Chap 4 Overview of Elements of Audit Process-Đã Gộp

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CHAPTER 4
Overview of elements of the financial report audit process
LEARNING OBJECTIVES (LO)

4.1 Explain the difference between accounting and auditing and the
importance of professional scepticism and professional judgment
to auditing.
4.2 Outline the logical process of identifying financial report
assertions, developing specific audit objectives and selecting
auditing procedures.
4.3 Explain the relationships between audit procedures and evidence,
and describe common audit procedures used in an audit of a
financial report.
4.4 Define sufficient appropriate audit evidence and its relationship to
auditing procedures.
4.5 Outline the audit risk model.
4.6 Explain the concept of materiality.
4.7 Define types of audit tests.
4.8 Explain how an auditor may use the work of an expert or
component auditor.
4.9 Describe the general requirement to document audit work and the
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contents of audit working papers.
Gay, Grant E., and Roger Simnett. Auditing and Assurance Services in Australia, McGraw-Hill Australia, 2018. ProQuest Ebook Central,
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RELEVANT GUIDANCE
ASA 200/ISA 200 Overall Objectives of the Independent Auditor and the
Conduct of an Audit in Accordance with Australian
(International) Auditing Standards
ASA 230/ISA 230 Audit Documentation
ASA 315/ISA 315 Identifying and Assessing the Risks of Material

Misstatement through Understanding the Entity and Its
Environment
ASA 320/ISA 320 Materiality in Planning and Performing an Audit
ASA 330/ISA 330 The Auditor’s Responses to Assessed Risks
ASA 450/ISA 450 Evaluation of Misstatements Identified during the Audit
ASA 500/ISA 500 Audit Evidence
ASA 501/ISA 501 Audit Evidence—Specific Considerations for Inventory

and Segment Information/Audit Evidence—Specific
Considerations for Selected Items
ASA 540/ISA 540 Auditing Accounting Estimates, Including Fair Value

Accounting Estimates, and Related Disclosures
ASA 580/ISA 580 Written Representations
ASA 600/ISA 600 Special Considerations—Audits of a Group Financial

Report (Including the Work of Component Auditors)
ASA 620/ISA 620 Using the Work of an Auditor’s Expert

ASA 700/ISA 700 Forming an Opinion and Reporting on a Financial Report
AUASB/IAASB AUASB Glossary/Glossary of Terms
GS 011 Third Party Access to Audit Working Papers
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CHAPTER OUTLINE
Although a financial report audit is only one type of assurance engagement, it is
the most common. Therefore, in this chapter an overview of the elements of the
financial report audit process is provided.
While a financial report audit of a complex entity is a complicated process, even

the most complex audit has certain basic elements. This chapter compares
financial report auditing with accounting, and explains the basic elements of the
audit process, including professional scepticism and professional judgment.
These building blocks are necessary to understand how an audit is
accomplished in conformity with Australian auditing standards. Most of the
auditor’s work in forming an opinion on the financial report consists of obtaining
and evaluating evidence about the assertions in the financial report by applying
auditing procedures. It is important to understand each of the elements—audit
evidence, materiality, assertions and audit procedures—in order to comprehend
the audit of a financial report, which will be conducted within the framework of
the audit risk model and the client’s business risk.
The auditor must also prepare and maintain adequate audit working papers to
document their work. This chapter explains the function and content of audit
working papers.
How this chapter fits into the overall financial report audit is illustrated in
Figure 4.1 , which is an expansion of part of the overall flowchart provided in
Chapter 1 .
FIGURE 4.1 Flowchart of planning and risk-assessment stage of a financial report audit
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LO 4.1 Accounting and auditing contrasted

As a process, financial report auditing is linked with accounting principles and procedures
used by businesses and other entities. An auditor renders an opinion on the financial report
of an entity. The financial report is the product of the entity’s accounting system and of
judgments made by those charged with the governance and management of the entity.
As indicated by ASA 200.3 (ISA 200.3), the purpose of an audit is to enhance the degree of
confidence of intended users of the financial report. Therefore, the ultimate objective of the
audit process is to present an opinion on the presentation of results of operations for a
given period and on the financial position at the end of this period. To form such a
judgment about the financial report of an entity, the auditor must look behind the financial
report to the data and the allocations of the data.
Therefore, there is a close relationship between accounting and auditing. Auditors work
primarily with accounting data. They attempt to satisfy themselves that the data
summarised in the financial report are the data arising from transactions and events that the
entity actually experienced. Further, they must make judgments about the allocations of
data that have been made by those charged with governance and management, and decide
whether the financial report presentation is appropriate or misleading. To make these
judgments, auditors cannot limit themselves to the records and accounts of the entity. They
must be concerned with the total entity, because non-accounting activities, including the
behaviour of the participants in the entity, influence not only the data but also the
judgments of those charged with governance and management relating to the accounting
for and reporting of the data. The audit function focuses on accounting, and the auditor
must first be a competent accountant, but the audit function also extends beyond
accounting (see Figure 4.2 ).
FIGURE 4.2 Relationship between accounting and auditing
Professional scepticism
The end product of an accountant’s work is a financial report. The financial report may
simply be the results of this work, or it may be adjusted according to the desires of those
charged with governance and management who might wish to classify and report Page 138
data in particular ways. As indicated by ASA 200.A48 (ISA 200.A48), it is
possible to prepare different financial reports from the same data, because accounting
standards allow a choice between several acceptable accounting methods, and because
judgment will be exercised in determining the amounts for some accounts, such as for
various provisions. Also, as discussed in Chapter 1 , the preparers of the financial
reports are potentially biased, as they have a vested interest in the information contained in
the financial report. Therefore, ASA 200.15 (ISA 200.15) requires the auditor to plan and
perform the audit with professional scepticism , recognising the possible existence of
material misstatements in the financial report. Professional scepticism is critical to the
audit process (see Auditing in the global news 4.1 ).
4.1 Auditing in the global news ...
Professional scepticism lies at the heart of a quality audit

In 2015, the International Auditing and Assurance Standards Board (IAASB),
International Ethics Standards Board for Accountants (IESBA), and the
International Accounting Education Standards Board (IAESB) convened a
small, cross-representational working group—the Professional Scepticism
Working Group—to formulate views on whether and how each of the three
boards’ sets of international standards could further contribute to
strengthening the understanding and application of the concept of
professional scepticism as it applies to an audit.
Today, the topic of professional scepticism is featured prominently in each of

the board’s strategic considerations, and all three boards have important
initiatives related to professional scepticism. All three boards see the
opportunity for shorter term actions as well as the need for longer term
considerations, in consultation with each other.
The importance of professional scepticism to the public interest is

underscored by the increasing complexity of business and financial
reporting, including greater use of estimates and management judgments,
changes in business models brought about by technological developments,
and the fundamental reliance the public places on reliable financial
reporting.
Source: IAASB, IESBA; IAESB (2017) ‘Towards Enhanced Professional Scepticism’, IFAC, August, New
York, p. 3. This text is an extract from ‘Towards Enhanced Professional Scepticism’ Observations of the
IAASB-IAESB-IESBA Professional Skepticism Working Group, published by the International Federation
of Accountants (IFAC) Aug 14, 2017 and is used with permission of IFAC. Such use of IFAC’s
copyrighted material in no way represents an endorsement or promotion by IFAC. Any views or

opinions that may be included in Auditing & Assurance Services in Australia 7e are solely those of
McGraw-Hill Education and do not express the views and opinions of IFAC or any independent
standard setting board associated with IFAC.
The Auditing and Assurance Standards Board (AUASB) Glossary describes professional
scepticism as ‘an attitude that includes a questioning mind, being alert to conditions which
may indicate possible misstatement due to error or fraud, and a critical assessment of audit
evidence’.
Professional scepticism needs to be exercised throughout the planning and performance of
the audit. ASA 200.A20–A22 (ISA 200.A20–A22) indicate that professional scepticism
includes:
questioning the reliability of documents, information and management explanations

being alert to possible contradictory evidence
questioning the sufficiency and appropriateness of audit evidence
being alert to conditions that may indicate risks of fraud
critically challenging management judgments, assumptions and estimates.
Further, with the rapid changes in technology in recent years, such as data analytics, which
have not as yet been incorporated into the auditing standards, there is a need for the auditor
to consider whether circumstances exist that indicate a need for audit procedures Page 139
to be applied in addition to those required by the auditing standards.
Professional scepticism is essentially a mindset. A sceptical mindset drives auditor

behaviour to adopt a questioning approach when considering information and in forming
conclusions. As a result, professional scepticism is linked to the fundamental ethical
principles of objectivity and auditor independence discussed in Chapter 3 and is an
inescapable element in the exercise of professional judgment.
Professional judgment
ASA 200.16 (ISA 200.16) requires the auditor to exercise professional judgment in
planning and performing the audit. The AUASB Glossary defines professional judgment as
‘the application of relevant training, knowledge and experience, within the context
provided by auditing, accounting and ethical standards, in making informed decisions
about the courses of action that are appropriate in the circumstances of the audit
engagement’.
Further, ASA 200.A25 (ISA 200.A25) emphasises that professional judgment is essential
to conducting an audit, as it is required for decisions such as determining materiality,
assessing audit risk, evaluating audit evidence, assessing the reasonableness of accounting
estimates and evaluating management judgments concerning the application of the
applicable financial reporting framework, including the appropriateness of accounting
treatments and policies and the appropriateness of the going concern basis. As indicated by
ASA 200.6 (ISA 200.6), the concept of materiality is applied by the auditor in planning and
performing the audit and in evaluating the effect of misstatements on the financial report.
Materiality will be discussed in detail later in this chapter in relation to planning and in
Chapter 11 in relation to completion of the audit.
Areas of audit interest

Separating the audit process into understandable parts requires a definition of the areas of
audit interest. The auditor is interested in the accountable activity of the entity; the
organisation of the entity, that is, its organisational structure ; and the risks arising
from its business strategy and the environment in which it operates, that is, its business
risk .
Accountable activity of the entity

From an auditing perspective, there are three stages in the accounting process:
1. The collection of original data The original accounting data are exchanges of
consideration between an entity and other entities or individuals. These transactions take
the form of sales of product, purchases of raw materials, purchases of labour, lending of
money, borrowing of money, repaying of money and being repaid. These are the basic
data of accounting and the first and most basic areas of interest to the auditor. The auditor
must understand the flow of transactions through the accounting system. Therefore, one
of the important parts of the audit is a review of the accounting system, because a
substantial part of the effort in an audit is concerned with the operation of that system.
2. The allocations and reclassifications of accounting data Accounting journals are often
called the ‘books of prime entry’, because the first stage of the accounting process
consists of recording the exchange transactions of an entity in a journal. However,
accounting journals also contain entries that do not represent exchange transactions.
These entries are made to allocate and reclassify original exchange data to other accounts
in preparation for placement in the financial report. All the allocations and
reclassifications in an entity’s journals are made according to procedures and practices
that have been developed by accountants over the years. For example, there are both
acceptable and unacceptable ways of depreciating fixed assets, amortising other long-
lived assets and allocating labour and materials costs to periods. This part of the audit
depends on the auditor’s knowledge as an accountant. As an accountant, the auditor
knows which allocation and reclassification methods are acceptable, and must observe
what the entity has done and decide whether it has followed acceptable methods Page 140
and made acceptable choices where judgment is involved. As discussed earlier,
this will involve the auditor applying professional scepticism to client choices, judgments
and estimates.
3. The presentation of the results of the accounting process As discussed in
Chapter 1 , in order to add credibility to a report, the auditor needs to examine that
the subject matter is prepared in accordance with suitable criteria and provide an
assessment to accompany the report prepared by the responsible party. Hence, in
accordance with ASA 700 (ISA 700) and the Corporations Act 2001, in a financial report
audit the auditor is required to report on whether the financial report presents fairly the
financial position and operating results (or gives a true and fair view) in accordance with
Australian accounting standards.
There are rules that govern the placement of various items in the financial report and the
terminology used to present them. The auditor must use accounting knowledge, at the
allocation stage, to decide whether the client has properly prepared the financial report.
Further, the auditor must review the accompanying notes to the financial report and judge
their adequacy and completeness. Guidance on these issues is available by reference to
accounting standards and other professional statements and to the disclosure requirements
contained in the Corporations Act 2001.
Organisation of the entity

The auditor also has the internal organisational structure of the entity with which to work.
In auditing terminology this is referred to as internal control . The auditor can make
enquiries of client personnel and review the system of documentation used by the entity;
trace various types of transactions from initial to ultimate disposition in the system to
observe its functioning; and, finally, make an evaluation of the system to identify strengths
and weaknesses. These activities are part of the auditor’s evaluation of the controls over the
accounting system. The accuracy and reliability of the accounting system depends on how
it is controlled.
The objectives of internal control are linked with the auditor’s concern with the flow of
transactions through the accounting system and the impact of business risk on the entity’s
ability to achieve its objectives. Internal control is designed and implemented to address
identified business risks that threaten the achievement of any of these objectives. Internal
control will be discussed further in Chapter 7 .
Business risk
The auditor needs to understand the entity’s business strategy, its business environment and
the risks it faces to determine whether these might affect the financial report. Auditors use
their understanding of the client’s business, industry and risks to develop a more efficient
and effective audit. Business risk will be discussed later in this chapter and in detail in
Chapter 5 .
QUICK REVIEW
1. Accounting is concerned with measuring and recording data, while
auditing is concerned with obtaining sufficient appropriate evidence as
to their propriety and accuracy.
2. Accounting involves the preparation of the financial report, while
auditing involves giving an opinion on the financial report.
3. Professional scepticism and the exercise of sound professional
judgment are critical to a high-quality audit.
4. One key area of audit interest is the accountable activity of the entity,
which includes the collection of original accounting data, the allocation
and reclassification of accounting data and the presentation of the
results in the financial report.
5. A second key area of audit interest is the organisation of the entity,
including internal control.
6. A third key area of audit interest is the entity’s business risk.
Page 141
LO 4.2 Financial report assertions and audit objectives

and procedures
In effect, by presenting a financial report, those charged with governance and management
are stating certain things about the entity’s financial position and operations. These
assertions by those charged with governance and management that are embodied in the
financial report are referred to as financial report assertions . The auditor uses
assertions to assess risks, by considering the different types of potential misstatements that
may occur and then designing appropriate audit procedures that address these risks. The
assertions deal essentially with recognition and measurement of the various elements of the
financial report and related disclosures. ASA 315 (ISA 315) has two categories of
assertions: classes of transactions and events and related disclosures, and account balances
and related disclosures. These are set out in ASA 315.A128 (ISA 315.A128), as follows in
Exhibit 4.1 .
TWO CATEGORIES OF FINANCIAL REPORT
EXHIBIT 4.1
ASSERTIONS
1. Assertions about classes of transactions and events, and related disclosures, for
the period under audit
(a) Occurrence —transactions and events that have been recorded or
disclosed have occurred and pertain to the entity.
(b) Completeness —all transactions and events that should have been
recorded have been recorded and all related disclosures that should have
been included in the financial report have been included.
(c) Accuracy —amounts and other data relating to recorded transactions and
events have been recorded appropriately and related disclosures have been
appropriately measured and described.
(d) Cut-off —transactions and events have been recorded in the correct
accounting period.
(e) Classification —transactions and events have been recorded in the proper
accounts.
(f) Presentation —transactions and events are appropriately aggregated or
disaggregated and clearly described, and related disclosures are relevant and
understandable.
2. Assertions about account balances, and related disclosures, at the period end
(a) Existence —assets, liabilities and equity interests exist.
(b) Rights and obligations —the entity holds or controls the rights to assets,
and liabilities are the obligations of the entity.
(c) Completeness —all assets, liabilities and equity interests that should have
been recorded have been recorded, and all related disclosures that should
have been included in the financial report have been included.
(d) Accuracy, valuation and allocation —assets, liabilities and equity
interests are included in the financial report at appropriate amounts and any
resulting valuation or allocation adjustments are appropriately recorded, and

related disclosures have been appropriately measured and described.
(e) Classification —assets, liabilities and equity interests have been recorded
in the proper accounts.
(f) Presentation —assets, liabilities and equity interests are appropriately
aggregated or disaggregated and clearly described, and related disclosures
are relevant and understandable.
Source: Extracted from Australian Auditing and Assurance Standards Board (AUASB), 2015 ASA 315
Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its
Environment. (c) 2018 Auditing and Assurance Standards Board (AUASB). The text, graphics and layout
of this publication are protected by Australian copyright law and the comparable law of other countries.
No part of the publication may be reproduced, stored or transmitted in any form or by any means without
the prior written permission of the AUASB except as permitted by law. For reproduction or publication
permission should be sought in writing from the Auditing and Assurance Standards Board. Requests in
the first instance should be addressed to the Technical Director, Auditing and Assurance Standards
Board, PO Box 204, Collins Street West, Melbourne, Victoria, 8007.
The auditor needs to obtain evidence that supports each of the assertions for every material
component of the financial report. A component of the financial report may be an account
balance (or group of account balances), a class of transactions or a disclosure.
The categories of assertions provide a framework for developing specific audit Page 142
objectives for each material account balance, class of transactions or disclosure.
An audit objective is an assertion translated into terms that are specific to the particular
balance or class of transactions, the entity’s circumstances, the nature of its economic
activity and the accounting practices of its industry. Consider Global example 4.1 ,
which shows some specific audit objectives.
GLOBAL EXAMPLE 4.1 Assertions and objectives for the account
balance of inventory of a manufacturing company
Financial
report
assertion Illustrative audit objectives
Existence Inventories included in the statement of financial

position physically exist.
Inventories represent items held for sale in the
normal course of business.
Rights and The company has legal title or similar rights of

obligations ownership to the inventories.
Inventories exclude items billed to customers or
owned by others.
Completeness Inventory quantities as per the accounting records

include all products, materials and supplies owned
by the company that are on hand.
Inventory quantities include all products, materials
and supplies owned by the company that are in
transit or stored at outside locations.
Accuracy, Inventories are properly stated at the lower of cost

valuation and and net realisable value.
allocation Slow-moving, excess, defective and obsolete items
included in inventories are properly identified and
valued.
Classification Inventory costs are recorded in the correct accounts.
Presentation Accounting policy for inventory is clearly described

in the financial report.
A number of accounting pronouncements now contain complex measurement and

disclosure provisions based on fair value, which need to be considered by the auditor. For
example, ASA 540 (ISA 540) Auditing Accounting Estimates, Including Fair Value
Accounting Estimates and Related Disclosures addresses audit considerations relating to
the valuation and allocation, accuracy, presentation and disclosure of material financial
report items presented or disclosed at fair value. These include understanding the entity’s
process for determining fair value, assessing its appropriateness and considering the use of
an expert.
QUICK REVIEW
1. Those charged with governance and management make assertions about
the entity’s financial position and operations, and these are embodied in
the financial report.
2. The auditor obtains evidence to support these assertions for material
components of the financial report.
LO 4.3 Audit procedures and evidence
Audit procedures are the actions that an auditor takes in acquiring evidence. The
procedures are not evidence in themselves; they are the means of acquiring evidence. ASA
500.5 (ISA 500.5) defines audit evidence as all of the information used by the auditor
in arriving at the conclusions on which the auditor’s opinion is based. It includes Page 143
all the data and information underlying the financial report and corroborating
information. Audit evidence includes evidence obtained from audit procedures performed
during the audit and may also include evidence obtained from other sources, such as
previous audits. However, ASA 500.A11 (ISA 500.A11) states that where evidence from a
prior audit is used the auditor must perform audit procedures to ensure its continuing
relevance.
The audit equation can be expressed as:
audit evidence = underlying accounting data + corroborating information
The auditor needs to test the propriety and accuracy of the underlying accounting data in
order to be able to express an opinion on the financial report. However, some corroborating
information for material assertions within the financial report is essential. This audit
equation is illustrated in Figure 4.3 .
FIGURE 4.3 The audit equation
The use of audit procedures to obtain evidence to corroborate accounting data can be
illustrated by focusing on one type of transaction. Consider the diagram of a cash purchase
transaction in Figure 4.4 . The auditor may inspect the documentary evidence in the
entity’s records. The item received is recorded as an increase in inventory. A copy of the
purchase order is sent to the supplier and a receiving report is prepared to indicate receipt
of the merchandise. The item given up is recorded as a cash reduction, and there will
probably be a paid cheque indicating payment. The transaction is also recorded by the
supplier, from whom information can be obtained if necessary.
FIGURE 4.4 A cash purchase transaction
At the end of the accounting period, the entity holds a number of items in inventory as a
result of purchase transactions. Evidence may be obtained by examining the final
inventory, which is the net result of exchange transactions, including both purchases and
sales. The inventory balance in the statement of financial position can be corroborated
partly by looking in the warehouse and noting that there are a certain number of boxes of a
given item. Seeing the items is evidence that they exist and that therefore, provided that
other assertions such as rights and obligations (ownership) are satisfied, they should be
reflected in the client’s statement of financial position. However, the auditor must also
obtain further evidence concerning the acquisition cost of this inventory. This may be done
by locating the purchase invoice. Then, by recalculating the extension of inventory
quantities multiplied by prices and the addition of these extensions, the auditor
corroborates the amount shown for inventory in the accounting records.
In practice, the counting of inventory is so time consuming that auditors usually observe
the client’s employees making the counts and only make test counts. ASA 501 (ISA 501)
Audit Evidence—Specific Considerations for Inventory and Segment Information Page 144
sets out the required procedures for the audit of inventory. These procedures are
more extensive than those illustrated in this simple example and will be discussed in
Chapter 9 .
Common audit procedures

A list of all the audit procedures to be used in the corroboration of a particular account is
called an audit plan or an audit program. Some common audit procedures outlined in ASA
500.A14–A25 (ISA 500.A14–A25) are: inspection, observation, external confirmation,
recalculation, re-performance, analytical procedures and enquiry. Several of these, such as
inspection, observation and enquiry, are familiar methods for obtaining information.
However, in auditing these methods are employed in circumstances that require additional
explanation.
Inspection
Inspection involves the examination of documents, records or tangible assets. The

reliability of inspection of records or documents depends on their nature and source and on
the effectiveness of internal control over their processing. In addition, ASA 500 (ISA 500)
emphasises the need to inspect original documents rather than photocopies. The inspection
of tangible assets provides reliable audit evidence concerning their existence but not
necessarily their valuation, completeness or ownership.
Observation
Observation involves the auditor observing the behaviour of operating personnel and
the functioning of the business in operation. These observations are made from the
perspective of their effects on accounting and their implications for auditing, such as
evidence of control activities being carried out.
External confirmation
External confirmation is a type of enquiry by which an auditor normally obtains

written statements from outside parties such as banks, solicitors or debtors on information
that they are qualified to give. The independent party questioned must be reliable and
knowledgeable about a subject of interest to the auditor. In some cases, the object of
interest may be held by the outside party. For example, the auditor typically confirms cash
on deposit in banks. In other cases, an auditor may need information concerning an item
that does not have a physical existence, such as an obligation owed to the client. Thus, an
auditor often confirms accounts receivable.
The statement of the outside party should be communicated directly to the auditor. The
possibility of influence or change of information by the client’s employees should be

avoided. Steps must therefore be taken to maintain control over confirmations. This issue is
further complicated by the need to have the request for confirmation come from the client.
The outside parties have engaged in transactions with the client and will not disclose
information about their dealings with that client to someone else who asks for it. If the
client makes the request, cooperation is much more likely. This necessitates the following
controls over confirmation requests:
1. The confirmation request is prepared by the client’s personnel and given to the auditor for
inspection and mailing.
2. The auditor inserts the confirmation request in an envelope bearing the auditor’s return
address and mails it personally.
3. Included with the confirmation request is a stamped return envelope addressed to the
auditor.
Recalculation
The arithmetical accuracy of the many calculations required in the processing of data can
be proven by recalculating the results. Examples of typical calculations include
additions of ledger account balances, depreciation or amortisation calculations and
inventory extensions and additions.
Re-performance Page 145
The auditor may independently execute (or re-perform ) procedures or controls that
were originally performed as part of the entity’s internal control.
Analytical procedures
Analytical procedures are based on the dual nature of business transactions (reflected
in the double-entry bookkeeping system) and the interrelationships between the variables
of business operations. They involve the investigation of fluctuations in relationships to
ascertain whether there are inconsistencies in relation to other relevant information or
variations from predicted amounts. The different types of analytical procedures will be
discussed in Chapter 5 .
Enquiry
The auditor must ask many questions during the course of an examination. The question-
and-answer process includes interviewing and obtaining written statements from
management and employees. Explanations of significant variations in accounting data are
frequently obtained from employees. However, the auditor cannot rely on unsupported
answers, but must obtain support for the reasonableness of the answer given. One formal
application of the procedure of enquiry is the use of an internal control questionnaire to
gain information about the prescribed control activities.
The audit trail

An important requirement of the audit process is the existence of an audit trail , which
consists of all accounting documents and records prepared as transactions are processed
from origin to the financial report. Although it is commonly called the audit trail, it is
created for the use of those operating and using the system and is really a management
trail. The audit trail enables transactions to be traced from initial entry in the system to
intermediate records, where the transactions become components of subtotals, and
ultimately to disposition in the final records, where subtotals are summarised for
presentation in the financial report. The direction of the tracing can be modified: the
auditor can vouch the entry in the final record back to the point of initiation or check in
either direction from intermediate records.
Selecting audit procedures

The selection of particular procedures to achieve specific audit objectives will be
determined by the auditor’s professional judgment, based on the risk of a material
misstatement and what is required to achieve sufficient appropriate audit evidence. The
greater the risk of a material misstatement the stronger the audit procedure required.
Therefore, the auditor’s judgment in selecting audit procedures will be influenced by the
following considerations contained in ASA 500 (ISA 500) and ASA 330 (ISA 330):
the auditor’s understanding of the entity and its environment

the auditor’s assessment of business risk and inherent risk
the nature of the internal control and the assessment of control risk
the materiality of the particular component of the financial report
the financial report assertion involved
experience gained from previous audits
the results of other audit procedures, including whether they identified specific instances
of fraud or error
the source and reliability of the information available
the persuasiveness of the audit evidence obtained.
For example, if there is a high risk of material misstatement concerning the existence of
accounts receivable the auditor is likely to test existence by confirmations or subsequent
receipts, whereas if there is a low risk of material misstatement in sundry debtors Page 146
the auditor is likely to test existence by using substantive analytical procedures.
For existence of inventory, the auditor would attend the stocktake to count the inventory, to
check that it exists, whereas for accuracy, valuation and allocation of inventory the auditor
would check the carrying value of the inventory in the accounting records to subsequent
sales prices, to check that it does not need to be written down to net realisable value.
Global example 4.2 shows some audit procedures that may be applied to achieve
specific audit objectives. Audit procedures for various controls and accounts are discussed
in detail in Chapters 8 and 9 .
GLOBAL EXAMPLE 4.2 Relationship between financial report
assertions, audit objectives and evidence/procedures for the
account balance of inventory
Financial
report Example of an audit
assertion Illustrative audit objectives procedure/evidence
Existence Inventories included in the Stocktake—select

statement of financial position from inventory
physically exist. records and count
physical stock.
Completeness Inventory quantities as per the Stocktake—select

accounting records include all from physical stock,
products, materials and count and check
supplies owned by the against inventory
company that are on hand or records.
in transit.
Rights and The company has legal title or Check shipping

obligations similar rights of ownership to documents (bills of
the inventories. lading) for ownership
of goods in transit.
Accuracy, Inventories are properly Compare subsequent

valuation and stated at the lower of cost and sales prices to cost.
allocation net realisable value.
Classification Inventory costs are recorded Check coding on

in the correct accounts. costs charged to
inventory to
determine that costs
have been charged
to the correct
account.
Presentation Accounting policy for Review accounting

inventory is clearly described policy notes in the
in the financial report. financial report.
QUICK REVIEW
1. Audit procedures are used to obtain audit evidence.
2. Audit evidence includes underlying accounting data and corroborating
information.
3. Common audit procedures include inspection, observation, external
confirmation, recalculation, re-performance, analytical procedures and
enquiry.
4. The selection of audit procedures is influenced by a number of factors,
including the assessment of inherent and control risk and the materiality of
the component of the financial report.
Page 147
LO 4.4 Sufficient appropriate audit evidence

The basic criterion of ASA 200.17 (ISA 200.17) and ASA 500.6 (ISA 500.6) is that the
procedures selected should provide sufficient appropriate audit evidence for the
auditor to form conclusions concerning the validity of the individual assertions embodied
in the components of the financial report and to give an auditor’s opinion. As indicated in
Chapter 1 , ASA 200.5 (ISA 200.5) recognises that the auditor can only provide a
reasonable level of assurance concerning the fair presentation of the financial report and
that an absolute level of assurance is not possible because there are inherent limitations of
an audit that mean most audit evidence is persuasive rather than conclusive. These inherent
limitations of an audit are discussed in ASA 200.A47–A54 (ISA 200.A47–A54) and arise
from the nature of financial reporting, as discussed earlier in this chapter; the nature of
audit procedures, including the difficulty in determining whether all information has been
included and the difficulty of identifying sophisticated and well-concealed frauds; and the
need for the audit to be completed within a reasonable period of time and at a reasonable
cost, which, among other things, means that sampling is used and so not all items are
checked.
The components of sufficient appropriate audit evidence are illustrated in Figure 4.5 .
FIGURE 4.5 Components of sufficient appropriate audit evidence
Sufficiency relates to the quantity of audit evidence necessary to provide the auditor with a
reasonable basis for an opinion on the financial report. The quantity of audit evidence
required is affected by the risk of material misstatement and the quality of the audit
evidence.
Appropriateness relates to the quality of the audit evidence. Therefore, appropriate

evidence must be both relevant and reliable. Relevance is largely a matter of the
relationship between the evidence and the financial report assertion involved. For example,
if the related assertion concerns the existence of an asset, the auditor may select items
included in the account balance and physically examine or confirm the items. However,
these particular audit procedures are not relevant to verifying the completeness assertion.
To achieve an audit objective related to completeness, the auditor must select from
evidence indicating that an item should be included in the account balance and see whether
it is included.
As discussed earlier, ASA 200.A20–A24 (ISA 200.A20–A24) indicate that Page 148
professional scepticism is necessary to the critical assessment of audit evidence.
As a result, the auditor needs to be alert for audit evidence that contradicts other audit
evidence and question the reliability of documents and responses obtained from
management or those charged with governance. A belief that management and those
charged with governance are honest and have integrity based on past experience does not
relieve the auditor of this requirement for professional scepticism in the current audit. The
Australian Securities and Investments Commission’s (ASIC) review of audit working
papers has indicated a need for auditors to improve their performance in obtaining
sufficient appropriate audit evidence to form an opinion on the financial report (see
Auditing in the global news 4.2 ).
Overall findings: audit file review

In our view, in 25% of the total 390 key audit areas reviewed across 93 audit
files, at 23 firms of different sizes, auditors did not obtain reasonable
assurance that the overall financial report was free of material misstatement.
While financial reports may not have been materially misstated, in our view
the auditor did not have a sufficient basis to form an opinion on the financial
report.
Source: © Australian Securities and Investments Commission. Reproduced with permission (2017),

Report 534: Audit inspection program report for 2015–16, June, p. 8.
The reliability of audit evidence is influenced by its nature and its source. Although
reliability depends on individual circumstances, the following generalisations adapted from
ASA 500.A31 (ISA 500.A31) are useful:
Evidence from sources outside an entity is more reliable than evidence obtained solely
from within an entity. (For example, a written confirmation directly from a customer is
more reliable than a duplicate sales invoice indicating that a sale was billed.)
Evidence generated internally is more reliable when internal control is effective than
when internal control is ineffective. (For example, pre-numbered documents combined
with a sequence check are more reliable than unnumbered documents.)
Evidence obtained directly by the auditor is more reliable than evidence obtained from
the client. (For example, a confirmation obtained directly from the bank is more reliable
than sighting a copy of a bank statement held by the client.)
Evidence in the form of documents or written representations is more reliable than oral
representations. (For example, a written confirmation from a debtor is more reliable than
a telephone confirmation.)
Evidence in the form of original documents is more reliable than photocopies, facsimiles
or documents that have been transferred into electronic form, the reliability of which may
depend on the controls over their preparation and maintenance.
The two aspects of appropriateness must be considered together because evidence may be
highly reliable but of limited relevance to the audit objective. For example, adding up an
account provides direct personal knowledge but is of limited relevance in achieving an
audit objective related to existence. The converse is also true: enquiry of management may
produce highly relevant evidence but it is of limited reliability.
Audit evidence is also more reliable when the auditor obtains corroborating evidence from
different sources. Conversely, if evidence obtained from one source is inconsistent with
that obtained from another, the auditor will need to determine what additional audit
procedures are required to resolve the conflict.
The auditor is required by ASA 500.9 (ISA 500.9) to obtain evidence about the Page 149
accuracy and completeness of information produced by the entity’s information
system when that information is used in performing audit procedures. For example, if the
auditor uses non-financial information such as production reports or budget data produced
by the entity’s information system in performing audit procedures, the auditor must obtain
information about the accuracy and completeness of that information.
Examples of reliability of evidence

In the selection of audit procedures, the relative reliability of the available evidence is
important. The relationship between reliability of evidence and selection of procedures is
well illustrated by tests of accounts receivable. Two methods of determining the existence
of receivables are confirmation and examination of documentary evidence. Confirmation is
generally more reliable than examination of documentary evidence, because evidence
obtained from an independent source is more reliable than evidence that has been routed
through the client’s system. Thus, a confirmation coming directly from a debtor can be
relied on more than documentary evidence, which can be suppressed or manipulated in the
client’s system.
However, not all accounts receivable confirmation requests are answered, perhaps because
the debtor is uncooperative or has a recording system that cannot determine the total
amount owed to one firm at a given time. In such circumstances, the alternative procedure
—examination of documentary evidence—must be employed. Such procedures take two
forms: review of subsequent payments and examination of sales documents. Just as

confirmation provides more reliable evidence than alternative procedures, review of
subsequent payments provides more reliable evidence than examination of sales
documents.
The auditor should examine the authenticity of subsequent payments and compare them
with the accompanying remittance invoices. These amounts should be traced through to
duplicate deposit slips, cash receipts records and the accounts receivable subsidiary ledger.
These payments should be checked against specific invoices being paid, because some
invoices may be in dispute. However, not all accounts are collected subsequent to the
balance date and before completion of the audit, and so, often, other documentary evidence
must be examined.
Examination of sales documents involves analysing outstanding balances into individual

outstanding charges and examining the documentary support for these charges. Pertinent
documents include duplicate sales invoices, delivery records, contracts and
correspondence.
Subsequent payments are a more reliable form of documentary evidence because the
cheque or electronic funds transfer is sent by an independent source—the debtor—to the
client, and the debtor expects it to be credited to his or her account. On the other hand, the
sales documents all originate within the client’s system and are, therefore, more subject to
control and manipulation.
Thus, there is a chain of evidence—sales documents, subsequent payments and

confirmation—whose reliability corresponds with the degree of independence from the
client’s system.
Electronic information
In many entities, some of the accounting data and corroborating information are available
only in electronic form. For example, when entities use business-to-business e-commerce,
the entity and its customers or suppliers use communication links to transact business
electronically. Purchase, shipping, billing, cash receipt and cash payment transactions are
often completed entirely by the exchange of electronic messages between the parties. Some
of this electronic information may exist only at a particular point in time and may not be
retrievable after a specified period if files are changed. As a result, the auditor must use the
electronic evidence of the transaction when gaining sufficient appropriate audit evidence.
The reliability of such electronic evidence is dependent on the controls over the creation,
alteration, accuracy and completeness of the electronic data, which will be discussed in
Chapter 7 in the section on computerised systems.
To access the details of such transactions the auditor must access the client’s computer
system, as this is where the information is located. This may require the use of computer-
assisted audit techniques (CAATs), which are audit software used to assist in the Page 150
testing of computer systems. CAATs are discussed in Chapter 8 in relation to
tests of controls and Chapter 9 in relation to substantive testing.
Technology is changing rapidly and is now able to capture and communicate data digitally
on a large scale, virtually simultaneously. Advanced data analytics is the process of
obtaining audit evidence by analysing patterns, deviations and inconsistencies and
extracting other information from data underlying the financial report through analysis and
modelling. Therefore, advanced data analytics enhances the auditor’s ability to gather
evidence from the analysis of large populations and provide greater insight about the entity
and the risks it faces. It also enables testing 100 per cent of a population. However, it does
not reduce the need for professional judgment and professional scepticism, but rather
enhances them, as indicated in Auditing in the global news 4.3 . Advanced data
analytics will be discussed further in Chapter 7 .
Impact of advanced data analytics on audits
Of particular relevance to an audit are technological developments resulting

in more powerful data analysis tools and techniques that can be used in
procedures to obtain audit evidence. These data analysis tools and
techniques provide the auditor, in an environment of increasing complexity
and large populations of audit relevant data, with enhanced capabilities to
more effectively and efficiently understand the entity and its environment.
Data analytics provide an opportunity to maximize the effectiveness of the

human element. For example, technology solutions can reduce the amount
of time dedicated to manual analysis, allowing more time to be spent by the
auditor on the more judgmental aspects of an analysis. Because data
analytics is able to provide the auditor with different and more informative
insights, the use of data analytics improves the auditor’s ability to identify
relationships and inconsistencies, enhancing the auditor’s judgments and

ability to be appropriately sceptical.
Source: International Auditing and Assurance Standards Board (IAASB) Data Analytics Working Group
(2016) Exploring the Growing Use of Technology in the Audit, with a Focus on Data Analytics,
September, International Federation of Accountants (IFAC), New York, p. 9.
Representations by management
During the course of an audit the auditor obtains from management many representations,
either oral or written, on matters related to the information in the financial report. These
representations are one form of audit evidence obtained during the audit. In evaluating the
sufficiency and appropriateness of audit evidence, representations by management need to
be carefully assessed. Management representations should be supported by independent or
other appropriate corroborating evidence. ASA 580 (ISA 580) provides guidance on the
use of such representations as audit evidence and will be discussed further in
Chapter 11 .
QUICK REVIEW
1. Audit evidence needs to be sufficient and appropriate.
2. Sufficiency relates to the quantity of audit evidence.
3. Appropriateness relates to the quality of the audit evidence.
4. The reliability of audit evidence is influenced by its nature and its source.
Page 151
LO 4.5 Overview of the audit risk model

Auditors adopt a business risk approach to determining what is sufficient appropriate audit
evidence. ASA 200.13 (ISA 200.13) defines audit risk at the financial report level as
the risk that the auditor will give an inappropriate auditor’s opinion when the financial
report is materially misstated.
Recent changes in the business environment, including the way in which entities are
organised and how they conduct their businesses, as well as the effects of globalisation,
technology and significantly increased pressures, have led to greater risk of fraudulent
financial reporting.
The auditing standards deal with the auditor’s assessment of the risk that the financial
report could be wrong, and how the auditor designs the rest of the audit to provide an
effective audit response to the identified risk. The auditing standards are designed to
enhance the auditor’s implementation of the audit risk model, which is the fundamental
statement of the theoretical basis for completing an audit.
Engagement risk is the auditor’s exposure to loss or injury to the professional practice
from litigation, adverse publicity or other events arising in connection with a financial
report audit. Auditors will consider the reputation of management and the financial
strength and credit rating of prospective clients in order to help assess the overall risk of
association with the business. Engagement risk is increased when the client entity is in a
weak financial position or is greatly in need of additional capital. When an audit client
goes bankrupt, the auditors are often named as defendants in lengthy and costly lawsuits,
with possible damage to their professional reputation. For that reason, some audit firms
choose to avoid engagements that have a relatively high business risk; others may accept
such engagements, recognising the need to expand audit procedures to compensate for the
unusually high levels of risk.
Engagement risk cannot be directly controlled by the auditor, although some control can be
exercised through the careful acceptance and retention of clients. Audit risk, on the other
hand, can be directly controlled by the scope of the auditor’s procedures.
Before issuing an opinion on a financial report, the auditor needs to reduce audit risk
sufficiently to make the opinion reliable. The auditor reduces audit risk by performing
audit procedures until there is sufficient appropriate evidence for each assertion of each
significant transaction class, balance or disclosure to provide reasonable assurance that the
financial reports are not materially misstated. The audit risk model focuses audit effort on
those classes of transactions, balances or disclosures that are likely to contain material
misstatements.
Components of audit risk

Audit risk is a function of the risks of material misstatement and of detection. ASA 200.13
(ISA 200.13) states that the risk of material misstatement is the risk that the financial
report is materially misstated prior to audit. The assessment of risk is a matter of judgment
rather than a precise measurement. ASA 200.A34–A36 (ISA 200.A34–A36) indicate that
the risks of material misstatement may exist at:
the overall financial report level for risks that are pervasive to the financial report as a
whole and may affect many accounts and many assertions
the assertion level for classes of transactions, balances or disclosures that are assessed to
determine the nature, timing and extent of further audit procedures required to obtain
sufficient appropriate audit evidence about those specific items.
ASA 200.13 (ISA 200.13) and ASA 200.A39 (ISA 200.A39) state that the risk of material
misstatement at the assertion level consists of the following two components:
1. Inherent risk The susceptibility of an assertion about a class of transactions, account

balance or disclosure to material misstatement given the inherent and environmental
characteristics, but without regard to related internal controls. For example, cash is more
susceptible to theft than an inventory of cement. Complex calculations are more likely to
have errors than simple calculations. The methods of assessing inherent risk will be
explained in Chapter 6 .
2. Control risk The risk that a material misstatement in an assertion about a Page 152
class of transactions, account balance or disclosure may not be prevented or may

not be promptly detected and corrected by the entity’s internal control. For example, poor
controls over the custody of inventory increase the possibility of theft. For each account
balance, the auditor identifies the transaction classes that affect the balance and considers
whether there is reasonable assurance that the specific control objectives for those
transaction classes have been achieved. There is an inverse relationship between the
degree of assurance that control objectives have been achieved and the degree of control
risk. An auditor determines a preliminary assessed level of control risk at the planning
stage, based on the auditor’s understanding of the internal control. A final actual assessed
level of control risk is determined based on the results of tests of controls during interim
testing. The methods of assessing control risk will be explained in Chapter 7 .
ASA 200.13 (ISA 200.13) defines detection risk as the risk that an auditor’s
substantive procedures performed to reduce audit risk to an acceptably low level will not
detect a material misstatement. In the planning phase of the audit, a planned acceptable
level of detection risk is determined for each significant assertion. The planned levels of
detection risk are revised, where necessary, if the auditor encounters evidence that alters
the original assessments of inherent risk or control risk.
Therefore, audit risk is a combination of inherent risk, control risk and detection risk. The
audit risk model is depicted graphically in Figure 4.6 .
FIGURE 4.6 Audit risk
While the auditor cannot change inherent or control risk, the auditor can obtain evidence of
a reduced assessed level of control risk by examining the entity’s internal control and
testing its effectiveness. If the evidence indicates that internal control is effective, the
auditor can assess a lower level of control risk. If evidence indicates that there are Page 153
problems with internal control, the auditor’s assessed level of control risk
accordingly remains high. There is always some control risk because of the inherent
limitations of any internal control.
The auditor can, however, alter the level of detection risk. For example, ASA 200.A45 (ISA
200.A45) indicates that the auditor can reduce detection risk by means of:
adequate planning
proper assignment of personnel to the audit engagement team

application of professional scepticism
appropriate decisions on the nature, timing and extent of audit procedures
effective performance of the audit procedures and evaluation of the results
supervision and review of the audit work performed.
As indicated by ASA 200.A44 (ISA 200.A44), detection risk is inversely related to the
effectiveness of auditing procedures and the risk of material misstatement. The greater the
risk of material misstatement, the less detection risk that can be accepted and so the more
effective auditing procedures must be. The impact of the risk of misstatement on audit
evidence is illustrated in Figure 4.7 .
FIGURE 4.7 Impact of increased risk of misstatement on audit evidence
Generally, the effectiveness of auditing procedures is related to the persuasiveness of the

evidence obtained by applying the procedures. Evaluating the effectiveness of auditing
procedures requires experienced professional judgment.
Detection risk can arise for the following two reasons, each of which the auditor needs to
address separately.
1. Sampling risk The risk that the sample is not representative of the population. This is
the risk that the auditor’s conclusion based on the sample used would be different had the
entire population been subjected to the same audit procedure. Sampling risk can be
reduced by increasing the sample size, but cannot be eliminated unless the entire
population is tested.
2. Non-sampling risk The risk of arriving at incorrect audit conclusions by failing to
apply appropriate or effective audit procedures, by applying the procedures improperly or
by drawing incorrect conclusions from the results. This risk exists even if the auditor
applies the audit procedures to the entire population. Non-sampling risk can be controlled
through the use of quality control procedures and by adhering to the auditing standards.
These two types of risk will be discussed further in Chapter 10 .
Assessment of audit risk

There are a variety of approaches to making an assessment of the various components of
audit risk. ASA 200.A42 (ISA 200.A42) points out that although the auditing standards
ordinarily describe a combined assessment of the risk of misstatement, the auditor may
make separate or combined assessment of inherent and control risk, depending on preferred
audit techniques or methodologies and practical considerations.
ASA 200.A42 (ISA 200.A42) indicates that the assessment of the risk of material Page 154
misstatement may be expressed in quantitative terms (such as percentages) or in
non-quantitative terms. However, the assessment of the degree of risk is a subjective
assessment by the auditor based on professional judgment. Therefore, in Australia audit
firms tend to categorise risk as high, medium or low rather than using percentages.
Exhibit 4.2 shows the level of detection risk that is usually acceptable, based on
assessments of inherent and control risks. It shows that there should be an inverse
relationship between the combined degree of inherent and control risks on the one hand,
and the detection risk established by the auditor on the other. For example, an auditor who
assesses inherent risk and control risk as low can accept a high level of detection risk and
still keep the audit risk acceptably low. However, if inherent risk and control risk are
assessed as high, the detection risk needs to be kept low in order to reduce audit risk.
THE INTERRELATIONSHIPS OF THE COMPONENTS

EXHIBIT 4.2
OF AUDIT RISK
Detection risk matrix
Assessment of control risk
High Medium Low
Assessment of inherent risk High Low Low Medium
Medium Low Medium High
Low Medium High High
In every audit, risk needs to be assessed and the judgments made need to be properly
documented. The relative level of risk influences the audit evidence required. Before
issuing an opinion the auditor needs to consider whether the achieved level of audit risk is
satisfactory based on the level set during the planning phase. If the achieved audit risk is
greater than the planned audit risk, the auditor needs to consider whether to reassess the
required audit risk or to lower the detection risk by gathering further audit evidence. If the
achieved audit risk is equal to or less than the planned audit risk level, then the auditor can
issue an unmodified auditor’s opinion.
Business risk
Bell et al. (1997, p. 15) have defined a client’s business risk as ‘the risk that an entity’s
business objectives will not be attained as a result of the external and internal factors,
pressures, and forces brought to bear on the entity and, ultimately, the risk associated with
the entity’s survival and profitability’. The auditor must have extensive knowledge about
the nature of the client’s business and industry in order to determine whether financial
report assertions are valid. The auditor must understand the business risks faced by the
client in addition to understanding the risks that affect the traditional processing and
recording of transactions.
In order to judge properly the fair presentation of the financial report, the auditor needs to
understand the entity’s business strategy, the risks faced by the entity and the entity’s
ability to respond to, or control, changes in its business environment. The auditor must then
determine whether those business risks affect audit risk. Figure 4.8 shows how client
business risk relates to audit risk. The auditor’s assessment of client business risk is part of
the assessment of the risk of material misstatement in the financial report. In other words,
the auditor assesses the specific business risks that the entity faces in order to determine
whether they might result in errors, fraud or other irregularities, and ultimately in a
materially misstated financial report.
FIGURE 4.8 The relationship of client business risk and the risk of material misstatement in the financial report to the
determination of audit risk
This focus on the client’s business risks leads to a more strategic and systematic approach
to the audit. The auditor uses knowledge of the client’s business and industry to develop a
more efficient and effective audit. The auditor places less emphasis on routine Page 155
transactions that are likely to be well controlled through the client’s internal control and
focuses on identifying non-routine transactions, accounting estimates and valuation issues
that are much more likely to lead to misstatements in the financial report. Focusing on
client business risk in this manner should lower audit risk.
A detailed discussion of the auditor’s understanding and evaluation of business risk is

contained in Chapter 5 .
QUICK REVIEW
1. Auditors use a business risk approach in determining what is sufficient
appropriate audit evidence.
2. Audit risk is a function of inherent risk, control risk and detection risk.
3. Detection risk may occur because of sampling risk or non-sampling risk.
4. There is an inverse relationship between the combined degree of inherent
and control risks on the one hand, and the detection risk established by
the auditor on the other.
LO 4.6 Materiality
In addition to evaluating audit risk, the auditor must make a preliminary estimate of
materiality when planning the audit. ASA 320.2 (ISA 320.2) points out that from a
financial reporting framework perspective, materiality means information, individually
or in aggregate, that if misstated or omitted from a financial report may affect economic
decisions of users taken on the basis of the financial report.
ASA 320.10 (ISA 320.10) requires that, when establishing the overall audit strategy, the
auditor must determine materiality for the financial report as a whole. However, if there are
one or more particular classes of transactions, account balances or disclosures for which
misstatements of lesser amounts than materiality for the financial report as a whole could
reasonably be expected to influence users’ economic decisions taken on the basis of the
financial report, the auditor must determine the materiality level or levels to be applied to
those particular classes of transactions, account balances or disclosures. Therefore, the
auditor needs to establish various materiality levels as indicated by Figure 4.9 .
Gay, Grant E., and Roger Simnett. Auditing and Assurance Services in Australia, McGraw-Hill Australia, 2018. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/adelaide/detail.action?docID=5729228.
FIGURE 4.9 Materiality levels
Page 156
Overall materiality
While the term overall materiality is used by auditors in practice to refer to
‘materiality for the financial report as a whole’, the term itself is not used in ASA 320 (ISA
320), which requires that the audit should be planned to ensure that the auditor has a
reasonable expectation of detecting material misstatements. As indicated in ASA 320.4
(ISA 320.4), the assessment of what is material is a matter of the auditor’s professional
judgment, which is influenced by their perception as to who are, or are likely to be, the
prime users of the financial information and what their information needs are. This
involves consideration of both the amount and the nature of the misstatement.
However, as noted by ASA 320.6 (ISA 320.6), the materiality level that the auditor
determines when planning the audit does not necessarily establish an amount below which
uncorrected misstatements, individually or in aggregate, will always be evaluated as
immaterial, as the auditor also needs to consider the nature of the item.
In all of its uses, materiality is a concept of relative significance. It depends on the amount
of the item of interest and some relevant basis of comparison. Absolute dollar amounts are
unworkable. An error of $10 000 might materially misstate the financial report of a small
business, but an error of $100 000 might not materially misstate the financial report of a
large business.
To estimate an amount of materiality for planning purposes, the auditor selects a Page 157
base and a suitable percentage to apply to that base. This requires professional
judgment, and not all auditors do it the same way. Some audit firms use a rule of thumb to
estimate materiality for planning purposes. Although no specific quantitative guidelines
concerning percentages for these rules of thumb are contained in the auditing standards,
Table 4.1 summarises possible percentage methods based on common practice. Most
auditors use the most appropriate base for the entity being audited, while some auditors use
a blend of these, making several calculations on a variety of bases and then taking the
average. Others use a sliding scale, such as a declining percentage of total assets.
TABLE 4.1 RULES OF THUMB FOR PLANNING MATERIALITY
Common Range of percentages applied to Relative advantages

bases base
Net profit 5–10 Relevance
Total revenue 0.5–1 Stability
Total assets 0.5–1 Predictability and

stability
Equity 1–2 Stability
The choice of a rule of thumb depends on value judgments about relevance, stability and
predictability. Net profit may be the most relevant base for a company with publicly traded
securities. However, because net profit can fluctuate significantly from year to year it lacks
stability, and it is not relevant to entities such as non-profit organisations. Size-related
bases such as total assets or total revenue may be preferred because of their relative
stability. Also, the information in Table 4.1 is often combined in the rule of thumb. For
example, another approach is to use the larger of 1 per cent of total assets or total revenue.
A rule of thumb as a decision aid in general planning is not universal in auditing practice.
An audit firm may adopt a particular rule of thumb or the judgment may be left to the
individual auditor to make under the particular circumstances.
The financial information used as a base may be taken from one of the following:
the financial report to be audited (if available and not likely to be adjusted significantly as
a result of the audit)
interim financial information (adjusted for expected seasonal or cyclical fluctuation and
annualised)
the previous period’s financial reports (adjusted for unusual matters and known
significant changes, such as a new wage contract or a merger).
The preliminary judgment about the amount to be considered material to the financial
report taken as a whole is an important general planning decision. The auditor may use this
judgment to identify components of the financial report to be emphasised, the locations to
visit in a multi-location company and, naturally, in planning the nature, timing and extent
of specific auditing procedures. A smaller materiality amount results in more extensive
testing and larger sample sizes for tests. Since different approaches to calculating
materiality can lead to substantially different amounts, the auditor’s judgment under the
particular circumstances is a key factor. When establishing a preliminary assessment of
materiality the auditor should also take into account:
the reliability of management information

any factors that may indicate deviations from normal activities
qualitative factors.
The auditor should select a benchmark or benchmarks appropriate to the entity’s

circumstances for a quantitative evaluation of materiality at the financial report level and in
relation to individual account balances, classes of transactions and disclosures. A
quantitative materiality level, represented by a percentage or dollar threshold, provides a
basis or initial step for the preliminary assumption that without considering all Page 158
relevant circumstances, a deviation of less than the specified amount is unlikely to
be material. The auditor applies this materiality level to audit procedures where appropriate
and uses it to evaluate the outcome of those procedures. The auditor uses professional
judgment to record misstatements below the materiality level, having regard to the
qualitative factors which may cause misstatements of quantitatively small amounts to be
material.
However, the magnitude of a misstatement alone is only one factor used to assess
materiality. The auditor reviews each misstatement in the context of information relevant to
users of the financial report, by considering qualitative factors and the circumstances in
which the misstatement or judgment has been made.
An empirical study by Martinov and Roebuck (1998) of the guidelines used in determining
the materiality assessment for the large audit firms in Australia showed that only one firm
did not use judgment for materiality levels in the planning stage of the audit. This firm
used a specific formula based on the size of the entity. The other firms reported that a
considerable amount of judgment is involved in determining materiality, although some
general guidance on the appropriate base to use is provided.
As indicated in ASA 320.12 (ISA 320.12), the amount considered material does not remain
fixed after its initial calculation. The auditor may revise this judgment as a result of audit
test findings and new information as the audit progresses, and the approach used in
evaluation at the completion of the audit may be considerably different. This means the
amount estimated for planning materiality should not be confused with the amount used in
the evaluation of the materiality of individual misstatements.
The auditor’s use of materiality in evaluation is influenced by qualitative considerations,

additional information and the nature of the decisions to be made. Qualitative
considerations, for example, may include the nature of the transaction, such as related-party
transactions or possible illegal acts. In accordance with ASA 320.14 (ISA 320.14), the
auditor must document the basis of the materiality decision and the factors considered in
making it.
Performance materiality
ASA 320.11 (ISA 320.11) requires the auditor to set performance materiality for the
purposes of assessing the risks of material misstatement and determining the nature, timing
and extent of further audit procedures that need to be performed.
ASA 320.9 (ISA 320.9) defines performance materiality as:
the amount or amounts set by the auditor at less than materiality

for the financial report as a whole to reduce to an appropriately
low level the probability that the aggregate of uncorrected and
undetected misstatements exceeds materiality for the financial
report as a whole. If applicable, performance materiality also
refers to the amount or amounts set by the auditor at less than the
materiality level or levels for particular classes of transactions,
account balances or disclosures.
As indicated by ASA 320.A12 (ISA 320.A12), planning the audit solely to detect
individually material misstatements would ignore the fact that the aggregate of individually
immaterial misstatements may cause the financial report to be materially misstated and
would leave no margin for possible undetected misstatements. Therefore, performance
materiality is set so as to reduce to an appropriately low level the probability that the
aggregate of uncorrected and undetected misstatements in the financial report exceeds the
materiality level for the financial report as a whole. Although no specific guidance is given
in the auditing standards regarding the dollar amounts or percentages to be used in the
setting of performance materiality, in practice, performance materiality commonly ranges
from approximately 60 per cent (for high risk) to 85 per cent (for low risk) of the figure
established for materiality for the financial report as a whole. However, the practice varies
considerably between audit firms.
Specific materiality
While the term specific materiality is commonly used by auditors in practice to refer to
the ‘materiality level for particular classes of transactions, account balances or disclosures’
described in ASA 320.9 (ISA 320.9), the term itself is not used in ASA 320 (ISA 320).
In some audit engagements, the auditor may need to identify misstatements of Page 159
amounts less than overall materiality that would affect economic decisions of
users of the financial report. Such misstatements could relate to sensitive areas, such as
note disclosures regarding senior executives’ remuneration or non-compliance with loan
covenants. In these circumstances, the auditor would consider the existence of specific
matters that indicate a need to establish a specific materiality level for one (or more)
particular class of transactions, account balance or disclosure. Therefore,
specific materiality may be required for sensitive areas due to their nature rather than their
monetary size.
The auditor should consider qualitative factors that affect the materiality of individual
misstatements to assess:
the significance of the item to the particular entity

the pervasiveness of the misstatement (for example, the misstatement might affect the
presentation of numerous items in the financial report)
the effect of misstatement on the financial report as a whole.
In determining the nature, timing and extent of procedures to be applied to a specific

account balance, the auditor needs to obtain a reasonable assurance of detecting
misstatements that, based on the preliminary materiality judgment, could be material to the
financial report as a whole when aggregated with misstatements in other balances.
Relationship between materiality and audit risk

The relationship between audit risk and materiality is inverse, as illustrated in
Figure 4.10 .
FIGURE 4.10 Inverse relationship between audit risk and materiality
This means that the higher the audit risk, the lower the materiality threshold the auditor
sets (see Global example 4.3 ). Thus, if the auditor determines that a particular account
is important, even a low level of error cannot be tolerated. The auditor allows for this by
increasing the extent of audit procedures, selecting a more effective audit procedure or
performing audit procedures closer to the balance date.
GLOBAL EXAMPLE 4.3 Materiality example
Lunchbox Ltd is a publicly listed manufacturer of plastic products. It has been

operating in the plastics industry for many years and has an experienced and
conservative management team. You have been conducting the audit for
four years and have not had any significant audit problems.
Around 50 per cent of Lunchbox Ltd’s revenue comes from plastic

containers designed for domestic use, which are sold through the major
supermarket chains. These products have faced heavy competition in the
past six months, eroding Lunchbox Ltd’s gross profit margins significantly.
Lunchbox Ltd has gross revenues of $180 million, total assets of $235
million, net assets of $102 million and net profit of $8 million.
Factors to consider in setting materiality

Net profit is likely to be of major interest to users, as Lunchbox Ltd Page 160
is a publicly listed company.
If net profit is considered to be unreliable due to the impact of intense
competition on profit, either net or total assets could be considered as a
more relevant and stable base.
The fact that a company is publicly listed is likely to decrease materiality,
given that the financial report will be widely distributed and will also be
relatively complex due to the large number of requirements with which it
must comply, thereby increasing inherent risk.
Competition/price cutting is also likely to decrease materiality, as it might
affect valuation of inventory, erode market share and result in a reduction
of profit, thereby increasing inherent risk.
The fact that this is the fourth year of audit without any significant audit
problems is likely to increase materiality, as lack of errors in previous years
will reduce inherent risk.
The fact that the company has an experienced and conservative
management is likely to increase materiality, as an experienced and
conservative management is less likely to make mistakes or be involved in

risky transactions, and so reduces inherent risk.
Materiality levels
The assessment of materiality involves judgment, taking into consideration
both quantitative data and qualitative aspects. In this case, as there are both
aspects likely to increase and decrease audit risk, overall materiality at the
financial report level is likely to be set somewhere in the mid-range of 5–
10 per cent of net profit, at say $600 000. As audit risk is in the mid-range,
performance materiality would likely be set at, say, 70 per cent of overall
materiality or $420 000.
The audit should be planned so that audit risk is kept at an acceptably low level. The audit
risk that the auditor seeks to restrict is the risk of a material misstatement remaining
undetected after applying audit procedures. This requires the auditor to plan the nature,
timing and extent of audit procedures by taking into account the level of materiality.
Therefore, the auditor’s consideration of materiality and audit risk are really inseparable.
Materiality relates to how precise auditing procedures need to be, and audit risk relates to
the degree of certainty achieved by the procedures. Therefore, as indicated in an AUASB
Bulletin (2012a), materiality is likely to be lowered in uncertain economic times.
It is important, therefore, that during the planning of the audit the auditor understands the
business sufficiently to understand what is material in the circumstances of that client, and
takes into account the audit risk in formulating the nature, timing and extent of the audit
procedures. The evaluation of misstatements identified during the audit is covered by ASA
450 (ISA 450), and the use of materiality in this evaluation will be discussed in
Chapter 11 .
Accounting materiality
Materiality in accounting used to be covered in AASB 1031 Materiality in Financial
Statements, which contained a similar definition of materiality to that contained in ASA
320 (ISA 320), but also contained quantitative guidelines based on percentages of base
amounts.
However, in December 2013 the Australian Accounting Standards Board (AASB) revised
and reissued AASB 1031, as an interim step in the complete withdrawal of this standard,
which took place in January 2015. The board initially amended AASB 1031 to remove the
existing guidance on materiality contained therein, and cross-referenced to other standards
and the new conceptual framework document, Framework for the Preparation and
Presentation of Financial Statements, that contain guidance on materiality. The revised
materiality requirements were, therefore, effective from 1 January 2014.
The definition of materiality in the Framework for the Preparation and Presentation of
Financial Statements, similar to ASA 320 (ISA 320), is that information is material if
omitting it or misstating it could influence decisions that users make on the basis of
financial information about a specific reporting entity. Further, the framework Page 161
states that materiality is an entity-specific aspect of relevance based on the nature
or magnitude, or both, of the items to which the information relates in the context of an
individual entity’s financial report. Consequently, the framework indicates that it cannot
specify a uniform quantitative threshold for materiality or predetermine what could be
material in a particular situation and reaffirms that the determination of materiality is a
matter of professional judgment. This is consistent with AASB Practice Statement 2
Making Materiality Judgments issued in December 2017 to provide reporting entities with
non-mandatory guidance on making materiality judgments when preparing general
purpose financial reports.
QUICK REVIEW
1. Materiality needs to be considered at the financial report level and at the
account balance, class of transactions and events, and disclosure levels.
2. Materiality needs to consider qualitative as well as quantitative factors.
3. Assessment of what is material is a matter of auditor judgment.
4. Performance materiality determines the items that will receive more
attention in terms of conclusiveness of evidence required or extent of
items examined.
5. Performance materiality is set so as to reduce to an appropriately low level
the probability that the aggregate of uncorrected and undetected
misstatements in the financial report exceeds the materiality level for the
financial report as a whole.
6. There is an inverse relationship between audit risk and materiality.
LO 4.7 Types of audit tests
An understanding of financial report assertions, specific audit objectives, the audit risk
model and auditing procedures provides the background necessary to consider the general
classes of audit tests. The conceptual distinction between the types of audit tests is
important in understanding the different phases or major steps in a financial report audit.
Audit tests are classified according to the auditor’s purpose in applying them. The two
basic purposes of applying audit tests are as tests of controls and as substantive tests, as
illustrated in Figure 4.11 .
FIGURE 4.11 Types of audit procedures
Page 162
Tests of controls
Tests of controls are performed to obtain evidence about either (1) the effectiveness of
the design of the policies or procedures in internal control, or (2) the operating
effectiveness of those policies or procedures. These tests may produce evidence to support
a lower assessed level of control risk, as discussed in Chapter 7 . The use of tests of
controls is covered in ASA 330 (ISA 330) and will be discussed further in Chapter 8 .
Substantive tests
Substantive tests are performed to obtain evidence about the validity and the propriety
of the accounting treatment of transactions and balances or, conversely, of errors or
irregularities therein. These tests reduce detection risk.
There are two general categories of substantive tests: analytical procedures and tests of
details.
Analytical procedures
As mentioned previously, essentially these procedures involve the study and comparison of
relationships between accounting data and related information. They focus on the
reasonableness of relationships and also identify unusual fluctuations for investigation.
Analytical procedures are used for three purposes:
1. to assist the auditor in planning other audit procedures (see Chapter 5 )

2. as a substantive test to obtain evidence about an assertion (see Chapter 9 )
3. as an overall review of the financial information near the end of the audit (see
Chapter 11 ).
It is important to recognise that analytical procedures are substantive tests that may achieve
specific audit objectives if the evidence is considered persuasive by the auditor.
Tests of details
Tests of details involve obtaining evidence on the items (or details) included in an
account balance, class of transactions or disclosure. Thus, tests of details are also referred
to specifically as follows
Tests of balances These are tests applied directly to the details of balances in general
ledger accounts. For example, the balances in the accounts receivable ledger are
confirmed with individual customers. Tests of balances will be discussed in
Chapter 9 .
Tests of transactions The auditor tests the processing of individual transactions by
inspecting the relevant documents and accounting records. For example, a sample of
shipping documents is traced to the sales journal to see whether shipments have been
recorded as sales. Tests of transactions will be discussed in Chapter 9 .
Tests of disclosures These tests are applied to disclosures in the financial report. For
example, audit procedures are performed to evaluate whether the overall presentation of
the financial report, including disclosures, is in accordance with the applicable reporting
framework. Tests of disclosures will be discussed in Chapter 11 .
Tests of transactions (substantive tests) and tests of controls that leave a documentary trail
may both involve the inspection of documents that support transactions. For this reason,
these tests are often applied together to the same group of documents. In that case, the test
is referred to as a dual-purpose test, which will be discussed in Chapter 8 .
QUICK REVIEW
1. The two main types of audit tests are tests of controls and substantive
tests.
2. The two general categories of substantive test are analytical procedures
and tests of details, which include balances, transactions or disclosures.
Page 163
LO 4.8 Using the work of an expert or a component

auditor
Using the work of an expert

Auditing often requires expert knowledge of several highly technical and rapidly
expanding subjects that require advanced training and experience. While these issues now
form an integral part of the audit environment, it is neither practical nor necessary for every
member of the audit staff to have the detailed knowledge needed to be expert in them.
Within an audit firm it is common for members and employees to be assigned as experts or
specialists on an industry, functional or technical basis.
Industry specialists
Audit firms often designate members as specialists in particular industries that have unique
organisational or operating characteristics that raise special accounting or auditing
considerations. For example, banks, insurance companies, retailers and extractive industry
firms all have unique operating characteristics that create particular problems in the
application of accounting principles or the audit of accounting estimates.
Every auditor in charge of an engagement is expected to have an in-depth understanding of

the entity and its industry. The audit manager and partner will also have specialist skills
and experience with the industry and the client. In the Big Four audit firms, industry
specialisations, discussed in Chapter 2 , are supported by knowledge management
systems, which contain information on industries and clients, and audit and accounting
issues that have arisen in that industry and how they have been dealt with.
Functional specialists
Functional specialists are often designated for the areas of taxation, management advisory
services, computer information systems and statistical and other mathematical applications.
Specialists in taxes and management advisory services provide services to clients in
separate engagements, and consult on request on pertinent matters that arise in audits.
Computer audit specialists and statistical audit specialists are normally auditors equipped
with advanced training and experience in their specialised fields. They usually work as
members of the audit team, and plan and review the application of the specialised tools—
the use of the computer or statistical sampling—in an audit engagement. Auditors in charge
of an engagement must recognise when the assistance of a computer audit specialist or a
statistical audit specialist is required, and must supervise their work. In a large firm,
computer and statistical specialists may also be supervised by coordinators in each
respective area.
Technical specialists
Some audit firms have designated technical specialists. In addition, auditors often need to
call on outside specialists for assistance or consultation during the audit process—for
example, to value assets such as land and buildings, and plant and machinery, or to
determine quantities of assets such as stockpiled minerals or petroleum reserves. While
education and experience equip the auditor with knowledge about business matters in
general, the auditor is not expected to have the expertise of a person trained or qualified to
engage in another profession or occupation, such as an actuary or an engineer. These
specialists may be engaged either by the client (a management’s expert) or by the auditor
(an auditor’s expert).
A management’s expert is defined under ASA 500.5 (ISA 500.5) as someone

possessing expertise in a field other than accounting or auditing, whose work in that field is
used by the entity to assist it in preparing the financial report.
An auditor’s expert is defined under ASA 620.6 (ISA 620.6) as someone possessing
expertise in a field other than accounting or auditing, whose work in that field is used by
the auditor to assist in obtaining sufficient appropriate audit evidence. ASA 620.7 (ISA
620.7) requires that if expertise in a field other than accounting or auditing is necessary to
obtain sufficient appropriate audit evidence, the auditor must determine whether to use the
work of an auditor’s expert.
If the auditor is going to use the work of a management’s expert (ASA 500.8/ISA Page 164
500.8) or an auditor’s expert (ASA 620.9–13/ISA 620.9–13) as audit evidence, the
auditor must do the following, depending on the significance of the expert’s work for audit
purposes:
Assess the capabilities and competence of the expert by reference to any professional
certification or licence and to the experience and reputation of the expert.
Assess the objectivity of the expert. This is especially relevant where the expert is
employed by the audit client. In this case the auditor should determine whether there are
any professional or statutory obligations governing the work of the expert that mitigate
any concern as to their objectivity. For example, many actuaries are employed by life
insurance companies, but they have professional and statutory obligations over and above
their employee status that require them to maintain an objective approach to their work.
Obtain an understanding of the work of the expert.
Evaluate the appropriateness of the work of the expert as audit evidence for the relevant
assertion, by discussing or reviewing the reasonableness of the assumptions and methods
used by the expert; by considering the relevance, completeness and accuracy of the
source data used; and by considering the consistency of the expert’s work with the results
of related audit procedures. The auditor, of course, evaluates the work of the expert only
as a reasonable person, based on the auditor’s knowledge of the client, and not as an
expert.
Using the work of a component auditor

In audit engagements where the client entity comprises one or more divisions, branches or
subsidiaries (components), the audit work may be undertaken by several different auditors.
In such a situation the principal auditor responsible for the opinion on the primary financial
report (that containing the information from the various components) is responsible for the
use made of the work of any other external auditor.
The components of a client entity may be audited by another external auditor (a componen
t auditor ) where the component is in a separate geographical location or where the
client has an existing commitment with another auditor. In these cases the audit of the
component could be undertaken by another office of the principal auditor’s firm (perhaps
in a different country), by an affiliated firm of auditors or by a totally unrelated firm of
auditors. In all these cases the primary auditor must be satisfied as to the work undertaken
by the other auditor, as this work forms part of the audit evidence which the principal uses
to form an opinion. Therefore, ASA 600.12 (ISA 600.12) states that the group engagement
partner must evaluate whether the group engagement team will be able to be involved in
the work of the component auditors to the extent necessary to obtain sufficient appropriate
audit evidence.
The principal auditor needs to understand the following matters concerning the component
auditor, as set out in ASA 600.19 (ISA 600.19) and in Exhibit 4.3 :
UNDERSTANDING THE WORK OF THE COMPONENT
EXHIBIT 4.3
AUDITOR
1. Whether the component auditor understands and will comply with the relevant
ethical requirements applicable to the engagement, including independence. This is
especially relevant where the component auditor is overseas.
2. The professional competence of the component auditor in terms of the specific
tasks undertaken by that auditor. Such information could be obtained by reference
to any professional organisations to which the auditor belongs, by enquiries of third
parties and by discussions with the component auditor.
3. Whether the group engagement team will be able to be involved in the work of the
component auditor to the extent necessary to obtain sufficient appropriate audit
evidence.
4. Whether the component auditor operates in a regulatory environment that actively
oversees their work.
Source: Extracted from Australian Auditing and Assurance Standards Board (AUASB) (2015) ASA
600 Special Considerations—Audits of a Group Financial Report.
Page 165
In order for the principal auditor to place reliance on the work of a component
auditor, particular procedures may need to be applied to that work. The nature and extent of
these procedures will depend on the circumstances of the engagement and on the principal
auditor’s familiarity with the work and competence of the component auditor. The
procedures applied could take the form of discussions with the component auditor; the
completion of a written summary, questionnaire or checklist identifying the audit
procedures applied by the component auditor; or, in extreme cases, a review of the
component auditor’s working papers. This process should be documented by the principal
auditor, along with the conclusions reached as to the use to be made of the work of the
component auditor.
QUICK REVIEW
1. When using the work of an internal or external expert, an auditor must
assess the capabilities, competence and objectivity of the expert and
obtain sufficient appropriate evidence that the work is adequate for the
purposes of the audit.
2. When part of the entity or group is audited by a component auditor, the
principal auditor is responsible for the opinion on the primary financial
report.
3. The principal auditor must be satisfied that the component auditor is
independent and competent and that their work provides satisfactory
evidence to support the principal auditor’s opinion.
LO 4.9 Documentation of audit work: audit working
papers
As the auditor carries out the steps in the audit, collecting evidence to support an opinion
on the financial report, there must be some means of documentation of the evidence
for future study and consideration. Audit working papers are the specific means used
to document audit evidence. The exact form and the detailed content of audit working
papers must be designed to meet the circumstances and the needs of individual
engagements. The form and content of audit working papers are influenced by the nature of
the engagement, the nature and complexity of the client’s business, the condition of the
client’s records and internal control, and the approach and staffing of each audit
engagement. Many audit firms have standardised the details of audit working papers, and
the formats vary. For these reasons, primary attention is given here to the general aspects of
audit working papers rather than to the detailed methods of their preparation. The auditing
standards and ASIC both emphasise the importance of the auditor documenting the work
that has been done and the decisions that have been made. When reviewing audit quality,
regulators start from the premise that anything in relation to the audit that is not
documented did not occur.
The function of audit working papers

The three main functions of audit working papers are to aid in:
1. planning and performing the audit

2. supervising and reviewing the audit work
3. gathering evidence and providing essential support for the auditor’s opinion, including
evidence that the examination was conducted in accordance with the auditing standards.
Audit working papers are an important physical aid in recording the results of audit tests.
For example, when a sample is taken the items drawn must be recorded and computations
must be made. In addition, audit working papers are necessary for coordination of the work
leading to an opinion. Final decisions concerning the opinion on the financial report are
made by partners and managers who perform few, if any, of the actual audit tests.
Therefore, there must be a means of reviewing the work performed. They use the audit
working papers as a basis for evaluating the evidence gathered.
To be useful, the audit working papers need to be clear and unambiguous, and Page 166
appropriately referenced and stored. The most critical aspect of audit working
papers is that they should stand in their own right and not require oral comments by the
auditor for completeness or clarity.
After an opinion has been given, audit working papers are the only evidence the auditor has
that an adequate examination was conducted. The auditor works with original documents
and accounting records, which must be left with the client when the examination has been
completed. The auditor must therefore include in the audit working papers a description of
the work done and the results of the tests performed. There is always a possibility that the
auditor will have to prove the adequacy of the examination in court, and in such
circumstances the audit working papers will be critical to the defence.
The requirement that audit working papers be properly prepared and maintained is found in
ASA 230.5 (ISA 230.5), which requires the auditor to document important evidence to
support the auditor’s opinion and show that the audit was conducted in accordance with the
Australian auditing standards. This basic principle is amplified in ASA 230.8 (ISA 230.8),
which requires the auditor to prepare audit documentation that shows the nature, timing
and extent of the audit procedures performed; the results of the audit work and the
evidence obtained; and the significant matters arising during the audit, the conclusions
reached by the auditor based on the evidence obtained and the judgments the auditor made
in reaching those conclusions.
In addition, ASA 230.A2 (ISA 230.A2) states that the form and content of audit
documentation is affected by matters such as the:
size and complexity of the entity being audited

nature of the audit procedures performed
risks of material misstatement identified
audit evidence obtained
exceptions identified
conclusions reached
audit methodology and tools used during the course of the audit.
ASA 230.7 (ISA 230.7) requires that the audit documentation be prepared in a timely
manner. This is amplified by ASA 230.A1 (ISA 230.A1), which points out that
documentation prepared after the audit work has been performed is unlikely to be as
accurate as documentation prepared at the time the work is being performed. Further, ASA
230.A21 (ISA 230.A21) indicates that, ordinarily, assembly of the audit file should be
completed within 60 days of the date of the auditor’s report.
As well as ASA 230 (ISA 230), various other auditing standards contain specific
documentation requirements with which the auditor must comply. Appendix 1 to ASA 230
(ISA 230) identifies and lists the paragraphs in other auditing standards that contain
specific audit documentation requirements.
The contents and requirements of audit working

papers
While audit firms have different approaches, there are two main divisions of audit working
papers for each engagement: the permanent file and the current working paper file.
Permanent file
The permanent file is used to store documents, schedules and other information
pertinent to the current audit and of continuing significance to the audit engagement in
future years. It normally contains the following items:
1. Excerpts and/or copies of the company constitution or replaceable rules, which describe
the regulations of the company and the basic approach to be adhered to by management.
These documents identify the objectives of the company, the number and types of shares
that can be issued, the rights of shareholders and the powers and duties of those charged
with governance.
2. Documents relating to ongoing contracts and agreements, such as loan agreements,
debenture deeds, labour agreements, trade contracts, leases and service agreements. All
of these matters can significantly affect a company’s operations and its financial Page 167
report, and the auditor should have evidence of the provisions of these
documents and the review thereof. These documents also assist the auditor in verifying
such matters as loan interest payments and receipts and lease assets and liabilities.
3. Continuing analysis of accounts that have ongoing importance to the auditor, such as
shareholders’ funds, long-term debt and fixed assets. With this information in the
permanent file, the auditor can concentrate on analysing changes in the accounts during
the current year while having the results of previous years available for review.
4. The results of analytical procedures from previous years. These include ratios and
percentages computed by the auditor, and trend analysis of relevant accounts, such as
sales and gross profit margins by major product class. This assists the auditor in
determining whether there are unusual changes in the current year which require further
audit consideration.
5. Extracts from minutes of relevant shareholder and management meetings and
committees. These provide the auditor with evidence for verifying various events that
may be reflected in the financial report, such as details of share issues, approval of capital
projects and changes in accounting policies.
6. Details relevant to audit planning, such as the locations of branch offices or subsidiaries,
details of cost centres and bank accounts, and inventory storage capacity and locations.
This information is useful to the auditor where certain audit procedures are performed on
a rotating basis or at different locations each year.
7. Copies of significant correspondence between the auditor and the client, such as any
management letters sent to the company’s board of directors detailing matters of concern
arising from previous audits.
The permanent file also holds the chart of accounts and accounting procedure manuals,
flowcharts and notes on internal control, organisation charts and excerpts from job
manuals, industry information, a list of related parties and the previous year’s audited
financial report.
At the start of an examination, the permanent file and the previous year’s current working
paper file are studied and used for reference purposes.
Current working paper file
The current working paper file contains all papers accumulated during the current
year’s examination, comprising the evidence gathered and conclusions reached in the audit
for that year. While the current file contains a range of detailed information, the following
items are the most important:
1. Evidence of planning, including a copy of the audit strategy.

2. The details of the review of the accounting system and related internal controls; the
client’s activities and accounting records; and the basis upon which the nature, timing and
extent of audit procedures were determined. This may include flowcharts or narratives of
the client’s systems and the auditor’s internal control questionnaires. Some of this
information may be transferred to the permanent file following completion of the audit.
3. The audit plan or audit program, listing the audit procedures undertaken and the names of
audit staff completing those procedures. The audit plan or audit program helps to ensure
that the audit is coordinated and integrated.
4. Details of the tests of controls and substantive tests of transactions and balances
completed.
5. The working trial balance, which is the schedule of general ledger accounts used as the
basis of preparation of the financial report. Many audit firms use the working trial
balance as the focus of working paper preparation. Schedules are prepared supporting
each item on the trial balance, and these schedules provide evidence of the work
performed and conclusions reached. Where the audit work results in an Page 168
adjustment to a particular account, the trial balance and supporting schedules
reflect the adjustment.
6. Trial balance working paper schedules, which include documents from sources external
to the entity confirming items in the accounting information supporting the financial
report. Examples are confirmations from debtors and creditors, confirmations from the
entity’s bank detailing bank account balances held by the entity, the balances of those
accounts and any securities held, and letters from the entity’s solicitors. There are also
reconciliations prepared by the auditor, the results of numerical and narrative analyses of
accounts, tests of reasonableness, results of audit enquiries to members of the entity’s
staff, excerpts from minutes of the meetings of the board of directors, copies of important
contracts and the conclusions drawn by the auditor on each matter considered.
7. The original draft of the financial report and auditor’s report, and evidence of appropriate
review and conclusions drawn to support the auditor’s opinion.
While the preparation of certain working papers by the client’s employees is desirable for
an efficient audit, there is a clear distinction between preparation of working papers and
accumulation of audit evidence. While the client can assist by providing information and
preparing schedules, the auditor is responsible for checking the accuracy of those
schedules. For example, if the auditor receives a schedule from the client listing the
acquisition of fixed assets during the period, the auditor checks the numerical accuracy of
the schedule, traces the information to the general ledger and then verifies the acquisitions
by examining supporting documents. The client schedule is retained as the working paper
with the auditor’s notations and conclusions recorded thereon.
Legal aspects of audit working papers

Audit working papers are the property of the auditor. The auditor should not permit general
access to the audit files by the client’s staff, as this would enable the client’s staff to
become familiar with the procedures used by the auditor and could facilitate fraud or
misrepresentation.
The ownership of audit working papers has been dealt with through the courts. The
decision of the Court of Appeal in England in the case of Chantrey Martin & Co. v
Martin [1953] 3 WLR 459 established that ordinarily the auditor owns the audit working
papers. The case involved an audit firm and a former employee whose employment had
been terminated. The employee argued that he had been dismissed because he had refused
to acquiesce in relation to certain irregularities he had discovered while auditing the
accounts of a client. So that this issue could be explored, the former employee sought
access to the audit working papers. The audit firm resisted this on the basis that those
papers were the property of the client, but the Court of Appeal disagreed and held that the
audit working papers were the property of the audit firm.
This decision has not been called into question. In fact, it can be argued that the increasing
emphasis placed upon the responsibilities and liability of an auditor, along with the more
onerous consequences of default, have reinforced the view that in compiling audit working
papers the auditor is acting independently of the client. Because auditors are responsible
for their actions, the audit working papers must be held independently of the client whose
activities are being audited. Legal ownership of the audit working papers, however, does
not change the auditor’s ethical responsibility not to violate the confidential relationship
with the client.
Audit working papers provide the auditor’s defence in terms of whether the audit was
undertaken in accordance with proper standards. Therefore, the auditor should adopt
reasonable procedures for safe custody, confidentiality and accessibility of audit working
papers. ASA 230.Aus A23.1 confirms the requirement of section 307B of the Corporations
Act 2001 and APES 320 to retain audit working papers for a minimum period of seven
years. Further, ASA 230.15 (ISA 230.15) prohibits the auditor from deleting or discarding
audit documentation after assembly of the file is complete and before the end of the
retention period. However, ASA 230.16 (ISA 230.16) and ASA 230.A24 (ISA 230.A24)
acknowledge that it may be necessary to modify existing audit documentation or add new
audit documentation after assembly of the audit file has been completed.
Similarly, section 307B of the Corporations Act 2001 requires auditors to retain Page 169
audit working papers for seven years or an earlier date if so determined by ASIC.
The Sarbanes–Oxley Act 2002 also requires auditors of US-listed companies or their
subsidiaries to maintain audit working papers for a minimum of seven years. In the US,
Arthur Andersen had criminal proceedings brought against them after the collapse of
Enron for allegedly destroying audit working papers concerning the audit.
Access to audit working papers

As indicated in Chapter 3 , the auditor has a duty of confidentiality under section 140
of APES 110 and, in accordance with GS 011.14, should not disclose information about a
client to a third party without specific authority from the client, unless there is a legal or
professional duty to disclose it. This is supported by ASA 230.Aus 16.1, which requires
that the auditor adopt appropriate procedures for maintaining the confidentiality of the
audit working papers.
GS 011 provides specific guidance to auditors when establishing and agreeing to
conditions under which third parties are granted access to audit working papers and related
documentation. GS 011.11 indicates that requests for access to an auditor’s working papers
may arise when one of the following is the case:
a controlling entity’s auditor wishes to review the audit working papers of a controlled
entity, in accordance with section 323B of the Corporations Act 2001
a representative of a prospective purchaser, investor or lender wishes to review the audit
working papers in order to advise their client about a transaction with the audited entity
an entity’s newly appointed auditor seeks to review the predecessor auditor’s working
papers in connection with the next auditor review of the entity
the internal audit function is outsourced to an audit firm and the entity’s external auditor
wishes to review the internal audit working papers
the auditor of a joint venture participant wishes to review the audit working papers of the
auditor of the joint venture.
GS 011.17 states that whenever a third party seeks access to audit working papers the
auditor should first obtain from the client and the third party an indemnity against any
liability that arises through that access. While in most cases a company cannot indemnify
its auditor in respect of a liability to the company that arises in the capacity as the
company’s auditor, it can indemnify its auditor against such liabilities to third parties. In
addition, the third parties themselves can indemnify the auditor against liability to those or
other parties.
GS 011.23 provides that audit working papers and other documents to which access is
given should in most cases include an express disclaimer of reliance and exclusion of
liability. In addition, GS 011.42 indicates that the auditor should consider whether to obtain
legal advice before granting third parties access to audit working papers, as such access
may expose the auditor to significant potential legal risk.
Preparing audit working papers

Certain matters concerning the mechanics of audit working papers are so traditional in the
practice of auditing that they require mention even in a general discussion. These matters
are the use of ticks, indexing and adjusting journal entries.
Ticks are symbols used by the auditor to indicate the nature and extent of procedures
applied in specific circumstances. Like all symbols, they are shorthand. For example, after
the auditor has examined vouchers supporting disbursements for every item on a working
paper listing the charges to an expense account, the auditor places a tick (✓) after each
item. At the bottom of the working paper the auditor explains the meaning of the symbol in
this manner:
✓ Voucher with supporting papers examined and found

satisfactory
Individual audit firms develop their own standardised markings and indexing. Indexing
audit working papers is a matter of coding the individual sheets of paper so that required
information may be found easily. The auditor prepares cross-references, creating a Page 170
trail through the records for the same reasons that an audit trail in the client’s
accounting records is important. A variety of indexing systems are in use: sequential
numbering, combinations of letters and numbers, and digit-position index numbers. The
following short example of the third system is sufficient to illustrate the general principle:
1000 Draft of auditor’s report
...
...
2000 Cash
2001 Count of petty cash
2002 Bank reconciliation
2100 Accounts receivable
...
...
3000 Fixed assets

...
...
Sometimes the client makes errors of omission or misapplies accounting standards when
preparing the financial report. Adjusting journal entries are the corrections that the auditor
feels are required. The auditor does not make the entries in the client’s records. Proposed
entries are made on the auditor’s working papers, and their later recording by the client is
reviewed. If the client declines to make the adjusting entries that the auditor considers
necessary for the financial report to give a true and fair view, the auditor issues a modified
auditor’s opinion.
For example, suppose an ordinary expense is incorrectly capitalised as follows:
Dr Machinery and equipment $175
Cr Cash $175
The adjusting journal entry necessary to correct the accounts is:
Dr Repair expense $175
Cr Machinery and equipment $175
(to record ordinary repair expense incorrectly capitalised)
Illustrative audit working papers
A typical audit program (list of procedures) for the audit of fixed assets is illustrated in
Exhibit 4.4 .
SIMPLIFIED EXAMPLE OF AN AUDIT PROGRAM FOR
EXHIBIT 4.4
PROPERTY, PLANT AND EQUIPMENT
CLIENT Palmwood Ltd Reviewed by

DRS
AUDIT PROGRAM FOR Property, plant and equipment
Date
AUDIT PERIOD 30/6/X4 5/8/X4
Working
Item paper
no. Audit procedure Done by reference
1 Obtain or prepare a schedule of property, plant, RP B

equipment and accumulated depreciation.
2 Vouch additions and retirement from the RP B/1, B/2

accounts through records to supporting
vouchers and examine support.
3 Examine supporting vouchers for repairs and RP B/4

maintenance to ascertain whether such
charges should be capitalised or expensed.
4 Recalculate depreciation calculations. RP B/3
5 Trace depreciation to depreciation expense RP B/3

accounts.
6 Ascertain that depreciation rates and RP B/3

depreciable lives being used appear to be
reasonably adequate.
7 Ascertain that depreciation rates and RP B/3

depreciable lives being used are consistent
with previous years.
8 Recalculate gains or losses on disposals and RP B/1, B/2

trace to gain or loss accounts.
Page 171
Exhibit 4.5 , consisting of five hypothetical audit working papers, illustrates the
accomplishment of the procedures specified in this audit program. This illustration presents
one possible format for audit working papers. The indexing system is a combination of
letters and numbers. The lead schedule is indexed ‘B’, while the supporting audit working
papers are numbered ‘B/1’ to ‘B/4’. A lead schedule is prepared for each major account
classification and is used to summarise all final amounts that will appear in the financial
report. Cross-referencing of individual items from one working paper to another and to the
lead schedule is also illustrated. Therefore, working paper B shows the closing balances
and summarised movements for the three fixed asset accounts and their respective
accumulated depreciation accounts. The additions and retirements to fixed assets are cross-
referenced to working papers B/1 and B/2, which show the detail of the additions and
retirements and how these were audited by checking to supporting documentation, such as
invoices.
EXHIBIT 4.5 AUDIT WORKING PAPERS
Page 172
Page 173
Page 174
On each working paper in the set, the procedures undertaken are indicated at the bottom of
the working paper. By clearly showing the procedures undertaken, the auditor’s working
papers reflect the types of evidence used, the timing of the procedures used to gain the
evidence and the extent of the procedures used. The depreciation calculations are cross-
referenced to working paper B/3, which shows the auditor’s calculation of the depreciation
figures compared to the client’s figures and the adjusting journal entry required. Working
paper B/4 shows the details of the vouching of the repairs and maintenance account and the
required adjusting journal entry required to correct an item of equipment that was
incorrectly expensed as repairs and maintenance. Therefore, the set of audit working papers
illustrated in Exhibit 4.5 shows the interrelationship between accounts as well as the
integrated approach to the audit of such accounts.
The trial balance and lead schedules can be prepared manually or a personal computer can
be used. The client’s general ledger accounts and balances can be entered into the trial
balance program. When adjusting and reclassification entries are entered, the computer
software posts the entries and updates the trial balance and lead sheets. The Page 175
software can also be used to consolidate financial reports and prepare the final
drafts of the financial report.
A computer can also be used to assist in preparing audit working papers, particularly when
standard working-paper format is applicable. Additionally, the auditor may be able to
download information from the client’s computer files directly into the audit working
papers for further analysis and testing. For example, the auditor can use software to scan a
client’s cash payments file and select all items over a specified dollar amount for further
analysis.
QUICK REVIEW
1. Auditors need to document important evidence.
2. Audit working papers are necessary for the planning, coordination and
review of the audit work.
3. Audit working papers provide documentary evidence that the audit has
been properly carried out.
4. The two main categories of audit working papers are the permanent file
and the current working paper file.
5. Audit working papers are the property of the auditors.
6. The auditor needs to ensure safe custody and confidentiality of the audit
working papers.
7. The auditor should only provide access to audit working papers in limited
circumstances and should provide a disclaimer of reliance and obtain an
indemnity against any liability that may arise.
Summary
The overall audit objective in a financial report audit is to give an opinion on the financial
report. This is achieved by gathering and evaluating evidence regarding management
assertions contained in the financial report, using both professional scepticism and
professional judgment. Management makes assertions concerning existence, occurrence,
completeness, rights and obligations, accuracy, valuation and allocation, accuracy, cut-off,
classification and presentation. The auditor needs to gather sufficient appropriate audit
evidence to enable an auditor’s opinion to be given. The auditing procedures to be applied
and the type of evidence to be gathered to support each assertion are matters of the
auditor’s judgment. Materiality is also a matter of judgment and is considered at both the
overall level and the account balance, class of transactions and events, and disclosure
levels, at both the planning and the completion stages of the audit. Where the auditor uses
the work of experts or component auditors, the audit procedures will need to ensure that
the work is adequate for the purposes of the audit. The audit working papers should provide
support for the auditor’s opinion, by documenting the procedures performed, the evidence
obtained and the conclusions reached.
Key terms
accountable activity
accuracy
accuracy, valuation and allocation
advanced data analytics
analytical procedures
appropriateness
audit evidence
audit procedures
audit risk
audit trail
audit working papers
auditor’s expert
business risk
classification
completeness
component auditor
control risk
current working paper file
cut-off
detection risk
documentation
engagement risk Page 176
enquiry
existence
expert
external confirmation
financial report assertions
inherent risk
inspection
internal control
management’s expert
materiality
non-sampling risk
observation
occurrence
organisational structure
overall materiality
performance materiality
permanent file
presentation
professional judgment
professional scepticism
recalculation
re-performance
rights and obligations
risk of material misstatement
sampling risk
specific materiality
substantive tests
sufficiency
sufficient appropriate audit evidence
tests of controls
tests of details
References and additional readings
Auditing and Assurance Standards Board (AUASB) (2012a) ‘Auditing considerations in a
prolonged uncertain economic environment’, AUASB Bulletin, August, Melbourne.
Auditing and Assurance Standards Board (2012b) ‘Professional scepticism in an audit of a
financial report’, AUASB Bulletin, August, Melbourne.
Australian Securities and Investments Commission (ASIC) (2017) Report 534: Audit
inspection program report for 2015–16, Melbourne.
Bell, T.B., Marrs, F.O., Solomon, I. and Thomas, H. (1997) Auditing Organisations
through a Strategic-Systems Lens: The KPMG Business Measurement Process, KPMG,
New York.
Harding, N. and Trotman, K.T. (2009) ‘Improving assessments of another auditor’s
competence’, Auditing: A Journal of Practice & Theory, Vol. 28, No. 1, pp. 53–78.
Holstrum, G.L. and Mock, T.J. (1985) ‘Audit judgment and evidence evaluation’, Auditing:
A Journal of Practice & Theory, Fall, pp. 101–8.
Houston, R.W., Peters, M.F. and Pratt, J.H. (1999) ‘The audit risk model, business risk and
audit-planning decisions’, The Accounting Review, July, pp. 281–98.
International Auditing and Assurance Standards Board (IAASB) Data Analytics Working
Group (2016) Exploring the Growing Use of Technology in the Audit, with a Focus on
Data Analytics, September, International Federation of Accountants (IFAC), New
York.
International Auditing and Assurance Standards Board, International Ethics Standards
Board for Accountants (IESBA) and International Accounting Education Standards
Board (IAESB) (2017) Towards Enhanced Professional Scepticism, IFAC, August.
Janvrin, D. (2008) ‘To what extent does internal control effectiveness increase the value of
internal evidence?’, Managerial Auditing Journal, Vol. 23, No. 3, pp. 262–82.
Leslie, D.A. (1985) Materiality: The Concept and its Application to Auditing, CICA,
Toronto.
Martinov, M. and Roebuck, P. (1998) ‘The assessment and integration of materiality and
inherent risk: an analysis of major firms’ audit practices’, International Journal of
Auditing, Vol. 2, No. 2, pp. 103–26.
Messier, W.F., Martinov-Bennie, N. and Eilifsen, A. (2005) ‘A review and integration of
empirical research on materiality: two decades later’, Auditing: A Journal of Practice &
Theory, Vol. 24, No. 2, p. 153.
Niven, D. (2010) ‘Auditor’s professional scepticism’, Charter, December, pp. 66–7.
Payne, E.A. and Ramsay, R.J. (2008) ‘Audit documentation methods: a path model of
cognitive processing, memory, and performance’, Auditing: A Journal of Practice &
Theory, May, pp. 151–68.
Page 177
Review questions
Accounting and auditing contrasted

4.1 ‘Financial accounting and financial report auditing are not the
same.’ Discuss. LO 4.1
4.2 Explain why professional scepticism is important in auditing. LO 4.1
Financial report assertions

4.3 List and explain the categories of assertions that apply to account balances,
classes of transactions and disclosures. LO 4.2
Audit procedures
4.4 Provide three examples of the use of inspection as an audit procedure.
LO 4.3
4.5 Explain what is meant by the ‘audit trail’ and how the auditor may use it.
LO 4.3
Sufficient appropriate audit evidence

4.6 Explain what constitutes ‘sufficient appropriate audit evidence’. LO 4.4
4.7 Outline the factors that may influence the reliability of audit
evidence. LO 4.4
Audit risk model

4.8 Describe the components of the audit risk model. LO 4.5
4.9 Define ‘detection risk’ and explain why it cannot be reduced to zero. LO 4.5
Materiality
4.10 Describe how judgments regarding the size of misstatements that are
considered material are used in the conduct of an audit. LO 4.6
4.11 What factors may affect the identification of an appropriate benchmark for
determining materiality for the financial report as a whole? LO 4.6
Types of audit tests
4.12 Outline the difference between tests of control and substantive tests.
LO 4.7
Using the work of an expert or component auditor

4.13 List three factors that may affect the group engagement team’s involvement
in the work of the component auditor. LO 4.8
4.14 What matters would an auditor usually consider when evaluating the
competence of an expert? LO 4.8
Documentation of audit work: audit working

papers
4.15 Outline the purposes of audit documentation, as indicated in ASA 230 (ISA
230). LO 4.9
Discussion problems and case studies
Accounting and auditing contrasted

4.16 MEDIUM Safe & Dry Ltd (SDL) manufactures and sells roof tiles. You are
conducting the audit of SDL for the year ending 30 June 2018 and you note
that SDL has a bank loan of $10 million from Regional Bank that is due to be
repaid on 31 October 2019. SDL will need to be able to renew the loan, as
SDL is unlikely to be able to meet its obligations without renewing it. Page 178
The loan contains a number of restrictive covenants, which, if
breached, entitle Regional Bank to recall the loan immediately.
SDL’s chief financial officer (CFO), Albert Kenny, has informed you that as the
loan has not been recalled, obviously there have been no breaches during
the year.
REQUIRED
How would your audit team exercise their professional scepticism in relation
to Albert’s claim? LO 4.1
Source: This question was adapted from the Chartered Accountants Program of the Institute of
Chartered Accountants in Australia, 2013 (2) audit and assurance module.
Financial report assertions

4.17 EASY Five misstatements related to the inventory of Creation Ltd are listed
below.
(a) Some inventory items are out on consignment to customers and were
not counted during the physical inventory.
(b) During the physical inventory count, the client’s employees mistakenly
counted some items twice.
(c) The basis of inventory valuation is not included in the financial report.
(d) Some inventory items are listed at cost, when net realisable value is
lower.
(e) Included in the inventory counts are some items that are held by the
client on consignment from suppliers.
REQUIRED
For each misstatement, list the financial report assertion involved. LO 4.2
4.18 MEDIUM You are the auditor of Bright Paints (BP) for the year ended 30
June 2018. BP manufactures several different paint types in over 100
colours, for both commercial and domestic use. Paint stock on hand is at risk
of spoilage due to poor warehouse facilities.
About 35 per cent of sales are made to large chain stores, with the
remainder to small retailers and tradespeople. Chain stores often negotiate
special deals on bulk orders that must be calculated manually, resulting in
frequent errors. No sales are made directly to the public. Sales are often
invoiced up to one week after the related inventory is shipped to the
customer.
REQUIRED
Identify and explain the accounts and financial report assertions that you
believe would be assessed as high risk. LO 4.2
Source: This question was adapted from the Chartered Accountants Program of Chartered
Accountants Australia and New Zealand, 2015 (2) audit and assurance module.
4.19 MEDIUM You are the auditor of Pets Paradise Limited (PPL), a national
chain of dog wellness centres that feature dog day care and boarding
facilities. Three of PPL’s wellness centres were refurbished during the year.
The CFO, Ashely Carbone, mentioned to you that ‘sometimes it can be
difficult to distinguish between capital improvements and maintenance
expenditure’. PPL also sells premium dog food.
PPL invoices customers upfront for the boarding facilities. PPL recently
changed its billing system to a new off-the-shelf system. Since the system
went ‘live’, there have been a few instances of incorrect amounts being
billed to the customer.
Inventory turnover has slowed dramatically over the past year. This is an
issue for some of the premium dog food lines, which have a relatively short
shelf life.
REQUIRED
Identify and explain the accounts and financial report assertions that you
believe would be assessed as high risk. LO 4.2
Page 179
Audit procedures
4.20 EASY Indicate the type of error that each of the following audit procedures
is designed to or is likely to disclose:
(a) Review of the repairs and maintenance account.

(b) Reconciliation of interest expense with loans payable.
(c) Confirmation of accounts receivable. LO 4.3
4.21 EASY For each of the audit procedures listed below, indicate which of the
following types of evidence-gathering procedure are being used:
1. Inspection
2. Recalculation
3. Confirmation
4. Analytical procedures
5. Enquiries
6. Observation
7. Re-performance
(a) Comparing the current-year gross profit percentage with the gross
profit percentage for the past four years.
(b) Agreeing the total of the accounts receivable subsidiary ledger to
the accounts receivable general ledger account.
(c) Discussing the adequacy of the allowance for doubtful accounts with
the credit manager.
(d) Performing test counts of the warehouse personnel’s count of raw
material.
(e) Examining a new bottling machine to ensure that this major
acquisition was received.
(f) Watching the client’s warehouse personnel count the finished goods
inventory.
(g) Obtaining a letter from the client’s solicitor indicating that there are
no lawsuits in progress against the client.
(h) Vouching the prices used by the client’s billing program for pricing
sales invoices to the client’s approved price list.
(i) Examining large sales invoices for a period of two days before and
after year end to determine whether sales are recorded in the proper
period.
( j) Sending a written request to the client’s customers requesting that
they report the amount owed to the client. LO 4.3
Sufficient appropriate audit evidence

EASY Evidence comes in various types and has different degrees of
4.22
reliability. Below are some pairs of various types of evidence:
(a) A bank confirmation versus observation of the segregation of duties
between cash receipts and recording payment in the accounts
receivable subsidiary ledger.
(b) An auditor’s recalculation of depreciation versus examination of raw
material requisitions.
(c) A bank statement included in the client’s records versus the client’s
shipping documents.
REQUIRED
For each pair, indicate which type of evidence is more reliable. Justify your
choices. LO 4.4
4.23 MEDIUM You are reviewing the audit working papers for Plastics Ltd,
which have been prepared by a junior audit team member. During your
review, you noted that when testing the accuracy, valuation and allocation
assertion for the property, plant and equipment (PPE) account balance, the
junior team member tested the PPE additions and disposals during the year
and recalculated the depreciation. No discrepancies were found in the
testing. The junior team member concluded that PPE was appropriately
valued. PPE is a material account balance to Plastics Ltd.
REQUIRED
Explain whether the junior audit team member has arrived at an appropriate
conclusion. LO 4.4
Page 180
4.24 HARD You are the audit senior on the audit of Open Road Ltd, a large
manufacturing company, for the year ended 30 June 2018. It is now 20
August 2018 and you are reviewing the audit working papers prepared by
the audit assistant, Gillian Carter. You notice the following matters:
(a) On 30 June, Gillian attended the inventory stocktake and observed
that the client followed the stocktake instructions. She selected
numerous items for test counting from the client’s inventory sheets
and all were found to be correct. Cut-off details were noted and
subsequently checked and found to be treated correctly. Gillian
concluded that the inventory was fairly stated.
(b) Gillian selected 20 invoices to test the control that the sales clerk
checks that the prices agree with the authorised price list. She found
three instances where the sales clerk had not signed the ‘prices
checked’ box on the invoice. The sales manager explained that the
sales clerk always checks the prices, but sometimes forgets to sign
the box. As the prices on all the invoices agreed with the authorised
price list, Gillian concluded that the control was operating
satisfactorily.
(c) As part of her work on subsequent events since balance date, Gillian
noted that there were a large number of returns in July of product
XLP. However, as this product was first sold in June and represented
only 1 per cent of sales for the year, she concluded that the amount
was immaterial and that no further work was necessary.
(d) Advertising expenses are material, although only 50 per cent of last
year’s balance. Gillian selected a large sample of entries and agreed
them to supporting documents. No errors were found. Gillian
concluded that advertising expenses were reasonable.
(e) As part of the verification work on accounts payable, Gillian carried
out a search for unrecorded liabilities. She tested a random sample of
20 payments made after 30 June 2018 and found three instances of
payments that related to services provided in June that had not been
accrued at 30 June 2018. However, as the total of the three payments
was immaterial, she concluded that no adjustment was required for
unrecorded liabilities.
REQUIRED
For each of the five scenarios presented above, indicate whether you
believe that sufficient appropriate audit evidence was obtained to support
the conclusions reached. Give reasons for your decision. LO 4.4
Audit risk model

4.25 EASY An auditor must understand audit risk and its components when
planning a financial report audit. The firm of Thomas & Fine evaluates the
risk of material misstatement by disaggregating it into its three components:
inherent risk, control risk and detection risk.
REQUIRED
For each situation in the table below, select the component of audit risk that
is most directly illustrated. The components of audit risk may be used once,
more than once, or not at all. LO 4.5
SITUATION COMPONENT
OF AUDIT RISK
(a) Segregation
of duties is
inadequate.
(b) Confirmation of receivables by an auditor fails to

detect a material misstatement.
(c) Cash payments have occurred without proper

approval.
(d) A client,
Expo
Ltd, has
a large
cash
balance.
(e) A necessary substantive audit procedure has been

omitted.
(f) Technological
innovations
within the
industry have
caused a
major
product to
become
obsolete.
(g) A client, Rocket Ltd, has insufficient working capital to

continue its operations.
Page 181
4.26 MEDIUM Consider the following two independent material situations:

(1) Claire Trenton was the longtime CEO of Boutique Wines Ltd (BWL),
until she died unexpectedly during the current financial year.
Following her death, her son, Barry Trenton, became the new CEO of
BWL and immediately instituted a new management bonus scheme
and embarked on a rigorous cost-cutting exercise, which included a
reduction in key staff in the credit department.
(2) During the planning stage of the audit of BWL, the audit senior
assessed the sales control systems to be effective. However, when
testing sales, the audit assistant traced two sales to supporting
documentation (invoices) that had dates that were in the prior
financial year.
REQUIRED
For each of the two situations described above:
(a) Outline briefly why the situation constitutes an audit risk.
(b) List and explain the components of the audit risk model
affected. LO 4.5
Materiality
4.27 MEDIUM Your firm is the auditor of Structural Ltd, a publicly listed
company. Structural has a major shareholder that controls its board of
directors. The following financial information was extracted from its 30 June
2018 forecast, updated last month (November 2017) for actual year-to-date
results.
FORECAST 30 JUNE ACTUAL 30 JUNE
2018 $M 2017 $M
Revenue 480 430
Total assets 600 550
Net assets 302 275
Profit before income 53 41
tax expense
Structural is a manufacturer that sells mainly to the infrastructure

construction industry. The national economy is currently static with
consumer confidence falling in the last two quarters.
The company has an internal audit function that in previous years you have
assessed as effective. Your experience with the company in past years has
also shown that its forecasts are generally reliable.
REQUIRED
(a) Given the information provided, suggest an appropriate benchmark

as the starting point for determining preliminary materiality for
Structural. Provide reasons for your answer.
(b) List the factors you would consider in determining preliminary
materiality for the audit for the period ended 30 June 2018, and
explain how those factors affect your assessment of materiality.
(c) Describe how your view of preliminary materiality would be altered if
you discovered that during the year Structural had refinanced its debt
with a contractual commitment that requires its debt to equity ratio to
be better than 1:1 at all times. LO 4.6
4.28 HARD You are the auditor of Super Charge Ltd, an oil refiner and distributor
of petrol and supplies to its chain of service stations. During the year ended
30 June 2018, Super Charge signed an exclusive agreement with a major
shipping company in the US to provide fuel for its vessels. As Super Charge
decided not to enter into hedging arrangements, the contract resulted in
Super Charge incurring significant foreign exchange losses.
During your review of the aged debtors balance, you note that quite a few
of Super Charge’s wholesale customers are nearing the ‘over 120 days’
category, yet Super Charge has continued to supply these Page 182
customers. No correspondence or follow-up on these debtor
balances appears to have been undertaken by Super Charge.
During March 2018, Super Charge acquired High Ace Pty Ltd, which owns
and operates 10 service stations that have an exclusive arrangement to sell
only Super Charge products. Material adjustments were made to the
financial report at acquisition date, partly due to fraud discovered at High
Ace involving one of the service station employees giving free fuel to his
family and friends, and partly to issues with the pricing applied to fuel
inventory.
The High Ace service stations have historically performed extremely well,
as all are located in high-traffic locations. Since the acquisition, however,
the government has announced extensive roadworks which will eventually
lead to 75 per cent of traffic being diverted away from three of the High Ace
service stations.
Following the acquisition, the accounting system of High Ace was
integrated with that of Super Charge. The IT team experienced
considerable difficulty in this integration due to inconsistencies between
the revenue recognition policies adopted by Super Charge and High Ace.
REQUIRED
(a) Explain the most significant qualitative factors you would consider in
determining preliminary materiality for the audit for the year ended
30 June 2018.
(b) If all factors involved in the calculation of preliminary materiality for
the 2018 audit are exactly the same as the 2017 audit except for
those factors identified in (a), how will the preliminary materiality level
for the 2018 audit change from the 2017 level? LO 4.6
Types of audit tests

4.29 EASY Audit tests include tests of controls and substantive procedures.
Substantive procedures can be divided into substantive analytical
procedures, tests of balances, tests of transactions and tests of disclosures.
REQUIRED
For each test in the table below, select the type of audit test it represents.
LO 4.7
TYPE
OF
TEST TEST
1 Examine the financial report to determine whether all
related-party loans are properly presented.
2 Recalculate depreciation figure.
3 Trace sales recorded in the sales journal to shipping
documents.
4 Examine sales invoices for initials to indicate that
prices and extensions have been checked.
5 Check cost of closing inventory to subsequent sales
prices.
6 Confirm loan balances with financial institutions.
7 Compare wages expense to previous year and
budget.
Using the work of an expert or a component

auditor
4.30 EASY You are auditing the Aqualand Ltd group of companies for the year
ended 30 June 2018 and plan to request a component auditor to perform
work on the financial information of a component entity.
REQUIRED
List four areas you must understand prior to making the request. LO 4.8
Page 183
Documentation of audit work: audit working

papers
4.31 EASY You are assembling the final audit documentation on the audit of
Green Pastures Ltd for the year ended 30 June 2018.
REQUIRED
List three examples of acceptable changes to the audit documentation
during the final assembly process. LO 4.9
Continuous case study
Background information for the continuous case study, Reliable Printers Ltd (RPL), is
contained in the Appendix to this book. This case study will be used in each of
Chapters 4 to 12 , covering a financial report audit, and will provide students
with the opportunity to see how the issues covered in each chapter can be applied
practically to the same company, by following RPL through the complete financial
report audit process.
4.32 EASY As part of your planning process, you are considering whether you
will need to use the services of an expert in the audit of RPL.
REQUIRED
Based on the background information contained in the Appendix to this
book, explain whether it will be necessary to use the work of an expert in
the audit of RPL. LO 4.8
4.33 MEDIUM You are at the planning stage of the audit of RPL for the year
ended 30 June 2018 and have been asked by the audit manager to help
determine the materiality levels.
REQUIRED
(a) Referring to the background information contained in the
Appendix to this book, identify four factors that would influence
your determination of the preliminary figure for overall materiality for
the 2018 audit of RPL.
(b) Explain why the factors identified in (a) are relevant to your
calculation of the preliminary figure for overall materiality.
(c) Describe how the factors identified in (a) will influence your
preliminary figure for overall materiality in the audit planning process.
LO 4.6
Page 184

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Page 135

LEARNING OBJECTIVES (LO)

contents of audit working papers.

ASA 230/ISA 230 Audit Documentation

ASA 315/ISA 315 Identifying and Assessing the Risks of Material

ASA 320/ISA 320 Materiality in Planning and Performing an Audit

ASA 330/ISA 330 The Auditor’s Responses to Assessed Risks

ASA 450/ISA 450 Evaluation of Misstatements Identiﬁed during the Audit

ASA 500/ISA 500 Audit Evidence

ASA 501/ISA 501 Audit Evidence—Speciﬁc Considerations for Inventory

ASA 540/ISA 540 Auditing Accounting Estimates, Including Fair Value

ASA 580/ISA 580 Written Representations

ASA 600/ISA 600 Special Considerations—Audits of a Group Financial

ASA 620/ISA 620 Using the Work of an Auditor’s Expert

ASA 700/ISA 700 Forming an Opinion and Reporting on a Financial Report

AUASB/IAASB AUASB Glossary/Glossary of Terms

GS 011 Third Party Access to Audit Working Papers

While a ﬁnancial report audit of a complex entity is a complicated process, even

LO 4.1 Accounting and auditing contrasted

FIGURE 4.2 Relationship between accounting and auditing

Professional scepticism lies at the heart of a quality audit

Today, the topic of professional scepticism is featured prominently in each of

The importance of professional scepticism to the public interest is

copyrighted material in no way represents an endorsement or promotion by IFAC. Any views or

questioning the reliability of documents, information and management explanations

Professional scepticism is essentially a mindset. A sceptical mindset drives auditor

Areas of audit interest

Accountable activity of the entity

Organisation of the entity

LO 4.2 Financial report assertions and audit objectives

resulting valuation or allocation adjustments are appropriately recorded, and

Existence Inventories included in the statement of ﬁnancial

Rights and The company has legal title or similar rights of

Completeness Inventory quantities as per the accounting records

Accuracy, Inventories are properly stated at the lower of cost

Classiﬁcation Inventory costs are recorded in the correct accounts.

Presentation Accounting policy for inventory is clearly described

in the ﬁnancial report.

A number of accounting pronouncements now contain complex measurement and

The audit equation can be expressed as:

audit evidence = underlying accounting data + corroborating information

FIGURE 4.3 The audit equation

FIGURE 4.4 A cash purchase transaction

Common audit procedures

Inspection involves the examination of documents, records or tangible assets. The

External confirmation is a type of enquiry by which an auditor normally obtains

possibility of influence or change of information by the client’s employees should be

Re-performance Page 145

The audit trail

Selecting audit procedures

the auditor’s understanding of the entity and its environment

Existence Inventories included in the Stocktake—select

Completeness Inventory quantities as per the Stocktake—select

Rights and The company has legal title or Check shipping

Accuracy, Inventories are properly Compare subsequent

Classiﬁcation Inventory costs are recorded Check coding on

Presentation Accounting policy for Review accounting

LO 4.4 Suﬃcient appropriate audit evidence

Appropriateness relates to the quality of the audit evidence. Therefore, appropriate

Overall ﬁndings: audit ﬁle review

Source: © Australian Securities and Investments Commission. Reproduced with permission (2017),

Examples of reliability of evidence

forms: review of subsequent payments and examination of sales documents. Just as