Chapter 3.docx

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University of Toronto Scarborough
Financial Accounting
Henry Wong

Chapter 2: Ethics, Legal Liability, and Client Acceptance Audit Process in Focus  at planning and reporting stages, auditor adopts a broad view of client as a whole and industry in which it operates  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, an auditor will gain an understanding of their client, their client’s internal controls, their client’s IT environment, their client’s corporate governance environment, and their client’s closing procedures 3.1 Stages of an Audit  planning stage  gaining an understanding of the client, identifying risk factors, developing an audit strategy, and assessing materiality  materiality  information that impacts the decision-making process of the users of the financial statements  audit strategy  a strategy that sets the scope, timing, and direction of the audit and provides the basis for a developing a detailed audit plan  the risk of a material misstatement is the risk that the financial statements include a significant error or fraud  execution stage  detailed testing of controls and substantive testing of transactions and accounts  reporting stage  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  audit risk is the risk that an auditor issues an unmodified opinion when the statements are in fact materially misstated  sufficient appropriate evidence  the quantity and quality of the evidence that has been gathered  fraud  an intentional act through the use of deception to obtain an unjust or illegal advantage  going concern  the viability of a company to remain in business for the foreseeable future  corporate governance  the rules, systems, and processes within companies used to guide and control  during the planning stage, an auditor will also consider the adequacy of their client’s closing procedures  closing procedures  processes used by a client when finalizing the books for an accounting period 3.2 Gaining an Understanding of the Client  at the outset of every audit, an auditor must gain an understanding of their client  the purpose of this procedure is to assess the risk that the financial statements contain a material misstatement due to: o the nature of the client’s business o the industry in which the client operates o the level of competition within that industry o the client’s customers and suppliers o the regulatory environment in which the client operates  CAS 315 provides guidance on the steps to take when gaining an understanding of a client; it requires the auditor to do: a) Make inquiries of management and of others within the entity who may have information to help identify the risk of material misstatements. This includes making inquiries of both financial and non-financial staff at all levels of the organization, including those charged with governance, internal audit, sales, and operational personnel. b) Perform analytical procedures at the planning stage of the audit to identify any unusual or unexpected relationships that may highlight where risks exist. Analytical procedures are a study of plausible relationships between both financial and non-financial data. c) Perform observation and inspection procedures to corroborate the responses made by management and others within the organization. These procedures provide information about the entity and its environment. Examples of such audit procedures include observation or inspection of the entity’s operations, premises, and facilities; business plans and strategies; internal control manuals; and any reports prepared and reviewed by management (such as management reports, interim financial statements, and minutes of board of directors’ meetings). 3.2.1 Entity level  knowledge about the entity is gained through interviews with client personnel, including those charged with governance  by gaining an understanding of the client, the auditor is in a stronger position to assess entity-level risks and the financial statement accounts that require closer examination  major customers are identified so that the auditor may consider whether those customers have a good reputation, are on good terms with the client (i.e., likely to remain a customer in future), and are likely to pay the client on a timely basis  major suppliers are identified to determine whether they are reputable and supply quality goods on a timely basis  whether the client is an importer or exporter of goods is identified  if the client trades internationally, the auditor considers the stability of the country (or countries) the client trades with, the stability of the foreign currency (or currencies) the client trades in, and the effectiveness of any risk management policies the client uses to limit exposure to currency fluctuations (such as hedging policies)  the client’s capacity to adapt to changes in technology and other trends is assessed  if the client is not well positioned to adjust to such changes, it risks falling behind competitors and losing market share, which in the longer term can affect the going concern assumption  if the client operates in an industry subject to frequent change, it risks significant losses if it doesn’t keep abreast of such changes and “move with the times”  the nature of any warranties provided to customers is assessed  if the client provides warranties on products sold, the auditor needs to assess the likelihood that goods will be returned and the risk that the client has underprovided for that rate of return (adequacy of the warranty provision)  auditor will pay attention to goods being returned for the same problem, indicating that there may be a systematic fault  the terms of discounts given by the clients to its customers and received by the client form its suppliers are reviewed  an assessment is made of the client’s bargaining power with its customers and suppliers to determine whether discounting policies are putting profit margins at risk, which may place the future viability of the client at risk  assessment is made of client’s reputation with its customers, suppliers, employees, shareholders, and wider community  an understanding is gained of client operations—the auditor will note where the client operates, the number of locations it operates in, and the dispersion of these locations  an understanding is gained of the nature of employment contracts and the client’s relations with its employees  an assessment is made of a client’s debt sources, the reliability of future sources of financing, the structure of debt, and the reliance on debt versus equity financing  the client’s ownership structure is assessed—the auditor is interested in the amount of debt funding relative to equity, the use of different forms of shares, and the differing rights of shareholder groups; the client’s dividend policy and its ability to meet dividend payments out of operating cash flow are also of interest 3.2.2 Industry level  at the industry level, an auditor is interested in their client’s position within its industry, the level of competition in that industry, and the client’s size relative to competitors  the auditor evaluates the client’s reputation among its peers and the level of government support for companies operating in that industry  another consideration is the level of demand for the products sold or services supplied by companies in that industry and the factors that affect that demand  the more competitive the client’s industry, the more pressure placed on the client’s profits  a key issue for the auditor is client’s position among its competitors and its ability to withstand downturns in economy  if the client has a poor reputation, customers and suppliers may shift their business to a competing firm, threatening their client’s profits, which may be assessed by reading articles in the press and industry publications  support is sometimes provided to industries that produce items in line with government policy  the auditor assesses the different taxes and charges imposed on their clien
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