Chapter 4

Overview of elements of the financial report audit process

Learning objectives
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 contents of audit working
papers.

Major chapter sections

Accounting and auditing contrasted
Financial report assertions and audit objectives and procedures
Audit procedures and evidence

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Sufficient appropriate audit evidence
Overview of the audit risk model
Materiality
Types of audit tests
Using the work of an expert or component auditor
Documentation of audit work: audit working papers

Lecture plan
In this lecture the aim is to provide students with a framework for the financial report audit process,
which can be built on in future weeks. Students are introduced to many new concepts in this lecture.
The chapter outlines in detail the concepts of audit evidence and the audit risk model.

You should outline the learning objectives for this chapter and walk them through how this chapter
fits into the flowchart of the planning and risk assessment stage of a financial report audit.

[Use slides 4-1 to 4-3]

LO 4.1: Accounting and auditing contrasted

Students will have a good understanding of the financial reporting process, understand the
responsibility of management, and in the earlier lectures will have been introduced to the concept of
auditing. These slides provide an overview of these areas, including areas of audit interest and the
need for the auditor to exercise professional scepticism and professional judgment.

[Use slides 4-4 to 4-7]

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LO 4.2: Financial report assertions and audit objectives and procedures
It is unlikely that students would have thought of account balances, classes of transactions and
disclosures as consisting of a number of assertions. It is worthwhile working through this list,
showing students that evidence must be found for each assertion before it can be said that the
representation in the financial report is true and fair. It could also be stated that for different entities
facing different circumstances certain assertions will be more critical, and the auditor might need to
concentrate their attention on specific assertions.

It is useful to distinguish between the assertions that relate to classes of transactions, those that relate
to account balances and those that relate to presentation and disclosure.

For example, we explain that for transactions the auditor needs evidence of whether the transaction
occurs (occurrence), while for balances the auditor needs evidence that the asset/liability exists
(existence).

[Use slides 4-8 to 4-11]

LO 4.3: Audit procedures and audit evidence

This introduction to audit evidence is very important. It is important to show the breadth of audit
evidence and outline the audit procedures that help collect audit evidence and the factors affecting the
selection of audit procedures. Students are also introduced to the concept of an audit trail.

[Use slides 4-12 to 4-17]

LO 4.4: Sufficient appropriate audit evidence

The concept of sufficient appropriate audit evidence is an important concept to communicate. This
will entail a discussion of the relevance and reliability of audit evidence.

[Use slides 4-18 to 4-20]

LO 4.5: Overview of the audit risk model

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An overview is provided of the audit risk model. After defining the components, Figure 4.6 on slide
4-26 is a useful graphical depiction of how the risks relate. It is important to give examples of the
risks to illustrate them to best effect. Students are also introduced to the concept of business risk and
its relationship to audit risk. It is important that this is an overview, as more detail will be gone into
on each of the components of audit risk in future weeks.

[Use slides 4-21 to 4-32]

LO 4.6: Materiality
This is a matter of judgment for auditors and a concept that many students struggle with. It is
important to go through the various bases for evaluating materiality, providing the setting for the
preliminary materiality judgment and the relationship between materiality and audit risk and the
evaluation of misstatements based on accounting materiality.

[Use slides 4-33 to 4-43]

LO 4.7: Types of audit tests

This serves as an introduction to tests of control and substantive tests. The aim is to introduce the
concepts and how the different tests fit into the audit risk model.

[Use slides 4-44 to 4-48]

LO 4.8: Using the work of an expert or component auditor

Consideration is given to using the work of experts or other auditors and ensuring that the work of the
expert or other auditor is adequate.

[Use slides 4-49 to 4-52]

LO 4.9: Documentation of audit work: Audit working papers

The aim here is to show that working papers are the means to record the evidence. The slides
illustrate the major divisions of working papers and provide an example of a working paper.

The legal aspects of working papers are also considered.

[Use slides 4-53 to 4-64]

Summary
We provide a summary slide of the main learning takeaways in this chapter.

[Use slide 4-65]

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 SOLUTIONS

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REVIEW QUESTIONS
4.1 According to the AUASB Glossary, professional scepticism is ‘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’.
Further, ASA 200.A18-20 (ISA 200.A18-20) indicates that professional scepticism
includes:
 questioning the reliability of documents and information and explanations
provided by management
 being alert to contradictory evidence
 questioning the sufficiency and appropriateness of audit evidence and not
necessarily accepting the most readily available audit evidence
 being alert to conditions that may indicate risks of fraud
 critically challenging management judgments, assumptions and estimates.
Professional scepticism is important, as it enhances the auditor’s ability to
exercise professional judgement in identifying and responding to conditions that
may indicate possible misstatements in the financial report. Therefore,
professional scepticism is critical to enabling auditors to draw appropriate
conclusions in the conduct of their work. It is also essential to auditors fulfilling
their ethical requirements of objectivity and independence.

4.2 According to the AUASB glossary, professional judgment is ‘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.A23 (ISA 200.A23) emphasises that professional judgment is
essential to conducting an audit, as it is required for critical audit decisions such
as:
 determining materiality
 assessing audit risk
 evaluating audit evidence
 assessing the reasonableness of accounting estimates
 evaluating the appropriateness of accounting treatments and policies and the
appropriateness of the going concern basis.

4.3 Auditors use assertions as a focal point of the audit to assess risks by considering the
different types of potential misstatements that may occur and then to design audit
procedures that are aimed at uncovering that type of misstatement.

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4.4 The broad categories of assertions contained in ASA 315.A124 (ISA 315.A124) are
as follows:
Assertions about classes of transaction and events
 Occurrence: Transactions and events that have been recorded have occurred and
pertain to the entity.
 Completeness: All transactions and accounts that should have been recorded have
been recorded.
 Accuracy: Amounts and other data relating to recorded transactions and events
have been recorded appropriately.
 Cut-off: Transactions and events have been recorded in the correct accounting
period.
 Classification: Transactions and events have been recorded in the proper accounts.

Assertions about account balances

 Existence: Assets, liabilities and equity interests exist.
 Rights and obligations: The entity holds or controls the rights to assets and
liabilities are the obligations of the entity.
 Completeness: All assets, liabilities and equity interests that should have been
recorded have been recorded.
 Valuation and allocation: Assets, liabilities and equity interests are included in the
financial report at appropriate amounts and any resulting valuation adjustments are
appropriately recorded.

Assertions about presentation and disclosure

 Occurrence and rights and obligations: Disclosed events, transactions and other
matters have occurred and pertain to the entity.
 Completeness: All disclosures that should have been included in the financial
report have been included.
 Classification and understandability: Financial information is appropriately
presented and described, and disclosures are clearly expressed.
 Accuracy and valuation: Financial and other information is disclosed fairly and at
appropriate amounts.

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4.5 The seven general audit procedures are:
1. Inspection
Inspection involves the examination of documents, records or tangible assets.
2. Observation
By physically observing phenomena, the auditor gains first-hand knowledge of
their existence. Behaviour of operating personnel and the functioning of the
business in operation are observed, such as evidence of control activities being
carried out.
3. Enquiry
The auditor must ask many questions during the course of an examination. The
question-and-answer process includes interviewing and obtaining statements in
writing from management and employees. Explanations of significant variations in
accounting data are frequently obtained from employees.
4. Confirmation
Confirmation is a type of enquiry by which an auditor normally obtains a written
statement from outside parties such as banks, solicitors or accounts receivable on
information that they are qualified to give.
5. Recalculation
The arithmetical accuracy of the many calculations required in the processing of
data can be proved by recalculating the results. Examples of typical calculations
include additions of ledger account balances, depreciation calculations,
amortisation calculations and inventory extensions and additions.
6. Re-performance
The auditor may independently execute procedures or controls that were originally
performed as part of the entity’s internal control.
7. Analytical procedures
Analytical procedures involve the investigation of fluctuations in relationships to
ascertain whether there are inconsistencies in relation to other relevant
information or variations from predicted amounts.

4.6 The selection of particular procedures to achieve specific audit objectives is

influenced by the following considerations contained in ASA 500 (ISA 500) and
ASA 330 (ISA 330):
 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
 experience gained from previous audits

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  the results of other audit procedures
 the source and reliability of information available.

4.7 Sufficiency relates to the quantity or amount of audit evidence necessary to provide
the auditor with a reasonable basis for an opinion on the financial report.
Appropriateness relates to the quality of the audit evidence, including both its
relevance and reliability. Relevance is largely concerned with the relationship
between the evidence and the financial report assertion involved, while the
reliability of audit evidence is determined by the nature and source of the
evidence.

4.8 Representations of client personnel and management is internal information and is

subject to bias and thus is not as reliable as external evidence.

4.9 Audit risk is a function of the risks of material misstatement and of detection. The
risk of material misstatement consists of two components: inherent risk and control
risk. The audit risk model is a function of inherent risk, control risk and detection
risk. The audit risk model is described as follows.
AR = f (IR, CR, DR), where:
AR = audit risk, which is the risk that the auditor will give an inappropriate
auditor’s opinion when the financial report is materially misstated. Audit risk is
set by the auditor and will always be relatively low, as the auditor does not want
to give an inappropriate opinion. The level set by the auditor for a particular
client will be affected by the engagement risk, which 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.
IR = inherent risk, which is the susceptibility of an assertion to material
misstatement about a class of transactions, account balance or disclosure, given
the inherent and environmental characteristics, but without regard to related
internal controls. Inherent risk is determined by the characteristics of the entity
and the environment in which it operates.
CR = control risk, which is the risk that a material misstatement in an assertion
about a 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.
Control risk is essentially determined by the entity’s internal control, although an
auditor can set it at high if it they do not want to rely on internal control for cost
benefit reasons, irrespective of the internal control system being strong.

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 DR = detection risk, which is the risk that an auditor’s substantive procedures
performed to reduce audit risk to an acceptably low level, will not detect a
material misstatement. The desired detection risk is effectively determined by the
other factors in the model. The actual detection risk can then be altered to the
required level by changing the nature, timing and extent of testing, as well as
quality control factors on the audit, such as assignment of staffing and extent of
supervision and review.
Assessment of each component is subjective and is based on the professional
judgment of the auditor. The levels high, medium or low are generally used, rather
than specific percentages. A detection risk matrix is shown as Exhibit 4.1 on page
163 of the textbook.

4.10 The auditor uses materiality to evaluate the presentation of financial data and
determine the nature, timing and extent of audit procedures (sometimes called
planning materiality). Materiality is a concept of relative significance. It depends on
the relationship between the amount of the item of interest and the amount of some
relevant basis of comparison.
The auditor needs to consider qualitative as well as quantitative factors when
planning materiality. ASA 320 (ISA 320) provides quantitative and qualitative
factors that may affect the assessment of materiality to plan audit procedures. The
weighting put on different factors is a matter of professional judgment, so there is
no set figure for materiality in the auditing standards.
Qualitative factors may include the significance of the item to the particular entity,
the pervasiveness of the misstatement, the nature of the transaction, such as
related-party transactions or possible illegal acts, and the effect of the
misstatement on the financial report as a whole.

4.11 Planning materiality determines the items that will receive more attention in terms of
conclusiveness of evidence required or extent of items examined. If a low materiality
threshold is set, more evidence would be gathered than if a higher materiality
threshold were set.
The audit should be planned so that audit risk is kept at an acceptably low level.
The audit risk 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.
Thus, 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. There
is an inverse relationship between audit risk and materiality. This means that the
auditor sets a lower materiality threshold where there is a higher audit risk. The
auditor allows for this by increasing the extent of audit procedures, selecting a
more effective audit procedure and/or performing audit procedures closer to the
balance date.

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4.12 The auditor performs tests of control to see whether the policies and procedures of
internal control are effective. Substantive tests are performed on specific transactions
and balances to see whether the dollar amount of the account balance is materially
misstated.

4.13 Before relying on the work of a management expert (ASA 500.8 / ISA 500.8) or an
auditor’s expert (ASA 620.9 / ISA 620.9), the auditor should do the following things:
 Assess the skills and competence of the expert by reference to any professional
certification or licence, and the experience and reputation of the expert.
 Assess the objectivity of the expert.
 Obtain an understanding of the work of the expert.
 Evaluate the appropriateness of the work of the expert by discussion or review of
the assumptions and methods used by the expert, the auditor’s knowledge of the
client and results of related audit procedures.

4.14 Before relying on the work of a component auditor, the principal auditor should
follow the procedures set out in ASA 600.19 (ISA 600.19), to determine:
 whether the component auditor understands and will comply with the relevant
ethical requirements applicable to the engagement, including independence
 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
 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
 whether the component auditor operates in a regulatory environment that actively
oversees their work.

4.15 (a) The main functions of audit working papers are to:
 aid in the planning and performance of the audit
 aid in the direction and review of the audit work
 provide evidence of the audit work performed to support the auditor’s opinion.
(b) 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.
 Evidence of planning, including a copy of the audit strategy.

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  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.
 The audit plan/program, listing the audit procedures undertaken and the names of
audit staff completing those procedures.
 Details of the tests of controls and substantive tests of transactions and balances
completed, including evidence that sufficient appropriate audit evidence has been
obtained.
 The working trial balance, which is the schedule of general ledger accounts used
as the basis of preparation of the financial report.
 Trial balance working paper schedules, which include documents from sources
external to the entity confirming items in the accounting information supporting
the financial report.
 The original draft of the financial report and auditor’s report, and evidence of
appropriate review and conclusions drawn to support the audit opinion.
(c) The permanent file is used to store documents, schedules and other information
that are pertinent to the current audit and of continuing significance for the audit
engagement in future years. It normally contains the following items:
 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.
 Documents relating to ongoing contracts and agreements, such as loan
agreements, debenture deeds, labour agreements, trade contracts, leases and
service agreements.
 Continuing analysis of accounts that have ongoing importance to the auditor, for
example shareholders’ funds, long-term debt and fixed assets.
 The results of analytical procedures from previous years.
 Extracts from minutes of relevant shareholder and management meetings and
committees.
 Details relevant to ongoing audit planning, such as the locations of branch offices
or subsidiaries, details of cost centres and bank accounts, inventory storage
capacity and locations.
 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.
 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.

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DISCUSSION PROBLEMS AND CASE STUDIES

4.16 The specific ways that the audit team should exercise professional scepticism when
auditing the adherence to the loan covenants include three of the following:
 Obtain copy of the loan agreement and obtain sufficient appropriate audit
evidence to support Fix IT’s adherence to the loan covenants.
 Remain alert for manipulation of Fix IT’s results, which may have occurred to
ensure compliance with the loan covenants.
 Obtain confirmation from the bank of adherence to the loan covenants and remain
alert for any incorrect reporting of information to the bank.
 Be alert to other information provided by John or that contradicts John.
4.17
Risk Assertion at risk
(1) Valuation and allocation, as assets may not be recorded at the correct
carrying amount
(2) Completeness, as some liabilities may not have been recorded
(3) Cut-off, as revenue may not have been recorded in the correct accounting
period
(4) Occurrence, as recorded revenue may not be genuine
(5) Completeness, as expenses may have been left out

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4.18

Issue Key assertion Justification

(1) Valuation and Items counted were recorded under incorrect, more
allocation expensive, stock codes. This could lead to
inventory being overstated at year end.
(2) Existence Stock items were double counted (i.e. items
transferred from Adelaide were counted there and
also in Melbourne and Sydney, where the items
were transferred to). This could lead to inventory
being overstated at year end.

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4.19

Accounts Key assertion at risk Explanation

Sales/ Accuracy/Completeness Sales may be overstated (sales returns
Sales understated) as goods are likely to be
returns returned for a credit.
Inventory Valuation and There may be obsolete stock, as it may be
allocation difficult to sell clothes on hand that were
produced in Korea due to adverse publicity
calling for the products to be boycotted.
Accounts Valuation and Some customers may refuse to pay for their
receivables allocation clothes due to their dissatisfaction with the
company’s alleged behaviour.

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4.20 (a) 1 Inspection
(b) 6 Observation
(c) 3 Confirmation
(d) 2 Recalculation
(e) 4 Analytical procedures
(f) 1 Inspection
(g) 5 Enquiries
(h) 7 Re-performance
(i) 1 Inspection

4.21 (a) The auditor’s recalculation of depreciation is generally more reliable than the
examination of the raw material requisitions because the auditor has direct personal
knowledge of the outcome of the recalculation, whereas the raw material requisition
is an examination of only internal evidence.
(b) The bank confirmation would be considered generally more reliable than the
observation of segregation of duties because an independent external party provided
the information. Observation is not as reliable because the individuals performing the
functions might act properly when they know that they are being observed, but not act
properly when no-one is observing them.
(c) The bank statement would be considered generally more reliable than shipping
documents because the bank statement was prepared by an entity that is external to
the client, whereas the shipping documents are internal documents.
4.22 (1) When testing controls, we are trying to see whether the control is operating
effectively. The fact that the net miscellaneous reconciling item was not followed up
on a timely basis means that it is difficult for us to justify reliance on this control. The
fact that the reconciling item is immaterial is irrelevant when testing controls.
(2) The assistant has not considered whether there are factors that should have caused
the payroll expense to differ from the prior year. The work performed by the assistant
to date is not sufficient. When using analytical procedures as part of substantive
testing, it is necessary to compare actuals with expectations. Also, the payroll expense
is likely to be very material and so additional evidence is likely to be required.

4.23

Situation Component of
audit risk
(a) Technological innovations within the industry have Inherent risk
caused a major product to become obsolete

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 (b) Cash is more susceptible to theft than an inventory of Inherent risk
cement
(c) Segregation of duties is inadequate Control risk
(d) Cash disbursements have occurred without proper Control risk
approval
(e) A necessary substantive audit procedure is omitted Detection risk
(f) Bank accounts are not reconciled monthly, resulting in a Control risk
client failing to discover employee fraud on a timely
basis
(g) An auditor has complied with the auditing standards on Engagement risk
an audit engagement, but the shareholders have sued the
auditor for issuing a misleading opinion on the financial
report
(h) Confirmation of receivables by an auditor fails to detect Detection risk
a material misstatement
(i) Notes receivable are susceptible to material Inherent risk
misstatement, assuming there are no related internal
controls
(j) A client, Lemon Ltd, has insufficient working capital to Inherent risk
continue its operations

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4.24 (i) The increasing competitiveness of the industry in which Clothing Ltd operates has
an overall effect on inherent risk. There is likely to be an increase in inherent risk at
the financial report level, as management tries to maintain profits at the current level.
At the account balance, class of transaction and disclosure level, there is likely to be
an increase in inherent risk due to an increase in the level of judgment required to
accurately value inventory at the lower of cost or net realisable value.
(ii) The change in payroll processing and the related change in the internal control
affects control risk, which is likely to rise due to the changeover in processing
functions, the risk associated with new procedures, and the increased number of
locations processing the payroll function, (i.e. a computer service in each capital city
instead of one location at Head Office).
(iii) With declining sales and falling margins, Machinery Ltd may be heading towards
future going concern problems. This is important given the banker’s desire to see
improved results in the next reporting period and the related potential threat to loan
funding. The pessimistic articles in the financial press are also likely to have a
negative impact on results. These circumstances are likely to place increasing
pressure on the company’s management to produce favourable financial results,
thereby increasing inherent risk at the financial report level.

4.25 (i) There are likely to be public liability claims arising from the problems with the
glass turntables. There is also likely to be an adverse effect on sales and reputation in
the market, resulting in difficulty in selling this product going forward and getting
people to pay for product already sold. This is likely to increase the degree of
judgement required to arrive at materially correct figures for balances such as
accounts receivables, inventories and provision for warranty. This leads to an increase
in inherent risk at the account balance/class of transaction level.
(ii) The move into overseas markets is a positive one as far as increased sales are
concerned. However, there is an apparent lack of expertise in the company in relation
to accounting for foreign currency transactions. The complexity of foreign currency
transactions is likely to lead to an increase in inherent risk at the account balance,
class of transaction and disclosure level.
Given the increased pressure on the accountant, specific control procedures may also
be overlooked, resulting in a possible increase in control risk.
(iii) The fact that a fraud has been committed would increase inherent risk, as there is
a greater possibility of there being a material error in the financial report, as there
may be other frauds.
The fact that the internal control did not detect the fraud, which has occurred over a
prolonged period, would increase control risk.

4.26
Entity Most Explanation
appropriate
benchmark
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4.27 (a) An appropriate benchmark for determining preliminary materiality would be net
profit before income tax, as this is likely to be of major interest to shareholders and
analysts, given LGL is a publicly listed company. If net profit before tax is
considered unreliable due to changing economic circumstances, either net or total
assets could be considered as a more relevant and stable base.
(b)
Factors Effect on materiality
Listed public Likely to decrease materiality, given that the financial
company. report will be distributed to, and used by, a large number
of interested parties. There is a large number of reporting
requirements that LGL must comply with, as a publicly
listed company.
LGL sells mainly to The leather accessory industry is highly competitive and is
retail shops in a highly easily affected by changes in the economy, with customers
competitive market. having less disposable income during tough economic
times. Therefore, the LGL audit may be considered to be
of relatively higher risk, resulting in a reduction in the
preliminary materiality level.
Economy is in This is likely to reduce preliminary materiality, as there
downturn and may be pressure on future contracts and profitability; and
consumer confidence a greater risk of management manipulating the results.
has fallen.
Company has This will increase inherent risk as the company will be
outsourced its operating in a foreign environment and will be exposed to
Australian foreign exchange risk. This will result in a reduction in the
manufacturing to a preliminary materiality level.
new factory in China.

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4.28
Issue Impact on initial Explanation
materiality
1. No independent Decrease The board is now comprised
directors on the solely of the Tam family,
board. who occupy key management
positions and provide no
independence at the board
level.
2. Commission Decrease The remuneration structure
component of sales might lead Fast Feet’s sale
staff’s staff to create fictitious
remuneration revenues to boost their
increased. commission and salaries.
3. Company to list Decrease Management and the Tams
on ASX. will want the 2015 financial
results to be favourable to
attract investors in the IPO.

4.29
Test Type of test
1 Confirm loan balances with financial Substantive test of balances
institutions
2 Examine the financial report to determine Substantive test of
whether all related party loans are properly disclosure
presented
3 Trace sales recorded in the sales journal to Substantive test of
shipping documents transactions
4 Examine sales invoices for initials which Test of control
would indicate that prices and extensions
have been checked
5 Compare payroll expense to previous year Substantive analytical
and budget procedure
6 Recalculate depreciation figure Substantive test of
transactions
7 Check cost of closing inventory to subsequent Substantive test of balances
sales prices

Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
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4.30
Type of test Is given Actual Explanation
assertion assertion
Correct?
1 Test of No Occurrence The procedure does not test the
control completeness assertion, as the
sample is selected from the
recorded population (i.e. wrong
population).
This test of control would not
ensure the completeness of
revenue, as any items not recorded
cannot be selected (i.e. the
direction of testing is wrong).
The procedure of matching
invoices back to customer orders
and delivery docket proves that a
sale has occurred.
2 Substantive Yes N/A This procedure ensures that prices
test of detail charged are correct (i.e. accuracy).
If the prices are not correct, the
sales price will not match the
authorised list price.
3 Substantive No Occurrence Procedures that test the cut-off
test of detail assertion address the timing of
sales around year end to ensure that
sales just prior to year end have
been included and those after year
end have been excluded. This
procedure only tests whether sales
occurred prior to year end (i.e. it
tests the occurrence of transactions
recorded and delivered in the
current accounting period).

Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
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4.31 If the auditors of Greater Farming want to be able to rely on the work of the
management expert who assessed the expected life of the grading tractors, the auditor
would need to do the following.
 Assess the skills and competence of the expert by reference to any professional
certification or licence, and the experience and reputation of the expert.
 Assess the objectivity of the expert.
 Obtain an understanding of the work of the expert.
 Evaluate the appropriateness of the work of the expert by discussion or review of
the assumptions and methods used by the expert, the auditor’s knowledge of the
client and results of related audit procedures.

4.32 Despite engaging another auditor to audit the inventory account balance, in
accordance with ASA 600 (ISA 600), Zen still have an obligation to review the work
performed by the other audit team to ensure the work was performed as instructed
and that the procedures provided sufficient appropriate audit evidence in accordance
with Australian Auditing Standards. As such, the junior auditor’s conclusion is not
correct, as they have not reviewed the work performed by ABC.

4.33 The auditor should obtain sufficient appropriate audit evidence to be able to draw
reasonable conclusions on which to base the audit opinion. The auditor should
document matters that are important in providing evidence to support the audit
opinion and evidence that the audit was carried out in accordance with Australian
Auditing Standards. To achieve this, audit working papers ordinarily include
information such as:
 evidence of the auditor’s understanding of the internal control
 analysis of transactions and balances
 a record of the nature, timing, and extent of audit procedures performed and the
results of such procedures
 conclusions reached by the auditor
 copies of the financial report being reported on and the related auditor’s report.

CONTINUOUS CASE STUDY

4.34 The audit team is likely to need to engage an expert in two areas:

Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
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 1) The change in the depreciation of the printing presses from 20 years to 30 years on
a straight line basis suggests that it will be necessary for the audit team to engage an
expert to determine the useful life of the printing presses. Rogers and Brown are not
experts in assessing the expected life of printing presses and there appears to be some
diversity in the expected useful life of such assets. Accordingly, for the purpose of
forming a view on the board’s resolution to change the depreciation of the printing
presses from 20 years to 30 years on a straight line basis, it will be necessary to use
the work of an expert.
2) The valuation and allocation of intangibles is at risk. An article published in a
medical journal could cause the medical textbooks that RPL acquired the rights to
during the year to become obsolete. As a result, the valuation of the copyright
attached to the medical textbooks is at risk of being impaired and would require an
expert to value it.

4.35
a) Factors (b) Explanation (c) Influence upon preliminary
overall materiality
Existence of The internal audit function is The internal audit function
internal audit headed by an experienced should reduce the level of risk
function auditor, working together with of material misstatement,
two other qualified chartered which will result in the setting
accountants, and reporting of a higher materiality level.
directly to the board. This
should reinforce the internal
control environment, reducing
the possibility of material
misstatements in the financial
report.
Experienced The presence of experienced The likelihood of sound
management management is likely to internal controls should
contribute to the presence of contribute to overall lower risk,
sound systems of internal which will result in the setting
control and appropriate and of a higher materiality level.
prudent accounting policies.
Management The remuneration of the CEO The incentive to produce
remuneration includes a performance bonus strong results to achieve the
structure which is based on RPL performance bonus will
achieving specific growth in increase the risk of
sales and net profit after tax. manipulation of the financial
Accordingly, management is in report, which will result in the
the position to override controls setting of a lower materiality
and manipulate the financial level.
report.

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© McGraw-Hill Education (Australia) 2015
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 Requirement The loan agreement contains a The pressure to maintain the
to maintain debt covenant that requires RPL specified financial ratios, and
specific to maintain specified current and thus compliance with the debt
financial ratios debt to equity ratios. Failure to covenant, will contribute to a
maintain them will result in higher risk of manipulation of
Trim Finance having the right to the financial statements, which
recall the loan This provides an will result in the setting of a
incentive to management to lower materiality level.
manipulate the financial report
to ensure compliance with the
debt covenants and retention of
the loan funds.
Changes in In the current year, RPL The changes in accounting
accounting changed its accounting policies policies increases the risk that
policies in relation to inventory, the financial report will be
depreciation and revenue materially misstated, which
recognition. will result in the setting of a
lower materiality level.
Change in Acquisition of a new business Acquisition of the new
business generally increases inherent risk. business and possible
structure Specifically, RPL recognised an impairment issues with the
through the intangible asset for the copyright medical textbook copyright
acquisition of attaching to the medical increases the risk of material
the business textbooks that MBL produces. misstatement and will result in
operations of However, an article published in the setting of a lower
MBL. a medical journal could cause materiality level.
the medical textbooks that RPL
acquired the rights for to
become obsolete.
Installation of With a new system, there is a The new accounting system is
a new risk that more errors will be likely to significantly increase
accounting made, as staff are not necessarily risk and therefore, result in a
system familiar with the system and lower materiality level.
there may be errors in the
transfer of data from the old
system to the new system. In
addition, there is a high risk that
the system has not been
adequately tested.

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© McGraw-Hill Education (Australia) 2015
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