CAUA 3752 – AUDITING 1B

LECTURE 06

Topic and Reference:

AUDITING NOTES
JACKSON & STENT

Chapter 6
 PRELIMINARY ENGAGEMENT
ACTIVITIES

 Prior to accepting a client and a specific audit,

consider
 Client / auditor relationship
 Compliance with ethical requirements
 Considerations in terms of the code of conduct
 Type of threat, fundamental principles threatened,
safeguards..
 Terms of engagement
 Establish, or continue, the auditor/client relationship
 Consider reasons why auditor would NOT want to enter into
or continue relationship
 Lack of integrity of client
 Particular industry
 Client’s reputation with auditors
 Availability of auditor’s resources and skills
 Requirements of ISA 220
 Establish, or continue, the auditor/client relationship
 ISA 220 & ISQSI Quality control
 Must be complied with → required in order to report
 Provides guidance regarding specific matters
 Owners, Management’s integrity
 Competency of audit firm
 Ethical Requirements
 Comply with ethical requirements
 ISA 220
 Conflicts of interests
 Threats to auditor’s independence
 Contraventions of Code
 IFAC Code of Ethics
 Code applies to Professional Accountants in Public Practice
 Specific considerations
 Part B Section 220 – Conflicts of Interest
 Part B Section 290 – Independence in respect of assurance
engagements
 Establish terms of engagement
 Formalization of terms on engagement
 Letter to detail (including)
 Responsibilities of both parties
 Scope of the audit
 Inherent limitations of the audit
 Confirm Auditor’s independence
 Mgt’s responsibility to prevent RI
 Audit deadline/Audit fee
 OVERVIEW OF THE PLANNING
PROCESS
 Planning cannot be over-emphasized as it assist with,
attention to NB areas, potential problems,
competence, direction and supervision, completion in
time
 Information-gathering stage
 Stage 1, Understanding the entity and its environment
 Information-analysis stage
 Stage 2, Assess the risk of material misstatement in the
financial statements
 Stage 3, Determine materiality
 Documentation stage
 Stage 4, Establish the overall audit strategy
 Stage 5, Develop an audit plan
 UNDERSTANDING THE ENTITY
AND ITS ENVIRONMENT

 Why is the auditor gathering this information?

 Identify and assess the risk of material
misstatement
 Develop audit procedures in order to
respond to these identified risks →
thereby express an audit opinion at an
acceptable level of audit risk
 Areas to consider
 Industry, regulatory, and other external factors
 The nature of the entity
 The entity’s selection of accounting policies
 The entity’s objectives and strategies, and the
related business risks
 The entity’s financial performance
 The entity’s internal controls
 ASSESS THE RISK OF
MATERIAL MISSTATEMENT IN
THE AFS

 So far
 The auditor has gathered information on various
aspects of the client

 Now
 He will consider whether what he knows about the
client will lead him to believe that there is a risk
of material misstatement of the AFS

 I.e. the auditor will evaluate the effect that any

identified weaknesses will have on the Financial
Statement assertions
 Before proceeding with this stage of the planning
process
 Need to look closely at the concept of Audit Risk
 AUDIT RISK

 Definition of Audit Risk

 The risk that the auditor expresses an inappropriate audit opinion
when the annual financial statements are materially misstated
 I.e. he gives an unqualified opinion when it should be qualified
 Risk-based approach to auditing
 In order to minimise the auditor’s exposure to audit risk
 Identification of financial statement assertions that may be at risk of
misstatement
 Responds/Safeguards to this risk by
 designing an audit strategy and audit plan that will reduce the risk that
material misstatement, will not be detected, to an acceptable level
 ISAs directs the audit process – if correctly followed should reduce risk
 COMPONENTS OF AUDIT RISK

 AR = Inherent risk (IH) + Control risk (CR) and

Detection Risk (DR)
 Inherent risk “built-in risk”
 Susceptibility of assertion to misstatement
 Considered when the auditor gathers information
about the entity
 Level of IR contributes directly to the risk of
material misstatement
 Control risk
 A function of the design and operation of the
internal control system
 Control risk is directly related to inherent risk
 AUDIT RISK: THE CLIENT
RISKS
 Client Risks
 Inherent Risk
 Built-in risk in an account balance/transaction
 Risk that exists before internal controls are put in place!!!
 Risks related to specific type of industry and type of client
 Inventory – Diamonds vs. Cricket bats
 Control Risk
 A function of the design and operation of the internal control
system
 If the entity’s internal controls are NOT working as intended
 There is a risk that misstatement will occur (that will NOT be
addressed by the client)
 Auditor needs to be aware of this  implications for AFS
 AUDIT RISK: THE CLIENT
RISKS

 Control risk
 Auditor looks at control activities
 Strong Control Environment
 The entity’s risk assessment process
 The information system
 Segregation of duties
 Monitoring of internal controls
 Essential to evaluate the effect of the identified
weaknesses (in system) on the financial
statement assertions

 Example – Cash sales to staff and hawkers

 AUDIT RISK: THE AUDITOR’S
RISK

 Detection risk
 Risk that the auditor will not detect a misstatement that
exists and could be material
 Risk that is inherent in the client’s operations and is NOT
addressed by the client’s control system
 Detection risk is a function of the effectiveness of
the auditor’s audit procedures
 Detection risk may arise because
 Inappropriate audit procedure
 Misapplication of a procedure
 Misinterpretation of the results of a procedure / test
 There is an INVERSE relationship between [IR & CR]
and DR (Audit Risk)
 AUDIT RISK

 Detection risk
 By performing a “quality audit”
 Keep level of DR low
 Able to express audit opinion at acceptable level of
Audit Risk
 Develop the audit strategy and audit plan with the
desired level of DR in mind
 Audit risk is assessed at 2 levels
 At the overall financial statement level
 I.e. risk relates to financial statements pervasively
 Integrity, experience, knowledge of management
 Possibility of many misstatements
 Potentially affects many different assertions
 Auditor’s response will be general in nature
 Assigning staff with appropriate levels of experience and skills
 Providing more supervision to audit staff
 Elements of unpredictability (surprise) into the audit
 Changes to the way the audit is conducted
 Impacts on the overall audit strategy
ASSESSING RISK AT TWO LEVELS

 At financial statement level

 Will potentially affect many assertions and impact on the AFS
 Factors that may affect audit risk at the financial statement level
 Management's integrity
 Manipulation of AFS to meet their own needs
 Management’s experience and knowledge
 Errors in AFS
 Pressure on management
 Many business failures in industry
 Need to raise loans
 Nature of entity’s business
Technological obsolescence
 Factors affecting the industry
 Economic conditions
 Consumer demand for company’s products
ASSESSING RISK AT TWO LEVELS

 At financial statement level

 Responding to such risk includes
 Assigning staff with appropriate skills and
experience
 More supervision of staff
 Professional scepticism
 Elements of unpredictability
 Changes to the way in which the audit has been
conducted
 At assertion level
 Risk at financial statement level “trickles” down, and becomes risk at
the assertion level
 E.g. Poor management integrity
 Completeness assertion to counter understatement

 Factors that may affect audit risk at the assertion level

 Susceptibility of an account to misstatement
 Complexity of transactions
 Degree of judgement involved
 Susceptibility of assets to loss or misappropriation
 Complex and unusual transactions (at year-end)
 Transactions not subjected to routine processing
 The auditor’s response  audit procedures
 Valuation of inventory
 AUDIT RISK – AN APPROACH

 You should be able to

 Identify a risk
 Describe the risk i.e. why is it a risk?
 Perform audit procedures to address the risk
 Starting with the audit plan
 Follow through into the detailed audit
procedures
1. Factor: This is our first audit of BigSky (Pty) Ltd which would increase the audit risk
(detection risk): Discussion:
1.1 As we have no "history" with the client we will be less familiar with potential risks of material
misstatements etc., which may result in an inadequate audit strategy and plan. (Numerous assertions
may be affected).
1.2 In addition, this is the largest audit which I have controlled, and although I will be closely
monitored by my manager, my lack of experience may have an effect.
This is a detection risk which we (the audit firm) must manage. 
2. Factor: There is a tight deadline on the audit which would increase audit risk.
Discussion:
2.1 Where there are tight deadlines, pressure is placed on both the audit team and the client’s
financial staff. This may lead to
* Material misstatement going undetected due to lack of time.
* Misstatements of amounts and disclosures included in (or excluded from) the financial statements
arising from client staff being rushed or from not having sufficient supporting information pertaining
to the amount or disclosure. (Numerous assertions can be affected).
2.2 The post balance sheet period is also short. This limits the opportunity to perform tests on
transactions after year-end, which confirm year-end balances e.g. testing subsequent receipts.
This is a form of detection risk. 
3. Factor: The size and geographical spread of BigSky (Pty) Ltd.’s operations (i.e. has
branches throughout Namibia and South Africa) would increase audit risk.
Discussion:
3.1 In effect BigSky (Pty) Ltd is made up of more than 50 "businesses" situated countrywide and
internationally; it would be most unlikely that we could (or would) be able to "audit" all business
locations e.g. attend all inventory counts, evaluate the control environment at all businesses. This
increases the risk of misstatement in a number of account headings going undetected, and hence
increases the audit risk.
3.2 This risk is decreased by virtue of the fact that monthly reports are submitted to head office
for analysis (strong control environment?) and the fact that we will have access to these. 
4. Factor: The presence of a group internal audit department should reduce audit risk.
Discussion:
4.1 Internal audit is a form of internal control. The fact that this is a group internal audit
department, an independent control, and the fact that they are actively involved in “internally
auditing” BigSky (Pty) Ltd.’s outlets, should enhance the control environment and reduce the
opportunity for material misstatement to remain undetected.  
5. Factor: The compatibility of our audit retrieval software with BigSky (Pty) Ltd.’s system
should reduce audit risk.: Discussion:
5.1 As our software is compatible we will have the ability to efficiently and effectively
interrogate (audit) the client’s database. This improves our chances of obtaining sufficient
appropriate evidence, and reducing the possibility of material error going undetected,
particularly for those account headings where the software can be used (debtors, inventory,
fixed assets).
5.2 The “speed” at which we can perform CAATs means that more comprehensive testing can be
done faster. The risk of us not detecting a material misstatement and giving an inappropriate
audit opinion is reduced.
6. Factor: The large number of inter-company (group) transactions will increase audit risk:
Discussion:
6.1 These transactions are "related party" transactions which may not be "arm’s length". There
is the opportunity to manipulate the financial statements through inter-company transactions
(related) to achieve particular results, i.e. overstatement/understatement of inventory balances
(existence, completeness, manipulating profits by charging “fictitious” inter-company
administration fees, fictitious sales etc.).
6.2 This risk is mitigated by the fact that there is no indication that BigSky (Pty) Ltd has any
intention of manipulating the financial statements.
7. Factor: The frequent movement of inventory between the 50 retail outlets increases
audit risk, although this risk may be reduced by the fact that it is controlled using a
sophisticated software package.:
Discussion:
7.1 The risk here is that the year-end inventory figure may be overstated (existence) or
understated (completeness) due to the frequent movement between outlets. Inventory in a
retail organisation is normally a very large figure and any (material) misstatement in the account
heading will have a significant effect on fair presentation. Due to the numerous transfers and
tight deadline, goods in transit reconciliations may be inadequately performed.  

8. Factor: BigSky (Pty) Ltd imports from numerous countries which increases audit risk.:
Discussion:
8.1 Importing results in more complex transactions due to foreign currencies, fluctuations
therein, foreign exchange and forward cover implications and allocation of import duties and
shipping expenses. This may, for example, affect the accuracy of purchases, the cost of
inventory calculation (valuation) and the valuation of creditors. In addition, losses/gains on
foreign exchange may be incorrectly calculated and classified. 
9. Factor: Properly planned inventory counts at year end should decrease audit risk.
Discussion:

9.1 Properly planned inventory counts are likely to result in accurate counts (existence and
completeness) as well as appropriate identification of obsolete, damaged and slow moving
inventory which will result in more appropriate impairment allowances (valuation).
9.2 Inventory will be a major account heading and proper planning increases the chances of any
material misstatement in this account heading going undetected.
 AUDIT RISK – EXAMPLES: QU 1

You are currently assessing the risk for your audit client, French Connection Ltd, a
large manufacturing company and subsidiary within a conglomerate. The following
information relates to this entity: (14 marks) 
The Financial Director is very evasive in answering any of your queries.
FrenchConnection has been charged with diminishing quality control requirements in their
manufacturing process, which has been published in the media.
FrenchConnection has been showing good growth over the last 10 years of operation.
Although this has declined significantly in the last year due to the drop in its’ products
demand, further indicators show the possibility of the company risking going concern.
Directors’ annual bonuses are based upon earnings.
The company decided to retrench its internal auditors in a cost cutting exercise.
Closeto the end of the year a number of complex transactions relating to asset
revaluations were put through.
The Financial Controller was ill for 3 months during the year, which resulted in the debtors,
bank and creditors reconciliations not being done during this period. 
YOU ARE REQUIRED TO:
 Indicate whether each of the above will increase or decrease
your assessment of risk. Further, also indicate whether it is an
inherent risk or control risk.
The Financial Director is very evasive in answering any of your queries. (High Risk - Inherent Risk)
 

French Connection has been charged with diminishing quality control requirements in their (High Risk - Inherent Risk (Going
manufacturing process, which has been published in the media. concern issue) and Control risk, due
to lack of quality control
requirements)
 

French Connection has been showing good growth over the last 10 years of operation. (High Risk – Inherent Risk)
Although this has declined significantly in the last year due to the drop in it’s’ products
demand, further indicators show the possibility of the company risking going concern.

Directors’ annual bonuses are based upon earnings. (High Risk – Inherent Risk)
 

The company decided to retrench its internal auditors in a cost cutting exercise.  
(High Risk – Control Risk)
 

Close to the end of the year a number of complex transactions relating to asset revaluations
AUDIT RISK – ANSWER: QU 1
(High Risk – Control Risk)
were put through.

The Financial Controller was ill for 3 months during the year, which resulted in the debtors, (High Risk – Control Risk)
bank and creditors reconciliations not being done during this period.  
 AUDIT RISK – EXAMPLES: QU 2

During your “understanding of the entity and its environment” stage of

planning for the audit of Best pay (Pty) Ltd, you obtained the following
information, amongst other, about the company. (6 marks)

The company imports large quantities of stock. 

The products sold by Pick-n-Pay (Pty) Ltd have expiry dates, after
which they are not useable. 
80% of the company’s sales are for cash.

YOU ARE REQUIRED TO: Indicate per item above what line item on
the Annual Financial statements is affected as well as what
assertion will be affected.
ANSWER:

The company imports large quantities of stock. (Stock – Valuation)

 
The products sold by Pick-n-Pay (Pty) Ltd have expiry dates, after which
they are not useable. (Stock – Valuation)
 
80% of the company’s sales are for cash. (Sales – Completeness)
 
 THE AUDIT STRATEGY
AND THE AUDIT PLAN

 Overall audit strategy

 Sets the scope, timing, and direction of the audit
 Guides the development of the audit plan
 THE AUDIT STRATEGY

 Scope of the audit

 Refers to the extent of work to be covered
 Factors to consider
 Is the company listed or not?
 JSE requirements?
 Number of locations to be visited?
 Multiple locations
 Use of other auditors?
 Extent of computerization of the client?
 Use of IT experts?
 Scope of the audit
 Factors to consider
 New client?
 Audit procedures for opening balances?
 Internal audit department at client?
 Use of their work?
 When was the appointment made?
 Liaise with previous auditor?
 Timing of the audit
 Factors to consider
 The size of the client
 Very large, timing of visits
 Commence work ASAP

 Late appointment of auditor

 Impact on whether Interim Audit can be done
 Communication with Auditors/Specialists
 Reports
 Types and Timing
 Audit deadlines
 Tight deadlines? Interim/Year end?
 Direction of the audit
 Factors to consider
 Problem areas,
 Material account headings,
 Determination of materiality levels,
 Presence of significant risk areas
 Impact of assessed risk on Overall level
 Volumes of Transactions
 Rely on Test of controls
 Significant business developments
 Changes in Key Management
THE AUDIT PLAN

 Linked but in more detail than the audit strategy

 Professional Judgment and experience play part in blending
test of controls and substantive testing
 Defines the auditor’s response to the planned risk of material
misstatement at assertion level
 Relates to Nature, Timing and Extent of duties of specialists
 The nature of procedures
 Tests of Controls vs. Substantive procedures
 Substantive procedures
 Analytical review
 Tests of detail
 May need to reassess nature of procedures
 Based on results of Tests of Control
 The timing of audit procedures
 When will the tests be performed?
 Considerations
 Tight deadlines
 Refer to Audit Strategy
 Early verification and roll-forward procedures

 Extent of procedures
 How much testing is required?
 Level of risk associated with balance?
 Refer to chart of page 6/13 for matters to
consider in following components:
 Nature of tests
 Timing of tests
 Extent of tests
 EVALUATING, CONCLUDING
AND REPORTING

 Significant appropriate evidence has been obtained to reduce

Audit Risks
 Consider all evidence not just those that corroborate
 Materiality of Audit differences
 Fraud and Error, wrong recognition, Known and likely errors
 Document in WP and list in “overs and unders”
 The financial position, financial performance and cash flows are
fairly presented
 Accounting policies, disclosed, consistent and appropriate

 Accounting estimates
 Info is relevant, reliable, comparable and understandable
 Statutory requirements
 Subsequent events