TOPIC 3a: SCOPE OF FINANCIAL STATEMENTS AUDIT • Example: Long-term debt shown as a current liability will • Ratios analyzed

s a current liability will • Ratios analyzed include: Current ratio, quick ratio, AR
2. Cycles of Financial Statements mature in the current year, and all major restrictions from turnover, inventory turnover, gross profit margin, net
Financial statements are divided into segments or cycles to make the debt covenants are fully disclosed in the notes. profit margin.
audit more manageable: • Examples of changes at planning stage: An increase in
• Sales and collection cycle TOPIC 3d: AUDIT PLANNING current ratio may indicate problems selling inventory or
• Acquisition and payment cycle 1. Phases of an Audit collecting receivables; a decrease in gross profit margin
• Payroll and personnel cycle 1. Client Acceptance and Retention: Decisions to accept or indicates raw material cost increases or selling price
• Inventory and warehousing cycle decline an audit engagement based on management integrity, decreases.
• Capital acquisition and repayment cycle auditor independence, and the engagement letter. • Step 3: Make Preliminary Judgments About Materiality: Set
3. Management Assertions 2. Planning the Audit: Developing an audit strategy for the planning materiality to determine which areas need focus.
• Management is responsible for ensuring that the financial conduct and scope of the audit. • Step 4: Consider Audit Risk: Assess uncertainty across the
statements give a true and fair view in accordance with the 3. Performing Audit Tests: Conducting fieldwork (ToC and financial statement level and account balance level.
applicable financial reporting framework. substantive tests). • Step 5: Understand Internal Control Structure: Assess
• Assertions are explicit and implicit representations made by 4. Reporting the Findings: Communicating audit findings and control risk to develop audit strategies.
management about the recognition, measurement, presentation, issuing the report. • Step 6: Develop Audit Program: Formalize a set of written
and disclosure of various elements in the financial statements. 2. Client Acceptance and Retention instructions for the audit staff, detailing audit procedures,
\ Relevant Management Assertions & Definitions (PERNAH • New Client Evaluation: Evaluate the client’s standing, financial sampling methods, and timing.
KELUAR TEST): stability, and integrity. MIA By-Laws require communication
✓ Existence: The assets, liabilities, and equity interests with the former auditor to find out if there are disputes over fees TOPIC 3e: AUDIT RISK AND MATERIALITY (FOCUS: AUDIT RISK)
exist at a given date. or accounting principles. 1. Definition of Audit Risk (AR)
• Example: Management asserts that inventory shown on • Continuing Client Evaluation: Evaluated annually. Auditors • The risk that the auditor expresses an inappropriate audit
the balance sheet physically exists and is available for sale. may discontinue services if the client lacks integrity, fees are opinion when the financial statements are materially misstated
✓ Occurrence: A transaction or event has taken place unpaid, or the client carries excessive risk. (e.g., issuing an unqualified opinion on statements that contain
and pertains to the entity during the period. • Understanding Client's Reasons for Audit: Identify the material errors or fraud).
• Example: Management asserts that revenues reported in intended users of the financial statements (e.g., public • Auditors must plan and perform the audit to reduce audit risk to
the income statement represent valid sales that occurred companies require more accumulated evidence). an acceptably low level.
during the period. 3. Engagement Letter 2. Acceptable Audit Risk (AAR)
✓ Rights and Obligations: The entity holds or controls • A formal contract between the auditor and the client that • A measure of how willing the auditor is to accept that the
the rights to assets, and liabilities are the obligations of formalizes the engagement and defines the extent of each party's financial statements may be materially misstated after the audit
the entity. responsibilities to avoid misunderstandings. is completed and an unqualified opinion has been issued.
• Example: Management asserts that the entity has legal Purpose of engagement letter • Inverse Relationship with Evidence: When acceptable audit
rights of ownership to the inventory shown in the balance –To define clearly the extent of auditor’s and client’s risk is set lower,the auditor must accumulate more audit
sheet, or that capitalized leases represent rights to leased responsibilities evidence
property and the corresponding lease liability is an –To avoid misunderstanding between auditor and client Why Auditors Cannot Provide Absolute Assurance (PERNAH
obligation. –To provide written confirmation on auditor’s acceptance of the KELUAR TEST):
✓ Completeness: All transactions, assets, liabilities, or appointment, the scope of audit, form of report and scope of Auditors cannot eliminate audit risk completely and give absolute
equity interests that should have been recorded have non-audit services (if any) assurance because:
been included. • Principal Contents: Objective of the audit, management's 1. Audit testing relies on sampling (testing a percentage of
• Example: Management asserts that inventory represents responsibility for financial statements, scope of the audit, form transactions, not 100% of the population).
all items on hand and amounts payable include all liabilities of reports, inherent limitations of an audit (risk that fraud/error 2. Inherent limitations of internal control systems (human
as of the balance sheet date. may remain undetected), deadlines, and audit fees. error, management override).
✓ Valuation (or Allocation): Assets, liabilities, and equity 4. Benefits of Planning the Audit 3. Financial statements involve complex management
interests are included in the financial statements at • Increases efficiency and effectiveness. accounting estimates and judgments.
appropriate carrying amounts. • Minimizes audit costs by focusing on high-risk areas. 4. Audit evidence is mostly persuasive rather than
• Example: Management asserts that inventory is carried at • Helps detect potential problems early. conclusive.
the lower of cost or market value on the balance sheet. • Ensures procedures are performed systematically and avoids 5. Fraudulent actions are often intentionally concealed and
✓ Measurement: A transaction is recorded at the proper misunderstandings with the client. highly difficult to detect.
amount, and revenue or expenses are allocated to the 5. Detailed Planning Steps 3. The Audit Risk Model
proper accounting period. • Step 1: Obtain Knowledge of Client’s Business/Industry: • Inherent Risk (IR): The susceptibility of an assertion or
• Example: Management asserts that the cost of property, Understand external environments, key suppliers, major account balance to a material misstatement, assuming there are
plant, and equipment is systematically allocated over revenues, reporting structures, KPIs, and perform tours of
appropriate periods through depreciation charges. operations. Sources include prior year working papers, M&A, no related internal controls. Internal controls are completely
✓ Presentation and Disclosure: Components of the minutes of meetings, and inquiries. ignored when assessing IR.
financial statements are properly classified, described, • Step 2: Perform Analytical Procedures (Planning Stage): • Control Risk (CR): The risk that a material misstatement will
and disclosed. Involves comparing the client’s financial info with previous occur and not be prevented, or detected and corrected, on a
periods, budgets/forecasts, and industry averages to identify timely basis by the entity's internal control system.
unexpected fluctuations and unusual relationships.
 • Detection Risk (DR): The risk that the auditor's substantive TOPIC 3b: INTERNAL CONTROLS 5. Places an emphasis on control over classes of
testing procedures will fail to detect a material misstatement transactions rather than just account balances.
that exists. It is a factor of both sampling risk and non-sampling 1. Definition of Internal Controls (IC) ✓ 5. Inherent Limitations of IC (PERNAH KELUAR
risk (e.g., inappropriate procedures, misinterpreting results). • Internal control is the process designed, implemented, and TEST)
4. Factors Affecting Inherent Risk (IR) maintained by those charged with governance (TCWG), Internal controls can only provide reasonable assurance, never
Auditors assess inherent risk at two levels: management, and other personnel to provide reasonable absolute assurance, due to limitations such as:
A. At the Financial Statement / Entity Level: assurance about achieving an entity’s objectives. ✓ Human Judgment & Error: Faulty decision-making
• Nature of the client’s business: Certain industries are more 2. Objectives/Purposes of IC under pressure or human carelessness can break down
prone to obsolescence (e.g., electronics vs. steel fabrication). Internal control assists management in ensuring the orderly and controls (e.g., error in designing computer processing
• Management integrity, experience, and attitude: Dominance by a efficient conduct of its business. The core objectives are: controls).
single person or rapid management structural changes increase • Reliability of financial reporting. ✓ Failure to Understand/Take Action: Individuals may
risk. • Effectiveness and efficiency of operations. fail to understand the purpose of a specific control (e.g.,
• Unusual pressures on management: Tight reporting deadlines, • Compliance with applicable laws and regulations. ignoring a payroll exception report).
market expectations, or pressures to show artificial revenue • Adherence to management policies, safeguarding of assets, ✓ Inappropriate Management Override: Management
growth. prevention and detection of fraud/error, and may purposefully bypass established controls for their
• Factors affecting the industry: Operating in highly competitive accuracy/completeness of records. own motives (e.g., a sales director extending credit to a
conditions may tempt a company to misstate figures to show 3. Components of Internal Control customer in violation of credit control guidelines).
promising trends. There are five main components of an internal control system: ✓ Collusion: Two or more people working together to
• Initial vs. Repeat engagement: First-time audits carry higher 1. The Control Environment: Includes the governance and circumvent controls (e.g., collusion between a factory
inherent risk due to the auditor's lack of prior experience with management functions, attitudes, awareness, and actions worker, manager, and payroll clerk to process
the company. concerning internal control. It sets the tone of an organization. fraudulent overtime pay).
B. At the Account Balance and Transaction Level: Factors include integrity, ethical values, commitment to • Cost Constraint & Company Size: The cost of implementing a
• Result of previous audits: Misstatements found in previous competence, and management philosophy. control should not exceed its benefits.
years have a high likelihood of occurring again. ✓ 2. The Entity’s Risk Assessment Process:
• Related parties: Transactions are not at arm's length, increasing (PERNAH KELUAR TEST) The process where the entity 6. Tests of Control (ToC)
misstatement risks. identifies and manages its own business risks relevant Tests performed to obtain audit evidence about the operating
• Non-routine transactions: Unusual or complex transactions (e.g., to financial reporting objectives, estimates their effectiveness of controls in preventing, or detecting and correcting,
major property disposal, complex sale-and-leaseback) are more significance, and decides on actions to address them. material misstatements. Procedures include:
likely to contain errors than routine credit purchases. 3. The Information System & Communication: Consists of the • Inquiry of client personnel.
• Management Judgment Required: Accounts requiring estimation procedures and records established to initiate, record, • Inspection of documents, reports, and electronic records.
carry higher risk (e.g., allowance for doubtful debts, inventory process, and report entity transactions and maintain • Observation of control application.
net realizable value, useful lives of assets, warranty liabilities). accountability for assets and liabilities. • Reperformance of the application of procedures by the auditor.
• Susceptibility of assets to loss/misappropriation (e.g., highly 4. Control Activities: Policies and procedures that ensure
portable cash or attractive inventory). management directives are carried out. They can be IT or
5. Auditor’s Response to Risk Assessment manual. Examples include:
• If the risk of material misstatement is assessed as High Risk, the • Physical custody of assets (restricting access).
auditor must design and perform extended procedures and • Authorization and approval (defined limits).
gather more evidence. • Segregation of duties (separating initiation, physical
• If assessed as Low Risk, the auditor can perform custody, and recording to reduce fraud/error).
normal/standard procedures before issuing the audit report. 5. Monitoring of Controls: A process to assess the design,
operation, and quality of internal control performance over
time and take necessary corrective actions.

4. Importance of Internal Controls

• Management’s Perspective: Meets stewardship
responsibilities, safeguards assets and records, provides reliable
info for decision-making, and complies with the Companies Act
2016.
✓ Auditor’s Perspective (PERNAH KELUAR TEST):
1. Sufficient understanding of IC to plan the audit and
develop an effective audit approach.
2. Assurance about the reliability of data.
3. Evaluates how well the assets and records of the entity
are safeguarded.
4. Determines the entity’s ability to record, process,
summarize, and report financial data consistent with
management’s assertions.