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Acc 3531 notes_compiled

  1. 1. Accounting vs Auditing• ACCOUNTING: process that creates F/S and other financial info. for mgt (decision making) purposes.• AUDITING: enhance the credibility of F/S through the audit process (gathering & evaluating accounting records & supporting documents) in providing basis of opinion of auditor’s report.Main distinguishing factor: Auditor must possess accounting knowledge & expertise to accumulate & analyse audit evidence. 1
  2. 2. THE DEMAND FOR AUDITING• Greek, Egyptian & Islamic civilisations• Why do organizations request an audit? The existence of principal and agent relationship that causes: – Conflict of interests – Information asymmetry – Manipulation of records and reports• Audit acts as a cost-effective monitoring device for contractual relationship  conform to contracts? 2
  3. 3. The objective & definition• To enable auditors to express an opinion on whether the F/S are prepared, in all material respects, in accordance with an identified financial reporting framework.  TFV?• AUDITING (broadly defined) is a systematic process of objectively obtaining & evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions & established criteria & communicating the results to interested parties.• AUDITING (narrowly defined) is a written report 3 on the examinations of F/S for a client.
  4. 4. ASSURANCE SERVICES• Assure = to remove doubt / feel confident (Wilkipedia)• ASSURANCE services are independent professional services that improve the quality of information for decision makers. Analogy (House inspection)  Desirable characteristics  Independence & the appearance of independence 4
  5. 5. OVERVIEW OF THE AUDIT PROCESS (Major Phases)• preliminary Engagement activities• obtain Understanding of the entity• establish Materiality & assess Risks• Planning: set overall strategy & set audit plan• Tests of control & audit business processes• Complete the audit• Evaluate results & issues Audit Report 5
  6. 6. AUDIT OF F/S Auditor’s responsibilities  opinion on compliance with accounting regulation (based on auditing standards) .: Accounting stds vs. Auditing stds – Only reasonable assurance (not a guarantee) that F/S do not contain material misstatements• Why only reasonable assurance? – Use of testing  sampling – Inherent limitations of internal control – Audit evidence is persuasive not conclusive  documents assumed true unless suspected to be false – Use of judgement 6
  7. 7. FINANCIAL REPORTING FRAMEWORK• APPROVED ACCOUNTING STANDARDS (in Malaysia)  approved by MASB – FINANCIAL REPORTING STANDARDS (FRS) – PRIVATE ENTITY REPORTING STANDARDS (PERS)• Other regulation: – Co.s Act 1965, Banking Act (specific industries)• Auditors check to see if F/S comply with the above & substance over form*2-7
  8. 8. Auditing Standards• Measure the quality of auditor’s performance.• In conducting audit, auditors are required to rely on a codified set of auditing standards issued by national accounting authority  professional still needed• In Malaysia, relevant national standards are referred to as the approved standards on auditing:• the International Auditing & Assurance Standards Board (IAASB) under the International Federation of Accountants (IFAC) issues the International2-8 Standards on Auditing (ISA)
  9. 9. Main Categoriesof Audit Reports Unqualified Qualified / Modified
  10. 10. Parts of the StandardUnqualified Audit Report 1. Report title 2. Audit report address 3. Introductory paragraph 4. Scope paragraph 5. Opinion paragraph 6. Name of CPA firm 7. Audit report date 10
  11. 11. • AUDITOR’S REPORT  Report title• TO THE MEMBERS OF ABC Co.  Audit report address• We have audited the F/S: B/S, I/S & CFS• These F/S are the responsibility of the directors.• Our responsibility is to express an opinion on these F/S based on our audit.  Introductory paragraph• We conducted our audit in accordance with International Standards on Auditing .• What an audit entails• We believe that our audit provides a reasonable basis for our opinion.  Scope paragraph 11
  12. 12. • In our opinion, the financial statements give a true and fair view of, in all material respects, the financial position of the Company as of December 31, 20X1… and of the results of its operations and its cash flows for the year then ended• in accordance with financial reporting framework… Opinion paragraph•  Name of CPA firm•  Audit report date 12
  13. 13. Statutory requirements relating to financial statements audit• Section 169 of Company Act 1965- requires co. the directors to present the audited F/S at its AGM  Directors responsible for F/S• Section 174 (2) of the Act requires auditor to report to the members of the company at the AGM• Section 174 (3) of the Act requires Auditor to form an opinion.Appointment of Auditors& Disqualification of Auditors 13
  14. 14. Corporate Governance (CG)• Is the corporate framework or structure that an entity applies to direct & manage it business & affairs.•  System, units… that govern (monitor) the corporation. (governor)• Malaysian Code of CG issued by the Malaysian Institute of CG  principle & best practices• Board of Directors (BoD)  6 responsibilities  monitor the internal control (IC)• Audit Committee = independent directors?  communication link between management, auditors & BoD• Internal audit dept. / unit 2-14
  15. 15. INTERNAL AUDITORFocus more on accounting & internal control system & providing recommendations for improvements.Prior to using internal audit works, perform a preliminary assessment of internal audit function:Organisational status – IA report to higher mgmt levelScope of responsibility – relevance & usefulness of nature & extent of auditTechnical competence – adequacy of training & skillDue professional care – consider adequacy of work plan, documentation, etc. 15
  16. 16. AUDIT COMMITTEESection 344A of Listing Requirements of KLSE requires PLCs to set up an independent audit committee.Functions & duties: • Consider nomination of external auditor. • Review external auditor’s plan, audited FS & audit report. • Review scope and findings of internal auditors.Fiduciary duties: • assist board in ensuring the compliance of accounting policies & reporting practices. 16
  17. 17. ETHICS AND INDEPENDENCE• Ethics = system or code of conduct based on moral duties and obligations that indicates how one should behave.• Professionalism = the conduct, aims, or qualities that characterize or mark a profession or professional person. All professions operate under some type of code of ethics/ conducts. E.g- MIA issues By-Laws (On Professional Conduct and Ethics) for auditors2-17
  18. 18. Problems faced by auditors that may affect their professionalism:• Low-balling – decrease (initial) audit fees (lucrative management service fees) – Audit fees restricted anyway. – Need to maintain audit to recover costs• Opinion shopping – Choose auditor that agrees with accounts – Threaten to change auditors2-18
  19. 19. THE AUDITOR’S RESPONSIBILITY FOR ERRORS, FRAUD, AND ILLEGAL ACTS • To plan and perform the audit to obtain reasonable (not absolute) assurance about whether the financial statements are free of material misstatement whether caused by error or fraud. • To detect misstatements resulting from illegal acts is the same as that for error or fraud. • To exercise due professional care (professional skepticism)  critical & questioning mind • Whistle blowing (ROC for non-compliance)2-19
  20. 20. Certified Public Accounting Firms The legal right to perform audits is granted to CPA firms by regulation of each state. CPA firms also provide many other services totheir clients, such as tax and consulting services.
  21. 21. The Big-4• Ernst & Young• PricewaterhouseCoopers• KPMG• Deloitte KassimChan 2-21
  22. 22. Hierarchy of a Typical CPA FirmStaff LevelExperience Typical Responsibilities Staff Performs most of the 0-2 yearsAssistant detailed audit work Responsible for the audit Senior 2-5 years field work, including Auditor supervising staff work2-22
  23. 23. Hierarchy of a Typical CPA FirmStaff Level Experience Typical Responsibilities Helps the plan, manages Manager 5-10 years the audit, reviews work, and works with the client Reviews audit work and Partner 10+ years makes significant audit decisions2-23
  24. 24. Other Types of Audits Services• Operational = effectiveness & efficiency of operating procedures• Compliance = meeting / performing according to specific procedures (set guidelines)• Forensic = obtaining of legal evidence for a court case 2-24
  25. 25. Operational Audit Evaluate computerized payroll system Example for efficiency and effectiveness Number of records processed, cost ofInformation the department, and number of errorsEstablishedCompany standards for efficiency and Criteria effectiveness in payroll department Available Error reports, payroll records, and Evidence 2-25 payroll processing costs
  26. 26. Compliance Audit Determine whether bank requirements Example for loan continuation have been metInformation Company recordsEstablished Loan agreement provisions Criteria Available Financial statements and Evidence 2-26 calculations by the auditor
  27. 27. Forensic Audit• Business and Employee Fraud• Criminal Investigation• Shareholders and Partnership disputes• Business economic losses2-27
  28. 28. Other Activities of CPA Firms Accounting andbookkeeping services Tax services Management consulting services
  29. 29. TYPES OF AUDITORS • External auditors • Internal auditors • Government auditors • Forensic auditors2-29
  30. 30. ORGANIZATIONS THAT AFFECT FINANCIAL REPORTING & AUDITS• Malaysian Accounting Standards Board  regulate the accounting standards• Malaysian Institute of Accountants  regulate the accountants• Companies Commission of Malaysia  regulate the companies• Securities Commission  regulate securities2-30
  31. 31. EngagementCLIENT ACCEPTANCE & CONTINUANCE• Prospective or new client: – Identify status of the client in business community, financial stability, & relationship with previous auditor. (background on client) – Successor auditor must communicate with predecessor auditor reason for change. (new auditor must inform / ask previous auditor) 31
  32. 32. • The successor auditor is interested in asking questions related to: – integrity of management; – disagreements with management over accounting and auditing issues; – illegal acts; – internal control-related matters; – and the predecessors understanding for the change in auditors. 32
  33. 33. • Existing or recurring client: – Should evaluate existing clients whether to retain them. – Reasons: may be due to conflicts on accounting policies or auditing issues, or dispute on fees etc. – Reevaluate the integrity of management and excessive risk relative to industry/entity.• ESTABLISHING THE TERMS OF THE ENGAGEMENT  The auditor and the client must agree on the terms of the engagement, including the type, scope, and timing of the engagement. 33
  34. 34. Three topics are important for establishing the terms of the engagement: – (ISA 210) Engagement letter – (ISA 610) Internal auditors – Audit committee• Engagement letter – Serve as a contract – Outlines both parties’ responsibilities – Prevents misunderstandings. 34
  35. 35. Principal contents of EL Objective of audit of financial statements Management’s responsibility Scope of audit (pronouncement of regulations & applicable standards) Form of report Nature and inherent limitations of audit Unrestricted access in connection of auditOther components of EL• Arrangements involving use of specialists• Additional services to be provided relating to regulatory requirements 35• Others services to be provided
  36. 36. PLANNING THE AUDIT (How would you plan)?• Audit staffing.  considerations• Obtain knowledge of client’s business & industry (including applicable law & regulations).• Consider going concern issue.• Assess materiality, audit risk& control risk.• Assess the possibility of illegal acts (fraud/error).• Identify related parties.What are related parties?Why are they important to identify? 36
  37. 37. Audit planning (cont’d)• Conduct preliminary analytical procedures.• Develop an overall audit strategy and prepare audit programs.• Consider additional value-added services.• Consider the IA functions• Review audit strategy with audit committeeConsiderations on audit staffing• Professional expertise vs. costs  The more experienced & qualified the higher the rate/hour• Costs vs. reputation & risk of litigation• Independence of the auditor & the audit teamsign form 37
  38. 38. ASSESS A PRELIMINARY LEVEL FOR CONTROL RISK• In assessing a preliminary level of CR, the auditor must be concerned about the extent of IT used in processing accounting information, including: – The extent that IT is used in each business process. – The complexity of the entity’s computer operations. – The organizational structure of the IT activities. – The availability of data. – The need for IT-assisted techniques to gather and conduct audit procedures. 38
  39. 39. Assess The Possibility of Illegal Acts Indicators: Unauthorized transactions.• Investigation by a governmental agency or payment of unusual fines or penalties.• Violations of laws or regulations.• Large payments for unspecified services.• Sales commissions or agents fees that appear excessive.• Large payments in cash or bank cashiers checks.• Unexplained payments to government officials.• Failure to file tax returns or pay government 39 duties.
  40. 40. AUDIT STRATEGYSUBSTANTIVE Stratg. RELIANCE STRATEGYAn auditor assess Control An auditor assess Control Risk as High & extensive Risk as Low and non- substantive testing: extensive substantive – The controls are testing: assessed as ineffective & – To obtain more detailed inefficient. understanding of IC – To understand IC and not – To plan & perform test of to rely on IC at all times in controls & assess control the extent of audit testing risk – To document – To document control risk understanding of IC and assessment control risk assessment. – To plan extent of substantive testing 40
  41. 41. 3 FUNDAMENTAL CONCEPTS IN CONDUCTING AN AUDITMATERIALITY: magnitude (size) of an omission or misstatement of accounting information that may affect F/S significantly.(ISA 320) Materiality: material if omission or misstatements could influence the decisions of F/S users  very judgmental / subjective (professional judgement)• it provides threshold or cut-off point. 41
  42. 42. AUDIT RISK: The risk that the auditor mayunknowingly fail to appropriately modify theopinion on F/S that are materiality misstated. Risk of giving wrong opinion(ISA 240) Audit risk:• Possibility of auditor not detecting allmisstatements.• Control through proper audit planning, effectiveaccounting and internal control system. 42
  43. 43. • Sampling: The application of an audit procedure to less than 100 percent of the items (100% = population) • Due to cost & time constraints, the auditor examines only a subset of the client’s data (transactions) in the records.• To lower the audit risk, need to do more audit work  bigger sample• Audit risk vs. cost & time (balance)• Sample size depends on acceptable audit risk  established criteria & auditor’s experience.: Inverse relationship between: – Sample size & materiality  example – Sample size & acceptable audit risk .: if materiality threshold is low, a bigger sample is collected. 43
  44. 44. EVIDENCE: Info. derived from the audit procedures in order to support the F/S, audit objectives tested and opinion of the auditor’s report.(ISA 500) Evidence:• Relevance = whether the evidence relates to the specific audit objective being tested. egs. $ in Bank account = RM 554,000• Reliability = the diagnosticity of the evidence; does the evidence signal the true state of the assertion or audit objective. Can you rely on it to be true? 44
  45. 45. Links to Evidence• Management assertions & Internal Control• Materiality & Audit Risks Will determine the Nature, Extent & Timingof evidence collected• In collecting the evidence:• Think about what could go wrong in the accounting process (each step): – Internal controls }.: procedures to – Individual transactions }test whether issues – Account balances }reduced  TFV 45
  46. 46. Risk Assessment & Materiality• Professional guidance in considering materiality & audit risk when planning & performing an audit program• The wording of the auditors report recognizes both these concepts due to the following terms: – Reasonable assurance – In all material respects 46
  47. 47. AUDIT RISK• What is audit risk?• AUDIT RISK is the risk that the auditor may unknowingly fail to appropriately modify the opinion on financial statements that are materiality misstated.  Some parts of this risk can be controlled by the auditor.• AUDITOR BUSINESS RISK is the exposure to loss or injury to professional practice from litigation, adverse publicity, or other events arising in connection with F/S audited & reported on. 47
  48. 48. More …on audit risk• Audit risk must be at an acceptably low level• What is acceptably low?  professional judgement• If not low enough, need to perform more audit procedures.• The auditor needs to consider risks of material misstatement at 2 levels: – The overall f/s level – The assertion level for individual a/c balances & classes of transactions 48
  49. 49. THE AUDIT RISK MODEL AR = IR x CR x DRInherent Risk (IR) = material misstatement would occur inthe absence of internal control in the business. IR may be dueto the nature of the business.Control Risk (CR) = material misstatement is not detected byinternal control on timely basis.Detection Risk (DR) = risk that auditor will not detectmaterial misstatement in financial statements= composed of sampling & non-sampling risk 49
  50. 50. Detection Risk• Results from 2 types of risks or uncertainties: – Sampling risks – Non-sampling risks• What is sampling risk and non-sampling risk?• Sample may not reflect the population hence wrong conclusion drawn• Mistake made by auditor by using wrong test or misinterpreting results 50
  51. 51. LIMITATIONS OF THE AUDIT RISK MODEL• The model assume the components of the model (IR, CR, and DR) are independent of each other.• However, in practice, dependencies exist between these components [IR = f(CR)].• Auditor’s assessments of IR and CR may be different from the actual levels of IR and CR.• The audit risk model does not consider the possibility of non-sampling risk. 51
  52. 52. Use of the Audit Risk Model• 3 steps: – Set a planned level of Audit Risk – Assess Inherent Risk & Control Risk – Determine the appropriate level of Detection Risk AR = IR x CR x DR .: DR = AR IR x CR .: if AR ≤ planned level of Audit risk (target)  unqualified report 52
  53. 53. AUDITORS’ RESPONSIBILITY• Auditor needs to assess IR & CR, then determine level of DR & what audit procedures to be performed.• Auditor should document and describe: – Risk factors identified – Auditors’ response to those risk factors• IR is related to client’s business risk (* Not the same as Auditor Business Risk)  53
  54. 54. CLIENT BUSINESS RISK• Risk that an entity’s business objectives will not be attained as a result of the external & internal factors, pressures, and forces that may affect entity’s survival and profitability.In order to properly judge the fair presentation of F/S, auditor needs to understand the entity’s business strategy & risks and its ability to respond to the changing environment. 54
  55. 55. ASSESSING CLIENT BUSINESS RISK Industry level: • Critical industry issues • Significant industry risk • Structure and profitability within industry • Relationship industry and economic environment Entity level: market/product positioning, strategy and measures in dealing with customers/competitors. May affect going concern (.: need to keep updated) 55
  56. 56. Risk assessment procedures• INQUIRIES OF MANAGEMENT AND OTHERS• ANALYTICAL PROCEDURES• OBSERVATION AND INSPECTION• These will affect the nature, timing & extent of audit procedures 56
  57. 57. ERROR OR FRAUD• ERRORS are unintentional misstatements or omissions of amounts or disclosures and may involve: – Mistakes in gathering or processing accounting data – Unreasonable accounting estimates – Mistakes in the application of accounting principles.• FRAUD involves intentional misstatements that can be classified into two types: – fraudulent financial reporting – misappropriation of assets. 57
  58. 58. ASSESS THE RISK OF MATERIAL MISSTATEMENT DUE TO ERROR OR FRAUD• FRAUDULENT FINANCIAL REPORTING includes: – Manipulation, falsification, or alteration of accounting records or supporting documents from which the F/S are prepared. – Misrepresentation in, or intentional omission from, the F/S of events, transactions, or significant information. – Intentional misapplication of accounting principles. 58
  59. 59. • MISAPPROPRIATION OR DEFALCATION OF ASSETS includes: – Embezzling of cash receipts – Stealing assets – Causing the entity to pay for goods or services not received• Risk factors that cause possible presence of fraud in reporting: – Management’s characteristics and influence over the control environment – Industry conditions and economic environment. – Operating characteristics and financial stability. 59
  60. 60. • Risk factors that cause possible presence of misappropriation of assets: – Susceptibility of assets to misappropriation. – Controls.• Similar to indication of material misstatement due to fraud• Fraud Risk factors – Incentives / pressure to commit fraud – Opportunity to carry out fraud – Attitude / rationalism to justify fraud 60
  61. 61. Response to Risk of Material Misstatement due to Fraud• Overall response• Response at assertion level• Response to management override of controls* Documentation of risk assessment & response 61
  62. 62. MATERIALITYISA 320 (Para 3): Materiality is the magnitude ofan omission or misstatement of accountinginformation that could influence the economicdecisions taken by users of financial statements.It sets the threshold and cut off point indetermining the size of error or misstatements. 62
  63. 63. STEPS IN APPLYING MATERIALITY• Step 1: Establish a preliminary judgment about the materiality. – The max. amount by which the auditor believes the F/S could be misstated but still not affect the decisions of reasonable users. – Set materiality at f/s level: i) 5% of GP after depreciation ii) 3-5% of PBT iii) ½% of Revenues/ Sales iv) ½% of Total Assets v) 1% of equity 63
  64. 64. FACTORS THAT AFFECT PRELIMINARY JUDGMENT ABOUT MATERIALITYThe above was the quantitative aspectsModify for qualitative aspects:• Nature of business operations• Size of the company and volume of business transactions• Prior client’s history• To determine the base of the judgment i.e PBT, Total Assets,Total Equity, Total Revenues 64
  65. 65. • Step 2: Allocate the preliminary judgment to account balances (BS) or class-of transactions (PL). – Purpose- to plan audit procedures – Once allocated, it is referred to as tolerable amount of error or misstatement (ISA 530) – Small amount of materiality allocated, the more evidence to be gathered.• Step 3: Estimate the likely misstatement and compare to total preliminary judgment – If likely misstatement is less than the preliminary judgment, auditor can conclude that the F/S is fairly presented (unqualified report). – Otherwise, auditor should request the client to adjust the F/S. If client refuses, auditor could issue qualified/adverse audit opinion. 65
  66. 66. Factors that should be considered in allocating materiality to accounts balances• The magnitude of the account relative to the F/S e.g the larger the account balance, the greater the amount of materiality can be allocated.• The expectations of error e.g if auditor expect that little or no misstatement in an account, they can allocate larger amount of materiality.• The relative cost to audit e.g if an account is very expensive to audit (large inventory, AR and AP), auditor allocate more materiality to be cost effective. 66
  67. 67. How materiality affects the audit report?1. Given any misstatements or error that occurred, auditor need to evaluate and consider whether the misstatements/ error are immaterial (not affect the overall picture of F/S) or highly material (requires adjustment). These will affect the appropriate audit report to be issued.2. Any violations against the standards of financial reporting, materiality of violation influences whether an unqualified or qualified report should be issued. 67
  68. 68. Management Assertions• Statements that management assert (claim to be true)• 3 categories – Transactions – Account balances – Presentation & disclosure2-68
  69. 69. MANAGEMENT ASSERTIONS BY CATEGORY Assertions about class Assertions about account of transactions balances  Existence/  Existence/ occurrence occurrence  Accuracy Ownership/ Rights and Obligation  Completeness  Completeness  Cut-off  Valuation  Classification2-69
  70. 70. MANAGEMENT ASSERTIONS BY CATEGORY Assertions about presentation and disclosure  Occurrence and rights and obligation  Accuracy & valuation  Completeness  Classification2-70
  71. 71. FINANCIAL STATEMENTS: MANAGEMENT ASSERTIONS AND AUDIT OBJECTIVES Management assertions Audit objectives• Existence • Validity• Occurrence• Rights and obligations • Ownership• Completeness • Completeness • Cutoff• Valuation • Valuation• (Measurement) • Accuracy• Presentation and disclosure • Classification• (Classification & understandability) • Disclosure 71
  72. 72. AUDIT PROCEDURES• AUDIT PROCEDURES are specific acts performed by the auditor to gather evidence to determine if specific audit objectives are being met.•  steps taken to collect audit evidence based on audit objectives• A set of audit procedures prepared to test audit objectives for a specific component of the financial statements is referred to as an AUDIT PROGRAM. 72
  73. 73. The Purpose of Audit Procedures• RISK ASSESSMENT• TEST OF CONTROLS• SUBSTANTIVE PROCEDURES• Test of Controls• Evaluates whether controls have been properly designed to prevent or detect and correct material misstatements. (timely manner)• Test the operational effectiveness of the control:- How it is applied- Consistency of its application- By whom it is applied 73
  74. 74. TESTS OF CONTROLSPart of audit procedures in test of controls:• Inquiries of appropriate management, supervisory, and staff personnel.• Inspection of documents, reports, and electronic files.• Observation of the application of specific internal controls.• Walk-through test.• Reperformance of the application of the control by the auditor. 74
  75. 75. SUBSTANTIVE TESTS• Concentrate on detecting misstatements in account balances, individual transactions and disclosure components• Substantive tests of transactions (IS) -test of errors or fraud in individual transactions -example: examine purchase transactions that contain material value• Analytical procedures (AP)• Tests of account balances (BS) -concentrate on details of amounts contained in account balances -test whether material misstatement is included in the account balances 75
  76. 76. TYPES OF AUDIT PROCEDURES (purpose: risk assessment, test of control, substantive tests)• Physical examination• Documentation inspection• Confirmation• Analytical procedures• Inquiries of client personnel or management• Observation• Computation and Re-performance• Scanning 76
  77. 77. RELIABILITY OF EVIDENCE BASED ON PROCEDURESLevel of Reliability Type of proceduresHigh Physical examination ReperformanceMedium Documentation Confirmation Analytical proceduresLow Inquiries of client personnel or management Observation 77
  78. 78. ANALYTICAL PROCEDURES• ISA 520: analysis of significant ratios and trends including results from investigation of fluctuations and relationships that are inconsistent with other relevant information or deviate from predicted amounts.• Evaluations of financial information made by a study of plausible relationships among both financial and non- financial data.• Range from the use of simple comparisons to the use of complex models. 78
  79. 79. TYPES OF ANALYTICAL PROCEDURES (AP)• Compare current-year with prior year figure  Preliminary AP.• Compare current-year with budgets, projections & forecasts Variance analysis.• Relationships among elements of financial information within the current period  egs. loan terms & interest.• Compare client’s figure with industry data.  Ratio analysis.• Relationship of financial information to non-financial information.  # of employees, sales commission. 79
  80. 80. PURPOSES OF AP• Assist in planning the nature, timing, and extent of other audit procedures Understanding the overall picture of the business, indicates unusual cases• As a substantive test to obtain evidence (to support a/c balance or class of transactions) – Computation of prediction against actual – Detailed analysis of trends (ratio analysis)• As an overall review of the financial info. in the audit final review stage (completion) – Assess conclusions, evaluate overall FS presentation & recheck for non-investigation. 80
  81. 81. The effectiveness & efficiency of AP inidentifying material misstatementdepend on:• The nature of the assertion or audit objective  AP test all objectives except ownership & mostly effective in completeness.• The plausibility and predictability of the relationship.  Predictability of relationships (sales & commission).• The availability & reliability of the data used.  Depends on competency of audit evidence.• The precision of the expectation.  Accurate estimation. 81
  82. 82. Substantive Analytical Decision Process• Develop expectations (based on last year’s figure, most of the time)• Define tolerable differences: • Rule of thumb- difference of less than 10% or difference of less than RM50,000.• Compare the expectation to the recorded amount• Investigate differences if greater than tolerable differences 82
  83. 83. FINANCIAL RATIOS USEFUL AS AP• Short-term liquidity ratios• Activity ratios• Profitability ratios• Coverage ratios 83
  84. 84. Audit Procedures & Audit evidence• In carrying out your audit procedures, you need to collect audit evidenceAudit evidence:• Information obtained by the auditor in arriving at the conclusions on which the audit opinion are based. (ISA 500)• It is obtained to support F/S assertion.• Comprise of source of documents and accounting records. 84
  85. 85. Concepts of Audit Evidence• Nature – accounting records, corroborating evidence including written or electronic form (invoices, contracts, bank statement)• Competence (Appropriateness) - quality of evidence (reliability and relevance)• Sufficiency - quantity of evidence (due to cost of audit and nature of evidence)• Evaluation - persuasive / unbiased (critically analyzed)  thorough 85
  86. 86. The Competence (appropriateness) of Evidential MatterEvidence is considered COMPETENT when it is RELEVANT - it refers to whether the evidence relates to the specific audit objective being tested.  Egs. of relevance of audit procedure in collecting evidence RELIABLE - it refers to the diagnosticity of the evidence; does the evidence signal the true state of the assertion or audit objective. 86
  87. 87. General factors for assessing reliability• Independence of the source of the evidence.• Effectiveness of internal control.• Auditors direct personal knowledge.• Documentation (internal or external). 87
  88. 88. A MODEL OF BUSINESS PROCESSES • Financing  capital, invest in FA, loans payback • Purchasing  goods & others, payback creditors • Human Resource Management  employees (pay) • Inventory Management  stock / goods • Revenue  sales & a/cs receivables * AIS & IC must capture these  auditor must audit each of these.2-88
  89. 89. DOCUMENTATIONISA 230 - Documentation of work done & evidence accumulated in supporting the opinion in auditor’s reportFunctions of working paper (WP):1. Aid planning and performance of audit Contain evidence that document auditors work- comply to the auditing standards2. Assist supervision and review of audit work Evaluate the sufficiency of work done by subordinates3. Provide support and evidence to opinion of auditor’s report 89
  90. 90. The Importance of Working Papers1. Basis of planning an audit for subsequent year, as reference of prior working papers2. To provide record of evidence accumulated and conclusions indicating that adequate procedures have been performed & to demonstrate that sufficient and competent evidence accumulated by indicating proper x-ref, client’s name, period covered etc3. To support proper type of audit report based on the sufficient data accumulated.4. Basis for review by manager or partner to evaluate sufficient and competent evidence accumulated and support final audit opinion. 90
  91. 91. WORKING PAPER• Types of files: • Organisation of – Permanent file (PAF) – Current file (CAF) working paper: – Lead schedule• Format of WP: – X-ref between WP – Heading – Located in respective – Indexing & x-ref section – Audit ticks • Ownership of working• Types of working paper: – Audit programs paper: – Property of auditor – Trial balance – Including prepared by – Account analysis/listings client at auditor’s – Audit memoranda request – Adjustment/Reclassificati 91 on entries
  92. 92. AUDIT SAMPLING: AN APPLICATION TO TESTS OF CONTROLS & SUBSTANTIVE TESTINGSWhat is Sampling?AUDIT SAMPLING is the application of an auditprocedure to less than 100 percent of the itemswithin an account balance or class oftransactions for the purpose of evaluating somecharacteristic of the balance or transaction (ISA530) Applying audit procedure (testing) to less than100% of the items 92
  93. 93. The importance of Sampling• Timing, cost, extent and scope of audit• To provide reasonable (based on sample) not absolute (population) assurance• Sufficient evidence to support conclusions and audit opinion• Appropriate means in gathering and evaluating audit evidence since it is impractical to do 100% of transactions in accounts. 93
  94. 94. AUDIT RISK SAMPLING RISK• Samples taken may not be representative of the population tested.• Overcome: to increase number or sample size. NON-SAMPLING RISK• Error in conclusion not due to sample size but to nature of evidence that is persuasive rather than conclusive. i.e. inappropriate audit procedures, misinterpret evidence, or failure in recognizing the error.• Overcome: by proper planning, supervision and review. 94
  95. 95. TYPE I AND TYPE II RISK• TEST OF CONTROL – Type I Risk = The risk auditor will conclude that the control risk is higher than it actually is (assessed CR too high) – Type II Risk= The risk of assessing control risk too low• SUBSTANTIVE TESTING – Type I Risk = Risk auditor will conclude that material error exists when in fact it does not. – Type II Risk = Risk auditor conclude that material error does not exists when in fact it does exist. 95
  96. 96. AUDIT PROCEDURES THAT DO NOT INVOLVE AUDIT SAMPLING• Inquiry and observation• Analytical procedures• Procedures applied to every item in the population (100% examination)• Classes of transactions or account balances not tested 96
  97. 97. TYPES OF AUDIT SAMPLING Non-statistical versus statistical sampling Non-statistical (or judgmental): use of professional judgment in designing the sample size. Statistical: selection at random or use of law of probability theory  Advantages: 1. Design efficient sample 2. Sufficient evidence obtained 3. Quantify sampling risk  Disadvantage 1. Additional costs incurred for training on proper sampling techniques 97
  98. 98. Non-statistical Sample Selection MethodsItem selection based on auditor judgmental criteriaSelecting 100% items from population• Test entire population• Constitute large number of large value itemsDirected Sample Selection• Items most likely to contain misstatements• Items containing selected population characteristics• Large dollar coverage 98
  99. 99. Types of Statistical Sampling Techniques• Attribute Sampling - to estimate proportion of population that have specified characteristics (egs. non-compliance  battery).• Monetary Unit Sampling - to estimate the amount (in RM) of misstatement for a class of transaction or accounts balances• Classical Variable Sampling -use of typical statistical method in making estimates 99
  100. 100. ATTRIBUTE SAMPLING APPLIED TO TESTS OF CONTROLS• Attribute sampling is a statistical method used to estimate the proportion of a characteristic in a population.• The auditor is normally attempting to determine the operating effectiveness of a control procedure in terms of deviations from the prescribed internal control policy. 100
  101. 101. Attributes SamplingExample: Audit test on• how often a credit check is not performed on customer orders before shipment - sampling unit = customer order forms• how often an invoice is not sent after shipment is made - sampling unit = invoice or shipping documents?Common use of attribute sampling  test of controls 101
  102. 102. Monetary-unit Sampling (MUS) MUS uses attribute sampling theory and techniquesto estimate the amount (in RM or other currency unit) of misstatement for a class of transactions or an account balance. Sampling unit = in monetary terms – Focus on monetary value rather than rate of occurrences. – To test overstatement (high value items). 102
  103. 103. Audit Sample Selection- continue…• Statistical Sampling Simple Random Sample (random number table/audit software) Systematic Sample Selection (random/stratified random) Random – Select every nth elements in the sample Stratified – the population is divided into strata, then sample is drawn from each strata. 103
  104. 104. NEEDS FOR SAMPLING SUBSTANTIVE TESTINGS• To estimate the characteristic in a population.• Attempting to determine the deviations from the prescribed accounting system in ensuring the audit objectives are achieved.• To provide reasonable assurance.• Sufficient evidence to support conclusion & audit opinion.• Means of gathering and evaluating evidence. 104
  105. 105. PHASES IN SAMPLING APPLICATION• Planning• Performance• Evaluation 105
  106. 106. SPECIAL SITUATIONS IN PERFORMING THE AUDIT PROCEDURES• Voided documents.• Unused or inapplicable documents.• Missing documents.• Stopping the test before completion. Egs. List of invoices from creditors to see if the accounts are paid. 106
  107. 107. Non-statistical sampling for Test of Accounts Balances• Identify individually significant items -These items will be tested 100% -The remaining items which insignificant is subjected to sampling.• Determine the sample size = Population Book Value* x Assurance Factor Tolerable Misstatement*** Exclude 100% test ** estimated during audit planning• Calculate the sample results. 107
  108. 108. NONSTATISTICAL SAMPLING: DETERMINING SAMPLE SIZE Population Book Value Sam ple Size = x Assurance Factor Tolerable M isstatem ent C om b in e d R is k th a t O th e r S u b s tan ti ve P r oc e d u re s w i ll F a ilA s s e s s m e n t of to D e te c t M a te ri al M is s ta te m e n ts C o n tr o l R is k a n d I n h e re n t M a xi m u m S li gh tly M o d e ra te S u b s ta n tia l R is k b e lo w m a xi m u mM a xi m u m 3.0 2 .7 2 .3 2 .0S li gh tly b e lo wm a xi m u m 2.7 2 .4 2 .0 1 .6M o d e ra te 2.3 2 .1 1 .6 1 .2Low 2.0 1 .6 1 .2 1 .0 108
  109. 109. NONSTATISTICAL SAMPLING: CALCULATING SAMPLE RESULTS• The AICPAs guidance describes two acceptable methods for projecting the amount of misstatement found in a nonstatistical sample:• Project the amount of misstatement by dividing the amount of misstatement by the percentage of the dollars of the population included in the sample.• Project the average misstatement found in the sample to the population. 109
  110. 110. NONSTATISTICAL SAMPLING AN EXAMPLE - CALABRO Th e se nio r in c h a rge o f th e a u d it, D o n Jo n e s, h a s d e c id e d to d e sign an o n sta tistic a l sa m plin g a p p lic a tio n to e xa m in e th e a c c o u n ts re c e iva ble b a la n c e o fC a la b ro , In c . a t D e c e m b e r 3 1 , 2 0 0 0 . A s o f D e c e m b e r 3 1 , th e re w e re 1 1 ,8 0 0a c c o u n ts re c e iva ble a c c o u n ts w ith a b ala n c e o f $ 3 ,7 1 7 ,9 0 0 a n d th e p o p u latio n isc o m p o se d o f th e fo llo w in g stra ta: N um b e r a n d Si ze o f A c c o un ts B o o k V al u e o f Str a ta 1 5 a c c o u n ts > $ 2 5 ,0 00 $ 5 5 0 ,0 0 0 2 50 a c c o u n ts > 3 ,0 0 0 8 5 0 ,0 0 0 1 1 ,5 3 5 a c c o u n ts < $ 3 ,0 0 0 2 ,3 1 7 ,4 0 0 110
  111. 111. NONSTATISTICAL SAMPLING - CALABROJones has made the following decisions:• Based the results of the tests of controls, a low assessment is made for inherent & control risk.• Tolerable misstatement allocated to accounts receivable is $40,000. The expected amount of misstatement is $15,000.• There is moderate risk that other auditing procedures will fail to detect material misstatements.• All customer account balances greater than $25,000 are to be audited. 111
  112. 112. NONSTATISTICAL SAMPLING: DETERMINING SAMPLE SIZE Population Book Value Sam ple Size = x Assurance Factor Tolerable M isstatem ent C om b in e d R is k th a t O th e r S u b s tan ti ve P r oc e d u re s w i ll F a ilA s s e s s m e n t of to D e te c t M a te ri al M is s ta te m e n ts C o n tr o l R is k a n d I n h e re n t M a xi m u m S li gh tly M o d e ra te S u b s ta n tia l R is k b e lo w m a xi m u mM a xi m u m 3.0 2 .7 2 .3 2 .0S li gh tly b e lo wm a xi m u m 2.7 2 .4 2 .0 1 .6M o d e ra te 2.3 2 .1 1 .6 1 .2Low 2.0 1 .6 1 .2 1 .0 112
  113. 113. NONSTATISTICAL SAMPLING AN EXAMPLE - CALABROSample Size = ($3,167,900/$40,000) x 1.2 = 95** Allocation of the 95 to the 2 strata (BV/Pop BV x SS) Results St ra ta B o ok V a lue B o ok V alu e A u dit V alu e A m ou n t of o f St ra ta o f S am ple o f Sa m ple O ve rst ate m e nt > $ 2 5 ,00 0 $ 5 5 0,0 0 0 $ 5 5 0,0 0 0 $ 5 49 ,5 00 $ 500 > $ 3 ,0 00 8 5 0,5 0 0 4 2 5,0 0 0 4 23 ,0 00 2,0 0 0 < $ 3 ,0 00 2,3 1 7,4 0 0 9 2,0 0 0 91 ,7 50 250 113
  114. 114. Projected Misstatement St ra ta A m ou n t of P ercen ta ge o f P ro jecte d M isstatem ent S trat a S a m pled M issta tem en t> $ 2 5,0 0 0 $ 50 0 1 0 0% $ 5 00> $ 3 ,00 0 2 ,00 0 4 2 5,0 0 0 ÷ 85 0 ,5 00 = .50 4 ,0 00< $ 3 ,00 0 25 0 9 2 ,00 0 ÷ 2 ,31 7 ,4 00 = .07 3 6 ,2 50 T o tal Pr o jected M isstatem ent 1 0 ,7 50 114
  115. 115. CONCLUSION• If projected misstatements > tolerable misstatement, conclusion: there is unacceptably high risk that the account is misstated.• If projected misstatements is considerably < tolerable misstatement; compare the projected misstatements to the expected misstatements.• If projected misstatement is < expected misstatement, conclusion: there is acceptably low sampling risk that projected misstatement exceeds tolerable misstatements.• If projected misstatement significantly > expected misstatements, conclusion: there is unacceptably high risk that true misstatement exceeds tolerable misstatements. 115