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26 Risk ISA 315 – auditor should obtain an understanding of the entity and its environment…sufficient to identify and assess the risk of material misstatement in the financial statements.. Business risk •  Financial risk Total risk •  Operational risk •  Compliance risk Audit risk = risk of inappropriate opinion Slide 51 Audit risk Audit risk = the risk that the auditors give an inappropriate opinion on the financial statements. Two elements: Risk the financial statements contain a material misstatement + risk that auditors fail to detect it. Inherent risk + control risk Slide 52 27 Risk assessment – audit risk model Risk of material misstatement AR = IR x CR Audit Risk x DR Control risk Inherent Risk Detection Risk Sampling Risk Slide 53 Non-sampling Risk Risk assessment – audit risk model Inherent risk – susceptibility to misstatement that could be material…assuming no related internal controls Complex transactions, inexperienced staff, cash-based business, pressure to perform Control risk – risk that a material Control environment misstatement will not be Design of internal control prevented, detected or Operation of internal control corrected Detection risk – failure of the auditor to detect a material misstatement Auditor’s experience, new client, time/fee pressure, poor planning, industry knowledge Slide 54 28 Assessing risk ISA 330 •  To reduce audit risk to an acceptable level determine responses at the financial statement level and the assertion level •  Financial statement level: more experienced staff, more supervision, professional scepticism •  Assertion level: design and perform audit procedures whose nature, timing and extent are responsive to the assessed risks of material misstatement. Slide 55 Interim and final audit 1January Planning visit 31December Interim audit. Document system, procedural tests Final audit More direct checking of balances Slide 56 29 Sources of evidence Procedures for obtaining audit evidence Analytical Procedures Enquiry and confirmation Inspection Observation recalcUlation and reperformance Slide 57 Analytical procedures Ratio analysis: comparison with previous years, industry standards, budgets. •  Risk assessment eg risk of misstatement •  Are FS consistent with our understanding of entity? •  Source of substantive testing eg do figures look reasonable? Slide 58 30 How much audit evidence? ISA500: Sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base an audit opinion. Sufficient = quantity Appropriate = relevant and reliability •  External better than entity’s records •  Auditor-direct obtained better than indirect evidence •  Entity – better if a good internal control system •  Written – better than oral •  Originals better than photocopies Slide 59 The use of assertions Accuracy Completeness Cut off Allocation Classification and understandability Occurrence Valuation Existence Rights & obligations (ownership) (ACCA COVER) Slide 60 31 Internal control/Tests of controls These areas focus on the following accounting cycles: Revenue Purchases Inventory Revenue and capital expenditure Payroll Bank and cash Slide 61 Sampling ISA 530…consider objectives of audit procedure and the attributes of the population…Consider nature and characteristics of audit evidence, possible error conditions and the rate of expected error. Error: control deviations when performing tests of control, or misstatements when performing substantive procedures. Expected error is the error the auditor expects to be present in the population Slide 62 32 Types of sampling •  Random selection •  Systematic selection •  Haphazard selection •  Sequence/block selection •  Monetary unit sampling •  Stratification Slide 63 Monetary unit sampling – say 4 items wanted 80 70 400 90 1,600 20 700 50 1,010 80 30 600 380 80 150 550 640 2,240 2,260 2,960 3,100 4,020 4,100 4,130 4,730 5,110 5,000/4 = 1,250 Choose first at random – say, 700 Then: 1,950 3,200 4,450 Slide 64 33 Size of sample •  Sampling risk: risk that conclusion based on sample is different to conclusion if all items examined. Reduced as sample size increased. •  Non-sampling risk: risk of wrong conclusion arising from reasons other than sampling. Reduced by proper planning supervision and review Slide 65 Sampling risk – tests of control Under-reliance: sample does not support auditor’s assessment of control risk, actual compliance rate would support that assessment. Risk of Over-reliance: sample does support auditor’s assessment of control risk, but actual compliance rate would not support that assessment. Slide 66 34 Sampling risk – substantive procedures Risk of incorrect rejection: sample implies balance materially misstated, but actually not materially misstated. Risk of Risk of incorrect acceptance: sample implies that balance is non materially misstated, but in fact it is materially misstated. Slide 67 Tolerable error Tests of control: maximum rate of deviation from a control procedure that is allowed before the auditors reassess control risk. Substantive procedures: maximum monetary error that auditors are willing to accept and still conclude that financial statements are not materially misstated. Slide 68 35 Recording the accounting system •  Narrative notes •  Flowcharts •  Questionnaires Internal control questionnaires (ICQs) “How good is the system?” “Yes” = good; “No” = bad Internal control evaluation questionnaires (ICEQs). “Can specific problems occur?” “Yes” = bad; “No” = good Slide 69 Components of internal control •  Control environment •  Risk assessment process •  Information system •  Control activities •  Monitoring controls What can go wrong? How can we stop it? Slide 70 36 Control activities •  Segregation of duties •  Authorisation •  Comparison •  Computer controls •  Arithmetic controls •  Maintaining a trial balance and control accounts •  Accounting reconciliations •  Physical Slide 71 Inherent limitations of internal control •  Costs > benefits •  Human error •  Collusion •  Bypass of controls •  Non-routine transactions Slide 72 37 Tests of control - 1 •  Evaluation of systems (enquiry, analytical procedures, observation, inspection) •  Tests of controls should be carried out if suitable controls exist. •  Controls must be operating effectively Otherwise: •  Substantive procedures •  Substantive procedures might be more efficient if there are relatively few large transactions. Slide 73 Tests of control - 2 •  Enquiries •  Observation •  Inspection •  Management views •  Re-performance •  Testing Slide 74 38 Management reports – control weaknesses •  Problems with the present system Supplier invoices not cancelled when paid •  Implication/consequences Supplier invoices could be paid more than once •  Recommendation Supplier invoices should be stamped ‘Paid’ when paid Emphasise that other weaknesses might also exist Slide 75 Purchases system Ordering/granting – Receipt/invoicing - Recording/payment Slide 76 39 Sales system Ordering/granting - Despatch/invoicing - Recording/credit credit control Slide 77 Wages system •  Hiring and rates authorised •  Correct employees paid •  Paid authorised amounts for work done •  Deductions properly made and recorded •  Deductions paid to authorities; net paid to employees Slide 78 40 Capital expenditure system •  Expenditure authorised •  Tenders received •  Goods received •  Invoices authorised •  Recorded as capital expenditure in main ledger and fixed asset (non-current asset) register •  Physical inspection Slide 79 Cash system •  All monies are received, banked, recorded and safeguarded against loss/ theft. •  All payments are authorised and made to correct payees. •  Payments are not made twice for same liability. Slide 80 41 Inventory system •  All inventory movements authorised •  Inventory properly recorded •  Cut-off correct •  Physical safeguards against loss, theft, damage •  Proper valuation procedures •  Reasonable levels of inventory Slide 81 Fraud •  Fraudulent financial reporting •  Misappropriation of assets •  Managers responsible for prevention or detection •  Auditors should be aware of material misstatement due to fraud. Slide 82 42 Computer systems •  General controls – development, prevention of unauthorised changes etc., backup. Can be classified as development and administrative controls. •  Application controls – initiation, recording, processing and recording transactions. Slide 83 Computer systems •  Input controls •  Processing controls •  Controls over standing data •  Controls over output Slide 84 43 Real-time systems •  Access controls •  Controls over passwords •  Programming controls •  Firewalls •  Transaction logs •  File controls •  Balancing •  Pre-processing authorisation •  System development/maintenance controls Slide 85 Computer assisted audit techniques (CAAT) •  Audit programmes: interrogate accounting data. Select samples to investigate Re-perform calculations Look for unusual items •  Test data: operated on by client’s programs. Are programs operating correctly? Are controls operating? Slide 86 44 Receivables circularisations Write to selected debtors and ask for confirmation of amounts owing. •  Two types: Positive: want a reply from everyone written to. Negative: want a reply only if balance out of agreement. •  Replies should go directly to auditors’ offices. •  Can stratify sample so that a large percentage covered. •  Ask about old debts. •  Ask about Cr balances Slide 87 Receivables •  Reconcile ledger to control account •  Aged listings •  Correspondence •  Board minutes •  Collection period •  Receipts after year end Slide 88 45 Payables •  Reconcile ledger to control account •  Correspondence •  Board minutes •  Payables period •  Statement reconciliation •  Payments after year end Slide 89 Prepayments/accruals •  Compare to last year •  Payments after year end •  Invoices paid last few months •  Letter of representation Slide 90 46 Inventory counts Inventory is difficult to audit: quantity, description, condition, value, ownership •  Plan in advance: instructions, briefing, tidy inventory. •  Identify damaged and third party inventories. •  Pre-number shelves, inventory locations. •  Issue sequentially pre-numbered inventory sheets. •  Sign off each location as counted. •  Check: inventory sheet. •  Account for all inventory sheets. •  Check prices. Re-perform calculations, check additions. Slide 91 Cut-off - purchases Year end Before After GRN Included in? •  Purchases •  Payables •  Inventories GRN Included in? •  Purchases •  Payables •  Inventories X X X Slide 92 47 Cut-off - sales Year end Before After GDN Included in? •  Sales •  Receivables •  Inventories X GDN Included in? •  Sales •  Receivables •  Inventories X X Slide 93 Cash •  Bank certificate •  Bank reconciliation •  Cash count if material Slide 94 48 Non-current assets •  Physical inspection. •  Additions: check to invoices. •  Disposals: check to receipts. •  Check major additions/disposals to board minutes. •  Scrutinise repairs and maintenance account •  Re-perform depreciation calculations. •  Verify documents of title. •  Check that no assets need to be written down faster/valuation Slide 95 ISA 560 – Events after the reporting period Events occurring between the period end and the date of the auditors’ report and also facts discovered after the audit report has been issued •  Adjusting events: evidence of conditions that existed at the date of the statement of financial position. •  Non-adjusting events: conditions arose after the date of the statement of financial position. If accounts already issued, may have to take steps to prevent users relying on the accounts Slide 96 49 IAS 37 – Contingent liabilities and assets Contingent liability: possible liability arising from past events…. existence confirmed by future events •  Present obligation probably requiring outflow of resources: provision recognised and disclosures required •  Possible obligation, or present obligation that will probably not require outflow of resources: no provision, but disclosure •  Possible obligation, or present obligation where likelihood of an outflow is remote: no provision, no disclosure. Slide 97 IAS 37 – Contingent liabilities and assets Contingent asset: possible asset arising from past events…. existence confirmed by future events •  Inflow of economic benefits virtually certain: asset is not contingent •  Inflow of economic benefits is probable but not virtually certain: no asset recognised but disclosures •  Inflow is not probably: no asset recognised and no disclosure Slide 98 50 Internal audit Internal audit is an appraisal or monitoring activity established by management and directors for the review of internal control as a service to the entity. •  It functions by examining, evaluating and reporting to management and the directors on the adequacy and effectiveness of internal control. •  It is a key part of effective corporate governance. •  Importance referred to in UK Combined Code of Corporate Governance – directors must review need for internal audit department •  Would normally report to the audit committee Slide 99 Internal audit •  Helps achievement of corporate objectives •  Improves efficiency, effectiveness and economy •  Aids risk assessment and management •  Designs internal control system •  Checks operation of internal controls system •  Value for money audits •  Test IT controls •  Liaises with external auditors/ shares work Slide 100