planning stages involves gaining an understanding of the client, identifying factors that may impact the risk of a
material misstatement in the financial statements, performing a risk and materiality assessment, and developing
an audit strategy
- Audit Strategy A strategy that sets the scope, timing, and direction of the audit and provides the basis for
developing a detailed audit plan
- The risk of material misstatement is the risk that the financial statements include a significant error or a fraud
- Execution stage (performing stage) involves the performance of detailed testing of controls and substantive
testing of transactions and accounts
- Reporting stage involves evaluating the results of the detailed testing in light of the auditor’s understanding of
their client and forming an opinion on the fair presentation of the client’s financial statements
3-1-1 Planning an Audit
- Planning an audit of financial statements is required to reduce audit risk to an acceptably low level
- Audit risk is the risk that an auditor issues an unmodified or clean audit opinion when financial statements are
actually materially misstated
- Efficiency refers to the amount of time spent gathering audit evidence
- Effectiveness refers to the minimization of audit risk
- A well-planned audit will ensure that sufficient appropriate evidence is gathered
- Preliminary risk identification process used during planning stage: identify related parties (to ensure that they are
identified and appropriately disclosed following the relevant accounting standards), fraud risk, going concern risk,
corporate governance (the CSA have issued a policy statement for reporting issuers and this statement provides
MGTD60H3 Chapter 3 Audit Planning I
guidance on corporate governance policies), understand internal controls, understand IT environment, significant
accounts, significant classes of transactions, closing procedures (processes used by a client when finalizing the
books for an accounting period), materiality, and understand the client
3-1-2 Performing an Audit
- Involves detailed testing of controls, transactions, and balances
- If an auditor plans to rely on their client’s internal controls, they will conduct tests of control
3-1-3 Concluding and Reporting on an Audit
- Involves drawing conclusions based on the evidence gathering and arriving at an opinion regarding the fair
presentation of the financial statements
- Auditor’s opinion is expressed in the audit report
- An auditor will draw on their understanding of the client, their detailed knowledge of the risks faced by the client,
and the conclusions drawn when testing the client’s controls, transactions, and account balances
3-2 Gaining an Understanding of the Client
- The nature of the client’s business
- Industry in which the client operates
- Level of competition within that industry
- Client’s customers and suppliers
- Regulatory environment in which the client operates
- Auditors are required to:
o Make inquiries of management and both financial and non-financial staff at all levels including those
charged with governance, internal audit, sales, and operational personnel
o Perform analytical procedures which are a study of plausible relationships between both financial and
non-financial data
o Perform observation and inspection procedures to corroborate the responses made by the management
and others within the organization: observation and inspection of the entity’s operations, premises and
facilities; business plans and strategies; internal control manuals; and any reports prepared and reviewed
by management
3-2-1 Entity Level
- Knowledge about the entity is gained through interviews with client personnel, including those charged with
- The auditor will ask questions about what the client does, how it functions, how its ownership is structured, and
what its sources of financing are
- Major Customers
o Good reputation
o On good terms with client (likely to remain a customer in the future)
o Likely to pay client on a timely basis
MGTD60H3 Chapter 3 Audit Planning I
o Dissatisfied customers withhold payments which affects AR and cash flow which also affects going
concern status of the client’s business
o If a client only has one or a few customers, risk is increased
- Major Suppliers
o Reputable and supply quality goods on a timely basis
o Whether significant levels of goods are returned as faulty
o Terms of any contracts and payment with suppliers
o Whether client pays its suppliers on a timely basis
o Whether a client is an importer or an exporter, auditor assesses the stability of the country the client
trades with, stability of the foreign currency, and the effectiveness of any risk management policies
- Client’s Capacity to Adapt to Changes in Technology or Other Trends
o If not, risks falling behind competitors and lose market share which can affect going concern status
- Warranties
o Likelihood that goods will be returned
o Risk of client has underprovided for that rate of return
o Goods being returned for the same problem
o Steps being taken by the client to rectify the problem
- Discounts
o Client’s bargaining power with its customers and suppliers to determine whether discounts are putting
profit margins at risk
- Reputation
o Client’s reputation with customers, suppliers, employees, shareholders, and the wider community
o Not in the best interests of auditors to associate with a client with bad reputation
- Operations
o Where it operates
o Number of locations
o Dispersion of these locations
o More spread out the client’s operations are, the harder it is for the client to effectively control and
coordinate its operations, increasing the risk of errors in the FS
o Auditor will need to visit locations
o Auditor usually visits if client has opened a new large site, or if the business is located in a country with
high inflation and high risk of theft
- Nature of Employment Contracts/Relations with Employees
o Way employees are paid
o Mix of wages and bonuses
o Level of unionization among the workforce
o Attitude of staff to their employer
o When staff are unhappy, greater the industrial action (strikes)
- Sources of Financing
o Debt’s sources
o Reliability of future sources of financing