&

Auditing
Assurance
Services(M)
Semester 1 2019

UNIVERSITY OF ADELAIDE Semester 1: 2019 Lecture 3

BUSINESS SCHOOL Fundamental Audit Concepts
Dr Phil Saj PhD CPA
University of Adelaide 2

OVERVIEW
■ Audit Procedures
■ Audit Tests AUDIT
■ The Audit Program PROCEDURES
■ The Audit Risk Model
■ Materiality
University of Adelaide 3 University of Adelaide 4

Audit Procedures
Audit Procedures (ASA 500. A14-A25)

Examine documents, records and physical

Inspection
“Audit procedures are the actions examination of tangible resources

an auditor takes in acquiring Observation

Looking at the performance of a procedure
or activity carried out by the auditee’s staff
evidence.” Oral or written enquiry by auditor internally
Enquiry or externally about financial or
[G & S 2015: 152] non-financial information

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 Audit Procedures Examples of the Audit Procedure
(ASA 500. A14-A25) “Inspection”
Check calculations and reconciliations
Re-calculation ￭ The auditor inspected Receiving Report (source document)
(mathematical correctness) made by the entity
to determine the quantity of items received.
Auditor independently executes procedures
￭ The auditor inspected a Sales Order to determine
Re-performance and/or controls that were originally
whether or not it had been authorised by the Credit
performed as part of the entity’s internal control
Manager (as evidenced by the Credit Manager’s
External Enquiry whereby auditor obtains information initials).
Confirmation directly, in writing, from third party.
￭ The auditor inspected a Sales Journal (accounting record)
Evaluate financial information through to determine the sales that had been recorded.
Analytical
the analysis of plausible relationships
Procedures among both financial and non-financial data ￭ The auditor inspected an item of plant and equipment to
determine its existence and condition.
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The auditor inspected a Sales Order to find Examples of the Audit Procedure
out if it had been authorised (initialled) by “Observation”
the Credit Manager.
￭ The auditor observed cash handling procedures to
Sales Order determine whether or not there was a separation of
ABC Ltd No. 00324 duties between taking custody of the cash and
Address Date: July 24 2014
recording receipts.
From XYZ Ltd Customer No. 2364 Salesperson J. Lewis
￭ The auditor observed staff undertaking the annual
inventory count (stock-take) to determine whether or
Item Qty. Description Unit Count Unit Price ($) Total ($) not the proper procedures were applied
1 6 Radio Model Z23 each 50 300
￭ The auditor observed staff involved in purchasing
goods to determine whether or not there was a separation
Approval Signature: 300
GM of duties between executing the purchase transaction
and taking custody of the goods.
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The auditor observed staff undertaking the annual Examples of the Audit Procedure
inventory count to determine whether or not the “Inquiry”
proper procedures were applied
￭ The auditor inquired with the warehouse manager
about slow moving inventory.

￭ The auditor inquired with the client’s solicitor

about the expected outcome of a dispute with
the Australian Tax Office.

￭ The auditor with inquired the financial controller

about how she determined the amount of a
particular a provision for doubtful debts.

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 The auditor inquired with the client’s Examples of the Audit Procedure
solicitor about the expected outcome of a “Re-calculation”
dispute with the Australian Tax Office.
￭ The auditor recalculated the extension on an invoice to
determine whether or not it was accurate.

￭ The auditor recalculated the electricity expense to determine

if an outlay had been properly apportioned between periods.

￭ The auditor recalculated the interest expense based on the

outstanding loan balance, the interest rate, and the
proportion of the year outstanding to determine if the
amount recognised is valid.

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The auditor recalculated the extension on an Examples of the Audit Procedure

invoice to determine whether or not it
“Reperformance”
was accurate.
￭ The auditor reperformed the process undertaken
ABC Ltd Tax Invoice No. 00231 (copy 2) by a clerk who checks that the details on a sales
Date: July 24 2014
invoice match those on the corresponding shipping
To: XYZ Ltd. Deliver To:
order and sales order.
Account Customer Order No. Salesperson
241 4537 J.L.
￭ The auditor reperformed the process undertaken
Code Description Qty Price ($) Total ($) by a clerk in the purchasing department to check that
34 TV Model 43D 10 600 6,000 purchases are made only from approved vendors.
GST 600
Total ex GST 6,000 ￭ The auditor reperformed a bank reconciliation to
Delivery Instructions Amount Due 6,600
determine how effectively the accounts clerk
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performed this control .
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The auditor reperformed the process undertaken Examples of the Audit Procedure
by a clerk in the purchasing department to check “External Confirmation”
that purchases are made only from approved ￭ The auditor wrote to a sample of the client’s debtors and
vendors. asked them to confirm details of amounts owed to the
client.

￭ The auditor wrote to the client’s banks and

asked them to confirm details of financial assets and
liabilities

￭ The auditor wrote to the client’s solicitor and asked her

to confirm details of litigation and claims concerning
the client.

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 The auditor sought confirmation from the
client’s bank about balances held by the Analytical Procedures
bank and owed to the bank.
“…the term analytical procedures means
CREDIT ACCOUNT BALANCES (held in favour of the client)
Account Name BSB No. Account No. Currency Balance evaluations of financial information through analysis
Auditor/ client to complete know details in shaded area. Bank to complete unshaded of plausible relationships among both financial and
areas
non-financial data. Analytical procedures also
encompass such investigation as is necessary of
DEBIT ACCOUNT BALANCES (owed to the bank by the client)
identified fluctuations that are inconsistent with
Auditor/ client to complete know details in shaded area. Bank to complete unshaded
areas other relevant information or that differ from
Account Name BSB No. Account No. Currency Balance
expected values by a significant amount.”
(ASA520.4)

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Examples of the Audit Procedure

“Analytical Procedure”
Simple comparison with prior
￭ The auditor performed a trend analysis when evaluating
period and industry using ratio
risk of material misstatement at the planning stage of analysis
the audit.
CLIENT INDUSTRY
￭ The auditor compared the client’s inventory turnover
ratio with that of prior years and with the industry 2018 2017 2018 2017
average in order to determine if inventory was Inventory 3.3 3.8 3.9 3.4
appropriately valued.
Turnover
￭ The auditor estimated the client’s interest expense for the
period and compared it with the amount recorded by
the client.

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The Application of Audit Choice of Audit Procedure

Procedures ￭ Understanding of the entity and its environment

￭ Risk assessments ￭ Assessment of business risk and inherent risk

￭ Nature and assessment of internal controls
￭ Audit tests ￭ Materiality of the item
￭ Tests of internal controls ￭ Financial report assertion
￭ Substantive tests of transactions and ￭ Experience from prior audits of the client
balances ￭ Results of other audit procedures
￭ Source and reliability of available information
￭ Completion and review
￭ Persuasiveness of audit evidence obtained

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 Audit Tests

Tests of Provide evidence of the

effectiveness the client’s internal
AUDIT Control control system.

TESTING Substantive
Provide evidence of the validity and
the propriety of the accounting
Tests treatment of transactions and
balances.

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Tests of Control Example of an Internal Control

￭ When performing a test of control we are:
Activity
￭ Applying a procedure to test a specific
internal control that the client has put in
place to meet an objective (assertion).
￭ Identify the internal control.
￭ Identify the evidence source and the
attribute of interest.
￭ Determine the criterion for success Authorisation/Approval
(Tolerable Deviation Rate).
Purchases must be approved by the manager
￭ Determine the sample size. before they are processed?
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Example of an Internal Control Test of Controls

Procedure: Select a sample of Purchase
Activity Orders and inspect for evidence of authorisation
Occurrence: All purchases are bona fide transactions
Purchase Order that relate goods or services for use by the entity.
Grand Ltd Number: 1145
Address Date: March 2 2018
Purchase Order No. 1145 Purchase Order No. 1294
To Large Ltd Supplier No. 365 Prepared by: T Groom

Authorised by…P Jones Authorised by…P Jones

Item Qty. Description Unit Count Unit Price ($) Total ($)
1 4 TV Model Y56 each 250 1000 Purchase Order No. 1172 Purchase Order No. 1362
Customer
Order by…P Jones
Authorised Authorised by……….
Approval Signature: 1000
P Jones

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 Substantive Tests Nature of Substantive Tests
￭ When performing a substantive test we: Tests in which the auditor obtains and
￭ Apply a procedure to test an assertion about Tests of evaluates evidence of items (details)
a particular item in the financial statements. Details Included in an account balance,
￭ We need to identify the evidence class of transactions or disclosure.
(information) we will use for verification
￭ We need to determine the criteria for Tests in which the auditor compares
success (requirements of the accounting Substantive relationships between accounting
standards and materiality level). data and related information to
Analytical
determine the reasonableness of
￭ We need to determine the method of Procedures relationships, and to identify unusual
evidence collection, and (where sampling is
fluctuations.
used) the sample size.
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Nature of Tests of Details Example: Substantive Test of a Balance

Tests of Tests to obtain evidence Assertions: existence/ rights and obligations-
of about the validity of a general recorded accounts receivable exist and the client
Balances ledger account balance. has a right to collect them.

Accounts Receivable
Tests of Tests to obtain evidence about
Transactions the validity of transaction classes. Debtor A Balance A
Debtor B Balance B
Tests to determine that required Balance C
Test of disclosures are made and that the Debtor C
Customer
Disclosures overall presentation of the Procedure:
Order Write to sample of the client’s debtors and
financial statements is satisfactory. ask them to confirm the balance owed to client.

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Example: Analytical Procedure Example: Substantive

Test of Transactions
Assertion: completeness- all Accounts Payable are Assertion: Occurrence - recorded sales actually occurred
recognised in balance sheet. and pertain to the entity.

Transaction Source Accounting Record

Accounts Payable Documents
Acc. Pay. Sale
Sales Journal
2016: $3.5
Shipping Date Dr Cr $
X Compare 2015: $3.6 Order
2014: $3.7
Customer Customer
Order
Procedure: Compare the closing balance of Procedure:
Order Vouch a sample of entries in the Sales
Accounts Payable with those of previous years. Journal to the Shipping Order

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 Occurrence of a Transaction Dual Purpose Tests
Vouching Audit tests that are specifically planned
to provide evidence concerning
Ace Shipping Note No. 20163215 Sales Journal page no.104
Date: October 5 2015 (copy 2)
(Ace Pty Ltd)
both a tests of control and
Ship To: King Ltd Bill To: King Ltd Date Description Dr Cr substantive matters
Acc. # Customer Salesperson
Order # 9/10/15 Acc. Receivable 6,000 6,000
78 K.H.
0234 Sales
No. Qty Item Description
One source of evidence
Code To record credit sale of 6
1 6 24 Desk desks to King Pty Ltd Same or different procedures
Checked by Jim Driver Date 5/9
Bob
Time 2.34 Satisfaction of different objectives
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Example: Dual Purpose Tests Audit Tests: Indirect and

Testing by the auditor that a required independent check Direct Evidence
by a client staff member has been performed(TOC)
and that the extension is correct (STOT) Provide indirect evidence
Tests of
ABC Ltd Tax Invoice No. 00231 (copy 2) of misstatement in
Date: July 24 2014
Control accounts
To: XYZ Ltd. Deliver To:
Account Customer Order No. Salesperson
241 4537 J.L.
Code Description Qty Price ($) Total ($)
Substantive
34 TV Model 43D 10 600 6,000 Provide direct evidence of
GM
GST 600 Tests misstatement in accounts
Total ex GST 6,000
Delivery Instructions Amount Due 6,600

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Audit program Example of an audit program

Client: Client No: Date W/P
■ Sets out the nature timing and extent of ABC Ltd 45822
Checked By…………………
Ref: I/4
audit procedures Audit program for: Notes Receivable Audit Period: 30/06/15
Item No. Audit Procedure Done by Date
■ Detailed set of instructions (procedures)
1 Agree face amount , interest rate
■ Guides staff and maturity dates to note
■ Control of time spent receivable document.
■ Evidence of work performed 2 Undertake positive confirmation
■ Evidence of consideration given to I C (n=10).

■ Evidence of proper planning 3 Recalculate accrued interest.

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 Sufficient Appropriate
Audit Evidence
“The auditor shall design and perform
THE AUDIT audit procedures that are appropriate
in the circumstances for the purpose
RISK MODEL
of obtaining sufficient appropriate
evidence” [ASA 500.6]

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QUESTION: Audit Risk Model

How does the auditor determine
what constitutes “sufficient
AR = IR x CR x DR
appropriate evidence”?

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AUDIT RISK MODEL Audit Risk

■ Provides the auditor with a framework for
identifying and responding to those factors “ the risk that an auditor expresses an
that are likely to cause the financial
inappropriate audit opinion when the
statements to be misstated.
■ When using the ARM, the auditor is applying financial report is materially misstated.”
the principle that the greater the risk of [ASA 200.13]
material misstatement, the greater the
amount of appropriate evidence required.
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 AUDIT RISK Audit Risk
■ The more certain auditors want to be of
expressing the correct opinion, the lower will be
the audit risk that they are willing to accept. The main causes of variation are:
■ The lower the audit risk that the auditor is willing to
■ the nature of the entity and its environment;
accept, the more work the auditor must do.

■ In setting the desired audit risk, auditors seek a

■ the effectiveness of the control structure;
balance between the costs of an incorrect audit
■ the effectiveness of the auditor’s procedures.
opinion and the costs of performing the additional
work necessary to reduce audit risk.
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Audit Risk INHERENT RISK

is a function of “The susceptibility of an assertion to a
misstatement that could be material either
Inherent Risk individually, or when aggregated with
other misstatements assuming there are
Control Risk no other controls.” [ASA 200.13]

Inherent risks arise because of the nature

Detection Risk of the entity and its environment.
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Impact of Inherent Risks on

Examples of Inherent Risk Factors Financial Reporting (some examples)
■ Management experience and knowledge
Account Potential
■ Unusual pressures on management Risk Factor
Impacted Misstatement
■ Nature of the client’s business
Inventory obsolete
■ Inventory subject to obsolescence Inventory
valuation Inventory
■ Dependence on a single supplier/ customer is problematic overstated
■ Foreign currency transactions
■ Related parties Unusual pressures on
■ Factors affecting the client’s industry management. Sales Sales
Sales
recognised before overstated
■ Macro economic factors
they are completed.
■ Rapid change
■ Complexity of transactions Complexity of
transaction: Loans (and equity)
E.g. Loans
■ Judgment required in determining account balances Debt instrument wrongly classified
■ Transactions not subject to ordinary processing
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 Impact of Inherent Risks on CONTROL RISK
Financial Reporting (some examples)
Account Potential “the risk that a misstatement could occur
Risk Factor
Impacted Misstatement in an assertion and that could be material,
Transactions not either individually or when aggregated with
subject to ordinary E.g Sales
processing sales over/ understated other misstatements, will not be prevented
or detected and corrected on a timely
Capitalisation
Judgement basis by the entity’s internal control
Intangible of expenditure.
required for
Assets R &D system.” [ASA 200.13]
account balance
over/ understated

Rapid change in
Depreciation/ Control risks arise because of the nature
technology PP&E Carrying amount
(useful economic life) of the entity’s internal control system.
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CONTROL RISK Examples of Control Risk Factors

■ Poor control environment
We need to consider control risk in relation
■ No commitment to competence
to each transaction cycle, account and
■ No audit committee (or committee lacks independence)
assertion. ■ Problems with the information system

For example: a client may have effective ■ Access not password protected
■ Programming errors
controls over the authorisation of sales
■ Ineffective control activities
(occurrence), but ineffective controls for
■ Lack of separation of duties
assuring that sales are accurately recorded
■ Poor authorisation processes
(accuracy). ■ Poor physical controls over source documents
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Impact of Control Risks on Impact of Control Risks on

Financial Reporting (some examples)
Financial Reporting (some examples)
Account Potential
Risk Factor
Risk Factor
Account Potential Impacted Misstatement
Impacted Misstatement
Poor physical Inventory record
Control
Environment Not all sales recorded controls over inventory overstated
(commitment to
E.g. Sales Inventory (theft of inventory)
(understatement)
competence)

Lack of Record of cash Access to terminals

E.g. Various, e.g. purchases
separation overstated not password
Cash receipts purchases wrongly classified
of duties (theft of cash) protected

Payroll expense Poor credit Valuation of

Program E.g. payroll Accounts
calculated and recorded authorisation provision for
errors expense Receivable
at the wrong amount process doubtful debts
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 INHERENT and CONTROL RISK The Business and Its Environment
Shareholders
■ I R and C R arise as a consequence of the Economic Internal Regulators
Control System
auditee’s decisions.
General Cash
Lenders Employees
Capital
■ I Rand C R cannot be controlled by the Sales &
Collection Acquisition Payroll &
Social/ Personnel Market
Activity Activity
auditor. Cultural
Activity
Purchases &
Payment Customers
Activity
■ The auditing standards point out that, in Inventory &
Community Warehousing Technology
practise, IR and CR may be considered Activity
together, or separately. Industry Suppliers
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Examples of Detection
DETECTION RISK Risk Factors
■ Problems with planning
“the risk that the auditor will not detect a ■ Insufficient knowledge of the client’s business
misstatement exists in an assertion that ■ Lack of understanding of inherent risks
■ Poor understanding of client’s internal controls
could be material, either individually or
■ Problems with collection of evidence
when aggregated with other ■ Inappropriate timing
misstatements. [ASA 200.13] ■ Sample size too small
■ Procedures inadequate

Detection risk arises because of the ■ Problems with interpreting results of testing
■ Contradictory results ignored
(in)effectiveness of the audit work. ■ Junior staff asked to interpret results
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DETECTION RISK Audit Risk Model

(Planning Form)
The auditor can reduce the level of
Detection Risk through: AR = IR x CR x DR
■ Appropriate planning, direction, or
supervision and review.
AR
■ Decisions about the nature, timing and DR =
extent of audit procedures
■ The effective performance of the . . . . (IR x CR)
. procedures and the evaluation of results
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Application of the Audit Risk Model
for determining sufficiency and
appropriateness of evidence
If a client has a high risk of misstatement
the auditor needs more appropriate
evidence in order to reduce detection risk.
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Detection Risk Matrix
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Materiality
Materiality in the context of an audit.
Misstatements, including omissions, are
considered to be material if they
individually, or in aggregate, could
reasonably be expected to influence the
economic decisions of users taken on the
basis of the financial report. [ASA320.2]
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Steps in Applying the Audit Risk
Model
[1] Set a planned level of audit risk
[2] Assess inherent risk and control risk
[3] Determine appropriate level of
detection risk.
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MATERIALITY IN
THE AUDIT
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The Role of Materiality in a Financial
Statement Audit
■ What would make a difference to the
users of the financial statements?
■ “Drives” the decision about the nature, timing
and extent of audit procedures: ASA 320.6.
■ Provides the benchmark for evaluating
results of substantive tests
■ Importance of professional judgment.
■ Materiality, risk and evidence.
■ Three levels: ASA 320.10 and 11.
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Three Levels of Materiality in a Materiality for the financial statement
Financial Statement Audit as a whole.
■ Materiality for the financial statement as a
■ Maximum amount by which the financial
whole.
statements could be misstated without
■ (Where applicable) a materiality level for affecting the decisions of users.
specific classes of transactions, balances or
■ Entity/ Engagement specific.
disclosures.

■ Performance materiality.

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Materiality for the financial statement Selecting the Appropriate Base

as a whole.
■ Statement of Financial Position
■ Materiality is a relative rather than an ■ Total Equity or
absolute concept. ■ Appropriate Asset or Liability Class Total

■ Bases are needed for evaluating materiality. ■ Statement of Financial Performance

■ Profit after tax (or x year average)
■ Qualitative factors as well as quantitative
■ Appropriate Rev. or Exp. amount (or average)
factors may affect materiality .
■ Cash Flow Statement
■ Setting materiality is a matter of judgment
■ Net Cash - O/ F/ I for period (or average)

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Quantitative Guidelines Qualitative Factors

■ Accounts where risks of misstatement
Base Range of Relative are higher - irrespective of account
Percentages Advantage
balance.
Net Profit 5.0 - 10.0 Relevance

Total Revenue 0.5 - 1.0 Stability ■ Fraud vs. other irregularities.

Total Assets 0.5 - 1.0 Predictability
and stability
■ Errors result in material consequences
Equity 1.0 - 2.0 Stability ■ E.g. contravention of loan covenant.

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 Qualitative Factor (Where applicable) a materiality level
(Example of a loan covenant) for specific classes of transactions,
■ Client has loan of $ $6m balances or disclosures
■ Loan covenant requires current ratio to be >= 2
■ Items about which there is particular
■ Current ratio = current assets
interest from users of financial statements.
current liabilities
■ Based on Trial Balance, current ratio = $4 m = 2.05
■ Industry specific: e.g. R&D in high
$1.95 m technology companies.
■ Assume materiality = 1% of T A ($16m.) = $160,000 ■ Segments.
■ Assume accounts payable (part of denominator) of
$120,000 was wrongly classified as NCL
■ Director and executive management
remuneration.
■ Current ratio is really $4m = 1.9
($1.95m +$.12m) ■ Related party disclosures.
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Performance Materiality Relationship Between Materiality

and Audit risk
“The amount, or amounts set by the auditor ■ Audit risk, materiality and evidence are
at less than materiality for the financial report considered together.

as a whole to reduce to an appropriately low ■ The higher the audit risk, the lower the
materiality level set by the auditor.
level the possibility that the aggregate of
■ The lower the level of materiality, the
uncorrected and undetected misstatements greater the amount (and quality) of
exceeds materiality for the financial report as evidence required.
a whole” [ASA320.9] ■ The lower the level of materiality, the more
confident that auditor can be about his/her
conclusions.
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Materiality, Audit Risk and Evidence Decrease Audit Risk

Evidence Materiality Evidence Materiality Evidence Materiality

Audit Audit
Risk Risk
Audit
Risk Level of materiality Amount and quality of
unchanged evidence unchanged
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