CHAPTER 5

Planning
EXAM FOCUS
Planning is critical to good auditing and the planning process involves a thorough
understanding of the concept of audit risk and the use of professional judgement in evaluating
financial data (ie, the concept of materiality). Examination questions have been set in the past
on the topic of working papers and their importance in establishing care and skill. Quality
control issues (ISA 220) are relevant in this context.

The use of analytical procedures is a highly examinable topic because you can be tested on
your skills as a financial analyst as well as your understanding of risk and the application of
materiality.

SYLLABUS AND STUDY GUIDE COVERAGE

This chapter covers the following elements of the ACCA study guide:

7 Preliminary Planning Procedures

¨ Describe the sources and nature of information gathered in planning audit and
review assignments.
¨ Describe the purpose of analytical procedures in planning and illustrate the
application of such procedures.
¨ Describe the components of risk and the use of information technology in risk
analysis.
¨ Illustrate and explain the im portance of the application of risk analysis.
¨ Define and illustrate the concepts of materiality and tolerable error.
¨ Evaluate misstatements.

8 The Work Plan, the Work Program and Documentation

¨ Distinguish between risk-based, procedural and other approaches to audit and

review work.
¨ Describe and illustrate the contents of work plans, w ork programs and working
papers.
¨ Explain the importance of documentation and describe the nature of
documentation required for different types of assignment.
¨ Illustrate the use of information technology in preparing work program s and work
plans.
¨ Describe and illustrate the use of microcomputers in the audit.

10 Internal Control I

¨ Distinguish between tests of controls and substantive tests.

16 Other Audit and Review Evidence I

¨ Distinguish between the interim and the final audit.

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¨ Describe and illustrate how analytical procedures are used as substantive

procedures.

In order to cover these elements the follow ing topics are included:

ISA 220 Quality control for audit work

ISA 230 Documentation
ISA 250 Consideration of laws and regulations
ISA 300 Planning
ISA 310 Knowledge of the business
ISA 320 Audit materiality
ISA 400 Risk assessments and internal control
ISA 510 ,QLWLDOHQJDJHPHQWV²RSHQLQJEDODQFHV
ISA 520 Analytical procedures
ISA 710 Comparatives

1 Introduction
1.1 Knowing the client
An auditor has a duty of care to carry out his work with a reasonable standard of skill and care
and therefore should not take on engagements w hich he cannot properly fulfil.

Consequently the auditor must:

¨ understand how the business operates, its strengths and its weaknesses, the markets
served, the products it supplies;
¨ have a good w orking relationship with the key members of the management team;
¨ have a clear understanding of the nature of the services provided by the auditor to his
client;
¨ EH DZDUH RI ZKDW FDQ EH UHJDUGHG DV ´EHVW SUDFWLFHµ DQG EH DEOH WR LPSOHPHQW WKH ODWHVW
professional developments.

In the case of companies audited in prior years, most of the information required for planning
will be available in the w orking papers and other files.

1.2 New audits

On being asked to accept appointment as auditor to a new client, there are various matters that
the auditor should consider before accepting such an appointment.

¨ Does the firm have the capability and resources to carry out the audit? The auditor w ill
need to determine the:
² size, location and nature of business of the prospective client;
² timing of the audit;
² number and degree of experience of the staff required;
² current commitments of the firm; and
² ILUP·VH[SHULHQFHLQWKHDXGLWRIVXFKDEXVLQHVV
¨ Is the audit firm independent of the client? The auditor m ust establish the independence
of the firm in the context of the Rules of Professional Conduct with regard to fees,
shareholdings, etc.
¨ Are there any other reasons for not accepting appointment?
¨ Are the opening balances capable of verification and fairly stated? (ISA 510).

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 Chapter 5 Planning

ISA 510 ,QLWLDOHQJDJHPHQWV²RSHQLQJEDODQFHV offers guidance w hen the financial statements are
being audited for the first tim e or w hen the financial statements for the prior period were
audited by another auditor. The current auditor w ill not have previously obtained audit
evidence supporting these opening balances.

Possible approaches include:

¨ UHYLHZLQJWKHSUHGHFHVVRUDXGLWRU·VZ RUNLQJSDSHUV

¨ examining current period events to support the opening balances; for example receipts of
cash at the start of this year should support the accounts receivable stated at the end of last
year.

¨ examining the records underlying the opening balances; for example a schedule of
investments held at the end of last year can be tested by considering sales and purchases of
investments during the year as well as the schedule of investments held at the end of this
year.

The auditor m ust obtain sufficient appropriate audit evidence that all the opening balances are
not materially m isstated.

ISA 710 Comparatives additionally requires the auditor to obtain sufficient appropriate audit
evidence that the comparative figures (ie, the numbers disclosed for the previous year for
comparison purposes) are fairly incorporated in the financial statements for the current period.
If this is a new audit, the auditor may have to carry out specific substantive tests on the
comparative figures to secure the evidence required. If the auditor is unable to obtain
sufficient evidence in respect of these figures he may have to qualify his opinion on grounds of
uncertainty.

2 Planning methodology
2.1 ISA 300±3ODQQLQJ
¶3ODQQLQJ· PHDQV GHYHORSLQJ D JHQHUDO VWUDWHJ\ DQG D GHWDLOHG DSSURDFK IRU WKH H[SHFWHG
nature, timing and extent of the audit. The auditor m ust plan to perform the audit in an
effective manner.

ISA 300 provides general guidance in a context of recurring audits. For a first audit, the
planning process w ill probably need to be expanded beyond the matters covered below.

´7KHDXGLWRUVKRXOGSODQWKHDXGLWZRUNVRWKDWWKHDXGLWZLOOEHSHUIRUPHGLQDQHIIHFWLYH
manner.

The auditor should develop and document an overall audit plan describing the expected
scope and conduct of the audit.

The auditor should develop and document an audit programme setting out the nature,
timing and extent of planned audit procedures required to implement the overall audit plan.

The overall audit plan and the audit programme should be revised as necessary during the
FRXUVHRIWKHDXGLWµ

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approach for the individual client. This will be based on:

¨ NQRZOHGJHRIWKHFOLHQW·VEXVLQHVVDQGUHFHQWKLVWRU\
¨ knowledge of the persons involved in running the business;
¨ DQDSSUHFLDWLRQRIWKHFOLHQW·VV\VWHPRIFRQWUROVDQGWKHH[WHQWRIUHOLDQFHWKHUHRQ
¨ the scale and size of the organisation;
¨ the volumes and value of transactions; and
¨ the geographical spread of business operations.

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The auditor m ust thoroughly familiarise himself with the affairs of the business and its recent
financial history.

This is done by:

¨ reviewing his files of w orking papers; and

¨ regular contact w ith the client.

2.2 ISA 310±.QRZOHGJHRIWKHEXVLQHVV

´,Q SHUIRUPLQJ DQ DXGLW RI ILQDQFLDO VWDWHPHQWV WKH DXGLWRU VKRXOG KDYH RU REWDLQ D
knowledge of the business sufficient to enable the auditor to identify and understand the
HYHQWV WUDQVDFWLRQV DQG SUDFWLFHV WKDW LQ WKH DXGLWRU·V MXGJHPHQW PD\ KDYH D VLJQLILFDQW
effect on the financial statements or on the examination or audit report.

The auditor should ensure that assistants assigned to an audit engagement obtain sufficient
NQRZOHGJHRIWKHEXVLQHVVWRHQDEOHWKHPWRFDUU\RXWWKHDXGLWZRUNGHOHJDWHGWRWKHPµ

In the first audit the necessary information m ust be collected before planning can commence.
A starting point is to consider in broad term s the industry in which the business operates. The
following matters should be noted:

¨ typical kinds of business within the industry (eg, large international);

¨ the broad functions involved (eg, manufacturing, distribution, wholesaling);
¨ any particular features of the business important to management (eg, long-term contracts);
¨ typical sources of income (eg, room lettings in a hotel);
¨ typical kinds of expenditure (eg, food in a restaurant);
¨ the kinds of records kept (eg, day books, registers); and
¨ management's information needs.

Such information is vital if the auditor is to discuss the industry, its problems and solutions
with management in a credible manner. Being well informed makes it easier to become better
informed.

Types of information required about a new client

Business Personal
Size and nature Names of key contacts
Locations Qualifications and background
Product range Experience and competence
Customers and suppliers Responsibilities
Competitors Staff turnover
Organisation structure Industrial relations
Brochures and tariffs
Sources of finance
Bankers

Accounting Audit administration

Prior year financial statements Legal documents
Location of accounts department Legal advisors
Accounting system (computerised?) Client schedules and working papers
Management or interim accounts Timetable
Budgets Internal audit
Terms of loan agreements Inventory counts
Branch visits

2.3 ISA 250±&RQVLGHUDWLRQRIODZVDQGUHJXODWLRQV

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 Chapter 5 Planning

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results thereof, the auditor should recognise that non-compliance by the entity with laws
DQGUHJXODWLRQVPD\PDWHULDOO\DIIHFWWKHILQDQFLDOVWDWHPHQWVµ

,W LV QRW WKH DXGLWRUV· UROH WR SUHYHQW QRQFRPSOLDQFH ZLWK ODZV RU UHJXODWLRQV  + RZHYHU WKH
auditor usually reports explicitly in his audit report on w hether the applicable statutory
framework is com plied with, and any non-compliance m ight create a material liability that
should be provided in the accounts.

2.4 Client liaison

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client w ill obviously wish to avoid audit visits at critical times of the year (eg when quarterly
accounts are being prepared). The auditor should consult with his client in order to ascertain
important dates as follows:

¨ the date to which accounts are to be made up for the period under review;
¨ the date by which final accounts will be prepared together w ith supporting schedules;
¨ the date on w hich the directors intend to meet in order to approve the financial statements;
¨ the date of the AGM w hen audited accounts must be laid before the mem bers;
¨ the date by which accounts m ust be filed at the Companies Registry.

2.5 Time and fee budgets

The auditor should aim to provide his client with an efficient and cost effective service.
Budgetary planning is an im portant part of the overall audit plan in order to ensure that:

¨ the work is completed efficiently;

¨ the costs of carrying out the audit are monitored;
¨ WKHFOLHQW·VIHHFDQEHQHJRWLDWHGRQDUHDVRQDEOHEDVLVDQG
¨ forward planning for staff requirements is facilitated.

2.6 Staffing
The audit budget w ill also assist the auditor to determ ine the manpower requirements. It is
LPSRUWDQW WR VHOHFW WKH ULJKW ´P L[µ RI VNLOOV VR WKDW WKH DXGLW ZRUN LV FRPSHWHQWO\ SHUIRUPHG
Other factors to consider include:

¨ VWDIIPHPEHUV·SULRUH[SHULHQFHRIWKHFOLHQWDQG
¨ personal qualities of staff (eg, potential personality clashes w ith client or other audit staff).

2.7 The planning meeting

Once staff have been selected they should be briefed at a planning meeting. The matters
discussed at the meeting must be documented in the form of a minute and should cover the
following:

¨ any special features that may be encountered on the audit; and

¨ the general instructions to staff on their responsibilities.

2.8 Timing of audit visits

The tim ing of the audit visits varies according to the type of enterprise.

W hen dealing w ith a large public company audit there is a need to ensure that the w ork is so
spread that undue pressure is not placed upon the auditor in the critical period between the
GDWHRIWKHEDODQFHVKHHWDQGWKHGDWHRIWKHGLUHFWRUV·PHHWLQJWRILQDOLVHWKHDFFRXQWV,QVWHDG
work will be spread over the period prior to the balance sheet date as follows.

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First interim visit

The purpose of this visit is to:

¨ review accounting systems;

¨ document any new system s or changes that have occurred;
¨ ascertain and evaluate internal controls using standard checklists, questionnaires etc; and
¨ FRQILUPWKHV\VWHPE\PHDQVRI´ZDONWKURXJKµWHVWVRQRQHRUWZRWUDQVDFWLRQV

Second interim visit

The purpose of this visit is to:

¨ test processing systems of the major transaction cycles of purchases, sales and payroll to
ensure that the controls are sound;

¨ test the records (on the basis of the above) in order to form an opinion as to w hether the
processing is accurate and the records are reliable.

Year-end inventory count

The objective of attending is to w itness the physical ascertainment of inventories.

Final audit visit

After the balance sheet date the auditor can devote himself to verifying assets and liabilities
and carrying out a review of the financial statements so as to be in a position to sign the
DXGLWRUV·UHSRUW

It is comm on, however, to find that the audits of small companies (whose control systems are
limited) are performed in a single phase commencing after the balance sheet date.

2.9 Audit planning memorandum

¨ Introduction

M ost audit firm s prepare an audit planning memorandum (a work plan) w hich sets out factors
to be taken into account, the methods by which the audit objectives will be achieved and the
organisational matters w hich need to be considered.

¨ Typical contents

Terms of the engagement

The work to be done ie, audit work, accounting work to be done for the client, tax work, letters
to be sent. This section will summarise the reports required and client expectations.
The client and its background
History, products, locations, especially noting factors such as a new managing director, a new
computer system, a new product.
Important figures and ratios
)URP SUHYLRXV \HDUV· DXGLW Z RUNLQJ SDSHUV DQG LI DYDLODEOH IURP PDQDJHPHQW DQG GUDIW
accounts.
Audit risk areas
These might include inventories and construction contracts or the requirement for involvement
of specialists.
Preliminary estimate of materiality

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 Chapter 5 Planning

Each member of the audit team should be concerned to identify all potential material
misstatements, so an initial materiality level should be identified.
Deadlines for com pletion
The audit work must be com pleted by the date that the accounts are due to be presented to the
members in general meeting.
Feedback on important issues to engagement partner
It is the audit engagement partner w ho will sign the audit report, so he must be aware of all
important issues for this audit.

2.10 ,6$±&RQVLGHULQJWKHZRUNRILQWHUQDODXGLWLQJ
Internal audit is an element of the internal control system established by management. The
extent to which the external auditor is able to take account of the w ork of the internal auditor
will depend on his assessment of the effectiveness of the internal audit function. In making this
assessment, the external auditor w ill be concerned w ith the follow ing factors.

¨ The degree of independence of the internal auditor from those whose responsibilities he is
reviewing.

¨ The number of suitably qualified and experienced staff employed in the internal audit
function.

¨ The scope, extent, direction and tim ing of the tests carried out by the internal auditor.

¨ The evidence available of the w ork done by the internal auditor and of the review of that
work.

¨ The extent to which management takes action based upon the reports of the internal audit
function.

Provided that relevant internal audit work has been carried out effectively, the external auditor
may be able to reduce the level of his ow n tests.

2.11 ISA 620±8VLQJWKHZRUNRIDQH[SHUW

An expert is a person or firm possessing special skills, knowledge and experience in a field
other than accounting and auditing.

Auditors have a general knowledge of business but are not expected to have the expertise of
other professions, such as those shown below.

Experts Area of expertise

Chartered surveyors Property valuations and long term contract WIP
Inventory counters and valuers Specialist inventories or assets (eg, jewellery, public houses)
Lawyers Statute/litigation
Actuaries Pension costs
Geologists Mineral reserves

The need for the auditor to seek expert evidence will depend upon:

¨ the importance of the matter to the financial statements (ie, the materiality).
¨ the risk of misstatements and the complexity of the matter.
¨ the quantity and quality of other evidence.

If management is unable or unwilling to engage an expert, the auditors may consider:

¨ engaging an expert themselves; and

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¨ WKHLPSOLFDWLRQVIRUWKHLUUHSRUW²SHUKDSVDTXDOLILFDWLRQ

The auditor w ill need to assess the competence and objectivity of an expert by

¨ professional certification; and

¨ experience and reputation.

7KH DXGLWRU·V UHSRUW VKRXOG QRW UHIHU WR XVH RI DQ H[SHUW ,I DQ H[SHUW·V HYLGHQFH LV
unsatisfactory then qualification should be considered. If it is satisfactory, the auditor should
accept responsibility for it by not referring to the expert in his report.

3 Quality control of audits - ISA 220

3.1 Procedures
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ensure that all audits are conducted in accordance with ISAs or relevant national standards
RUSUDFWLFHVµ

¨ $XGLWHQJDJHPHQWSDUWQHUVVKRXOGUHYLHZWKHILUP·VLQGHSHQGHQFHDQQXDOO\

¨ W ork should be done by staff with suitable skill and experience.

¨ The audit partner should be in constant contact with team members, ensuring that
supervision is carried out by him self or his manager.

¨ The audit plan should be monitored by regular reports on work done so that the partner or
manager is alerted to any changes from the agreed sequence of tasks.

¨ The procedures for carrying out audit field w ork should be documented in a manual of
instruction and followed by audit staff.

¨ The work carried out by audit staff should be properly documented and reviewed by a
more senior person.

¨ Troublesome points should be brought to the attention of partners, and staff should be
sufficiently skilled to be alerted to unusual matters so that they are followed up.

¨ There should be written evidence that audit w ork has been reviewed.

3.2 Quality control reviews

In recent years there has been an increasing awareness of the need for quality control
procedures to ensure that:

¨ audit work is carried out to a high standard of proficiency; and

¨ the exposure to the risk of allegations of incompetence is minim ised.

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EHIRUHVLJQLQJWKHUHSRUW´&ROGµUHYLHZ VDUHGRQHDIWHUWKHUHSRUWLVVLJQHG

Review panel or department

A review panel or department may be charged with the task of review ing an audit file either
before the report is signed or after the audit has been completed. (Even partners make
mistakes or oversights!)

It is essential that the review panel:

¨ possesses the necessary technical expertise; and

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 Chapter 5 Planning

¨ is truly independent.

Second partner review

The file is examined by another member of the partnership who has had no dealings with the
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SUDFWLFH$QDQQXDOUHYLHZLVSDUWRI$&&$·VV\VWHPRISUDFWLFHUHJXODWLRQ

A second practitioner review (sometimes called a peer review) is more comm only carried out
in North America (often at the request of regulatory bodies) than in the UK.

However, certain UK firms have formed technical associations for the purpose of exchanging
expertise and peer reviews are therefore not unknow n.

4 Recording audit work

4.1 ISA 230±'RFXP HQWDWLRQ
¶'RFXPHQWDWLRQ· PHDQV WKH Z RUNLQJ SDSHUV SUHSDUHG E\ RU IRU RU REWDLQHG DQG UHWDLQHG E\
the auditor in connection with the performance of the audit. This topic is highly exam inable
since the working papers of every audit must be sufficient to support the audit opinion.

´7KH DXGLWRU VKRXOG GRFXPHQW PDWWHUV ZKLFK DUH LPSRUWDQW LQ SURYLGLQJ HYLGHQFH WR
support the audit opinion and evidence that the audit was carried out in accordance with
,6$Vµ

W orking papers may be in the form of data stored on paper, film, electronic media or other
PHGLD: RUNLQJSDSHUVVXSSRUWDP RQJVWRWKHUWKLQJVWKHVWDWHPHQWLQWKHDXGLWRUV·UHSRUWDV
WRWKHDXGLWRUV·FRPSOLDQFHRURWKHUZ LVHZLWKDXGLWLQJVWDQGDUGVDQGWKXVUHFRUGFRPSOLDQFH
with auditing standards to the extent that this is important in supporting their report.

W orking papers are the record of:

(a) the planning and performance of the audit;

(b) the supervision and review of the audit w ork; and

(c) the audit evidence resulting from the audit w ork perform ed which the auditors
consider necessary and on w hich they have relied to support their report.

´7KHDXGLWRUVKRXOGUHFRUGLQWKHZRUNLQJSDSHUVLQIRUPDWLRQRQSODQQLQJWKHDXGLWZRUN
the nature, timing and extent of the audit procedures performed, the results thereof, and the
FRQFOXVLRQVGUDZQIURPWKHDXGLWHYLGHQFHREWDLQHGµ

Auditors should record in their w orking papers their reasoning on all significant matters w hich
require the exercise of judgement, and their conclusions thereon.

4.2 Perm anent audit file

M atters of continuing importance affecting the company or the audit should be kept in a
separate file, suitably indexed. The typical contents are:

¨ &RSLHV RI WKH FRPSDQ\·V IRXQGLQJ GRFXPHQWV DQG RWKHU DSSURSULDWH VWDWXWRU\ RU OHJDO
regulations.
¨ Copies of other documents of continuing importance:
² the letter of engagement;
² minutes of important board or general meetings;
² mortgages and charges;
² title deeds of freehold and leasehold properties;
² trade agreements; and
² agreements for licences and royalties.

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¨ 'HVFULSWLRQVRIWKHQDWXUHDQGKLVWRU\RIWKHFOLHQW·VEXVLQHVVLWVORFDWLRQVDQGSURGXFWV
¨ Organisation charts, w ith extra details for the finance department.

¨ A list of the main accounting records, showing w here they are kept and of w hat type (eg,
handwritten, mechanised or com puterised).
¨ Copies of previous financial statements.

¨ Copies of previous reports to management (reports from auditors to the client detailing the
weaknesses found in the accounting system).
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¨ $OLVWRIWKHFOLHQW·VRWKHUSURIHVVLRQDODGYLVRUV
¨ 'HWDLOVRIWKHFOLHQW·VLQVXUDQFHFRYHU
¨ Tables of significant ratios.
¨ Descriptions of accounting system s in flow chart and narrative form.
¨ Internal control evaluation data: questionnaires and checklists.
¨ Details of principal accounting policies.
¨ Accounts com pletion checklist.

4.3 Current audit file

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The typical contents are:

¨ A copy of the accounts or statements on w hich the auditors are reporting, authenticated by
GLUHFWRUV·VLJQDWXUHVRURWKHUZLVH
¨ An index covering all the working papers.
¨ A schedule for each item in the balance sheet, preferably including comparative figures,
showing its make-up and how existence, ownership and value or liability have been
verified. These schedules should be cross-referenced to documents arising from external
verification such as bank letters and the results of circularisation of accounts receivable and
attendance at physical inventory counts.
¨ A schedule supporting each item in the income statement, preferably including
comparative figures, and such other items in the trading or subsidiary accounts as may be
necessary.
¨ A checklist concerning compliance with statutory disclosure provisions.
¨ A record show ing queries raised during the audit and their clearance, with notes where
appropriate for attention the following year. Queries not cleared at the time should be
entered on to a further schedule for the attention of the person reviewing the audit and for
reference to the client if necessary. M aterial queries which cannot be settled satisfactorily
E\LP PHGLDWHUHIHUHQFHWRWKHFOLHQWPD\UHTXLUHDTXDOLILFDWLRQRIWKHDXGLWRU·VUHSRUWDQG
should be fully documented and supported by a note of all discussions with the client and
any explanations given.
¨ A record of extracts of minutes of meetings of the directors and shareholders. These
VKRXOGEHFURVVUHIHUHQFHGZ KHUHUHOHYDQWWRWKHDXGLWRUV·Z RUNLQJVFKHGXOHV
¨ Copies of letters to the client setting out any material weaknesses or matters w ith w hich
the auditors are dissatisfied in respect of the accounts or control procedures. Such letters
should be sent even where the particular matter has been discussed informally with one or
PRUHRIWKHFRPSDQ\·VRIILFLDOV
¨ Letters of representation (ie, written confirmation by the client of the information and
opinions expressed in respect of certain matters such as inventory values and amounts of
current and contingent liabilities).

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 Chapter 5 Planning

¨ Job administration data which includes:

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²GDWHVZKHQSKDVHVRIDXGLWZHUHFRPSOHWHG
²WLPHVXP PDULHVRIZ RUNFDUULHGRXWE\WKHDXGLWVWDII
²GHWDLOVRISHUIRUPDQFHP RQLWRUHGDJDLQVWEXGJHW
¨ W orking papers created to show the results of tests and evaluation of systems, records of
control weakness and the action taken.
¨ Schedules show ing the result of audit tests carried out on transactions and balances. An
important aspect of the current file is careful indexing and cross-referencing between items
in the accounts and items in the schedules so that the collected w orking papers
demonstrate that there is a sufficiency of audit evidence.
¨ The completed audit programme.

4.4 Ownership and custody of working papers

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safe custody of the working papers and for retaining them for a period sufficient to meet the
needs of the practice and in accordance with legal and professional requirements of record
UHWHQWLRQµ

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capacity and for his own use. Their safe custody is important and it is prudent to retain
working papers for at least six years.

However, papers received or created by an accountant acting in the capacity of an agent are the
SURSHUW\RIWKHFOLHQW7KHPRVWFRPP RQH[DPSOHRISDSHUV¶EHORQJLQJ·WRWKHFOLHQWLVWD[DWLRQ
correspondence.

5 Audit risk
5.1 ISA 400±5LVNDVVHVVP HQWVDQGLQWHUQDOFRQWURO
The end-product of auditing is the expression of opinion on the financial statements of an
enterprise. It is therefore not a risk-free activity. Audit risk is defined as the risk that the
auditor may give an inappropriate opinion on financial statements.

For example, the auditor may issue a qualified opinion w here, in fact, an unqualified opinion
was appropriate, or vice versa (which is highlighted more frequently in litigation).

Some firms quantify their overall acceptable level of audit risk as a matter of practice policy
and as the basis for mathematical derivation of sample sizes. An acceptable level of audit risk,
as a rough guide, is 5%. In other w ords, m ost firms w ould be satisfied with a level of audit
work that leaves them exposed to only a 5% risk of getting it wrong.

ISA 400 explains that audit risk has three component risks:

¨ Inherent risk (IR)

¨ Control risk (CR)
¨ Detection risk (DR)
AR

IR CR DR

75
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5.2 Inherent risk

This risk derives from the characteristics of the company to be audited, or the circum stances of
the audit.

¨ A company which operates in a high technology industry could be regarded as risky owing
to the impact of specialist technical advances on inventory values and trading base.
¨ A new clientFRXOGEHSHUFHLYHGDVKLJKULVNRZ LQJWRWKHDXGLWRU·VODFNRIH[SHULHQFHRIWKH
company and its management.
¨ An audit performed to a tight reporting deadline does not have the same reliance on
hindsight (in the form of exam ining post balance sheet events) to confirm the balance sheet
position, and is therefore risky.

Here are some of the factors that may affect the level of inherent risk.

¨ Doubts about the integrity, competence or experience of management.

¨ The history of accounting errors.
¨ Possible management bias. This might arise because of profit-related pay, tight reporting
deadlines, market expectations, possible business failure, or borrowing comm itments.
¨ The level of competition.
¨ The possibility of being taken over.
¨ Complex transactions undertaken.
¨ Cash-based businesses.
¨ Portable, high-value inventory items (eg, jewellery).
¨ Loss of key management staff.
¨ M ajor litigation.
¨ Frequent changes in auditors or advisors.

The level of inherent risk is usually assessed as high, medium or low by way of a questionnaire
ZKHUHWKHDQVZHU´<HVµWRDTXHVWLRQLQGLFDWHVDKLJKOHYHORILQKHUHQWULVN

5.3 Control risk

Control risk can be defined as the risk that material misstatement could occur and not be
prevented, or detected on a timely basis, by the accounting and internal control system s.

Here are some factors influencing the level of control risk:

¨ The history of errors found by the auditor.

¨ M anagement attitude and dominance.
¨ Inexperienced or incompetent staff.
¨ Lack of segregation of duties or inadequate supervision.
¨ The size of the entity and its accounting system s.

Control risk is usually measured in the same way as inherent risk (high, medium or low). It too
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risk.

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´1RµDQVZHUZ RXOGLQGLFDWHDKLJKOHYHORIFRQWUROULVN

5.4 Detection risk

76
 Chapter 5 Planning

'HWHFWLRQ ULVN LV WKH ULVN WKDW WKH DXGLWRU·V VXEVWDQWLYH SURFHGXUHV WHVWV RI GHWDLO RQ
transactions and balances, or analytical procedures) do not detect a material misstatement. This
could be due to the inappropriate nature, extent or tim ing of audit procedures.

5.5 The audit risk model

Inherent risk and control risk exist independently of the audit and must be assessed by the
auditor in order that detection risk (which isXQGHUWKHDXGLWRU·VFRQWUROFDQEH´PDQDJHGµWR
achieve an acceptable level of overall (ie, audit) risk. The audit risk m odel is illustrated below.

Audit risk = Inherent risk ´ Control risk ´ Detection risk

(AR) (IR) (CR) (DR)

(Ultimate risk) Auditor manages or manipulates to

achieve acceptable audit risk
Auditor assesses
(they exist independently of audit)

W here inherent risk and control risk together are high, detection risk m ust be m inim ised
(rendered low) by the audit procedures performed. The auditor can respond by varying the
nature, extent and timing of audit w ork, as illustrated below.

Methods of varying detection risk Examples where inherent/control risk are high

Change the nature of audit work Obtain third party confirmation in preference to relying
on internal documentation.

Use experienced staff 8VH DXGLW VWDII ZKR DUH IDPLOLDU ZLWK WKH FOLHQW·V ULVN
profile.

Change the extent of audit work Submit more items to scrutiny in audit testing.

Change the timing of audit work Perform a circularisation closer to the year end rather than
at the interim audit.

The process of risk management can be compared to a see-saw with AR as the point of balance.

IR
CR high

DR low
AR

DR high

CR
IR low

AR

77
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Two broad categories of audit test will be referred to in this chapter and throughout the rest of
the text.

¨ Substantive tests (tests of detail). These are tests that apply directly to figures found in the
financial statements (eg, tests to determine whether the balance sheet figure for receivables
or the income statement figure for payroll costs is correctly stated). Analytical review,
discussed in a later chapter, is also a form of substantive test.

¨ Compliance tests (tests of control). These tests are less direct, in that they are not related
specifically to a particular figure in the financial statements. Their aim is to establish how
well the accounting control systems have functioned during the period under review. If
they appear to have functioned well, the auditor gains indirect reassurance about the
reliability of the accounting figures and may reduce the level of his substantive testing
accordingly.

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but the older terms (substantive tests and compliance tests) are still widely used.

5.6 Possible approaches to audit and review work

7KH ROGIDVKLRQHG DSSURDFK WR DXGLW Z RUN LV D VRFDOOHG ´SURFHGXUDOµ DSSURDFK  7KH DXGLWRU
turns up at his client and works his way through a standard set of audit procedures, carrying
out checklists of tests until he believes he has enough audit evidence on which to base an audit
opinion.

The pressure on the time and cost of audits means that a procedural approach is no longer
appropriate in the typical audit. Instead a risk-based approach to audit has been developed.

Before starting his detailed audit testing, the auditor conducts a risk analysis of the audit and
the client, identifying the control risk and inherent risk. Immaterial sections of the business can
be ignored, and the level of auditing on the remaining sections is tailored to the perceived risks
involved. The risk-based approach to auditing offers the prospect of reaching an audit opinion
having spent fewer hours on the audit. Those hours that are used on the audit are used m ore
productively.

6 Audit materiality±,6$
6.1 Introduction
M ateriality can be described as an expression of relative significance or im portance of a matter
in the context of the financial statements as a whole. A matter is material if its omission or
misstatement would reasonably influence the econom ic decisions of users taken on the basis of
the financial statements.

M ateriality is not capable of general mathematical definition as it has both qualitative and
quantitative aspects. The idea of materiality is closely associated with that of tolerable error,
the maximum error that the auditor is w illing to accept in an account balance.

6.2 Considerations relating to materiality

A fundamental consideration is the size of the items in question. This is a relative concept and
can be looked at in tw o contexts.

78
 Chapter 5 Planning

¨ In a particular context by comparing the item to that category as a whole eg, an inventory
error of $50,000 compared to the value of inventory as a w hole of $650,000.

¨ In a general context by looking at the item in relation to the financial statements as a whole
eg, in comparison to sales revenue, profit before tax, total net assets, or reserves.

Another important consideration is the nature of the item. Certain item s in the accounts are
FDSDEOH RI SUHFLVH GHWHUPLQDWLRQ HJ GLUHFWRUV· HP ROXP HQWV DQG VKDUH FDSLWDO $Q\ HUURU
(however small) in respect of these items should be considered material and adjusted.

For items w hich are not capable of precise determination (eg, allowances for doubtful debts
and contingent liabilities) some degree of latitude is acceptable.

Finally, the auditor should also consider the likely influence on the user.

7KH GHILQLWLRQ RI PDWHULDOLW\ LV ´XVHURULHQWHGµ 7KH DXGLWRU LV UHSRUWLQJ WR WKH VKDUHKROGHUV
who are of primary importance w hen setting materiality levels.

Different users base their assessment of materiality on different criteria. For example, a bank
FRQVLGHULQJDORDQDSSOLFDWLRQZ LOOFRQVLGHUPDWWHUVWREHPDWHULDOLIWKH\DIIHFWWKHFRPSDQ\·V
profit before interest (because this affects interest cover), and net assets (because this affects
solvency and security).

6.3 The calculation of materiality

M ateriality is not based purely around a mathematical form ula. It cannot be calculated exactly
because materiality is based largely upon judgement.

Certain percentages can be used as a guide for materiality levels.

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²RIWRWDODVVHWV
²RISURILWEHIRUHWD[

+RZHYHU LWHPV Z KLFK DUH OHJDOO\ SUHVFULEHG FDQQRW EH PHDVXUHG LQ WKLV PDWWHU  'LUHFWRUV·
loans, for example, must be disclosed if they are required by statute even if they are immaterial
in percentage terms.

6.4 ,6$±$XGLWPDWHULDOLW\
The standard does not attempt to suggest how materiality can be determined. It is therefore
left to the individual firm to set its own guidelines on how audit staff should evaluate errors
and distortions. The following key points are made.

´7KH DXGLWRU VKRXOG FRQVLGHU PDWHULDOLW\ DQG LWV UHODWLRQVKLS ZLWK DXGLW ULVN ZKHQ
conducting an audit.

M ateriality should be considered by the auditor when:

(a) determining the nature, timing and extent of audit procedures; and
(b) evaluating the effect of misstatements.

In evaluating the fair presentation of the financial statements, the auditor should assess
whether the aggregate of uncorrected misstatements that have been identified during the
DXGLWLVPDWHULDOµ

6.5 Evaluation of misstatements

79
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A typical approach to error evaluation is to create a working paper w hich records the errors
found and their impact on the financial statements. This is illustrated in a specimen working
paper.

Doolittle and Ticket

CHARTERED CERTIFIED ACCOUNTANTS
CLIENT:
PERIOD ENDED:
STATEMENT OF ERRORS AND CUMULATIVE EFFECT
ITEM ERROR Net profit Net profit Net assets Net assets
+ - + -

TOTAL

Conclusion
I have reviewed the above and enquired into the errors and in my opinion the above is
material/not material to the financial statements.
I have noted these errors for the management letter which will be sent out on or about xx/xx/xx.
A Manager

7 Using IT to automate planning and recording

7.1 Introduction
The widespread use of personal computers has led to their use in automation of audit work.
Audit planning can be automated by the use of models that enable the auditor to carry out
various computational or statistical routines with speed and accuracy. Examples of these are
given below.

Z-scores

This model developed by Taffler and others is used to predict the risk of corporate failure.
Accounting items such as balance sheet and income statement data are input into the program
and various ratios are calculated. Specific constants or weights then combine these ratios in
order to compute the Z score.

Risk assessment

W e have seen the components of audit risk earlier in this chapter:

AR = IR ´ CR ´ DR

where AR = Audit Risk, IR = Inherent Risk, CR = Control Risk and DR = Detection Risk.

Clearly the risk assessment is fundamental to your audit strategy and the level of testing you
will employ.

7.2 Example software package

80
 Chapter 5 Planning

Auditplus is a software package that documents the process for you but does depend on the
skill and experience of the user. A brief account of how it works is reproduced from the Aud IT
magazine.

Auditplus assists in planning, controlling and recording audits in compliance with auditing
standards, by facilitating the production of a well documented audit file. It is important to
note, however, that the program does not replace the need for knowledge and experience on
the part of the user.

The program has been designed to require the input of only the m ost basic data, and Yes/No
responses, and can thus be used even by those with limited computer experience. From the
data input, the program com putes materiality levels and sample sizes for transactions testing,
and then prints a custom ised audit programme and planning memorandum for each client
company.

Auditplus will run on any W indows type IBM -compatible hard disk PC, using either mono or
colour display.

Before starting to input data, a certain amount of client knowledge is needed, as follows:

- Company name and year end.

- Has the nominal ledger been prepared by the client? (Or are accounts produced from
sum maries and an extended trial balance?)
- Does the company have any inventory and work in process?
- Does the company hold any investments?
- Does the company have any subsidiaries or associated companies?
- Actual or estimated sales revenue for the year, net of attributable sales tax.
- Actual or estimated profit/loss before tax. (If planning is being carried out before any
accounts are available, this figure will have to be based on the prior year, as adjusted
for any identifiable variances.)
- Actual or estimated gross assets.

The answers to these questions are used to decide whether certain sections of the audit
program me are required. The information should be easily obtainable by reference to previous
files and/or client contact. For the small practitioner the information required above may be
considerably m ore than is usually available before audit work is commenced. This implies that
audit planning may have been insufficient in the past.

The main menu offers a choice of:

- Audit Processing
- File M anagement
- Print Results
- Terminate Program

&KRRVLQJ´$XGLW3URFHVVLQJµEULQJVXSWKHQH[WVFUHHQZKLFKRIIHUVDFKRLFHRI

- Company Details
- Control Risk Assessment
- Compliance Test Results
- Inherent Risk Assessment
- M ateriality
- M ain M enu

´&RPSDQ\ 'HWDLOVµ LQYROYHV LQSXWWLQJ WKH EDVLF GDWD UHIHUUHG WR DERYH  7KH VFUHHQ ZLOO WKHQ
display the overall Planning M ateriality. It is possible to manually reduce materiality levels for
any audit area, though no changes should be made until the risk assessment is complete.

81
$&&$3DSHU)7H[W²$XGLWDQG$VVXDUDQFH,QWHUQDWLRQDO

Auditplus will not accept a higher materiality figure, in view of the increased risk of form ing
an incorrect audit opinion.

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FOLHQW·V V\VWHPV RI FRQWURO LQ GHYLVLQJ DQG H[HFXWLQJ KLV WHVWV  ,W ZLOO UDUHO\ EH XVHG RQ VPDOO
audits.

7KH ´,QKHUHQW 5LVN $VVHVVPHQWµ VHFWLRQ FRPSULVHV D VHULHV RI TXHVWLRQV GHVLJQHG WR LGHQWLI\
the inherent risk of the company as a whole and also of each balance sheet or incom e statement
area individually.

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- Save a file
- Load a file
- Delete a file
- Copy a file

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typed planning mem orandum for the audit file.

The planning mem orandum should be printed first, so that the auditor can check the input and
ensure everything is correct.

In addition to the planning mem orandum and audit programme, Auditplus incorporates
various checklists and completion records. These all indicate the level of staff seniority
required for completion.

7.3 Audit programm es

The PCAS (Private Company Audit System) is an example of an audit system allowing the
auditor to tailor an audit approach by a systematic collection of background information. The
PCAS system produces standard working papers and audit work program mes as part of an
effective and economic approach to audit planning.

7.4 The use of microcomputers in the audit

The growth of affordable small com puters has led auditors to devise ways of im proving their
techniques in audit automation. A cost-effective technique uses spreadsheet software to
process w orking papers from a PC-based package such as Sage. It is possible to convert the
FOLHQW·VFRP SXWHULVHGGDWDLQWRDQHXWUDOIRUPDWVRWKDWLWFDQEHLPSRUWHGLQWRDVSUHDGVKHHWDV
WH[WDQGPDQLSXODWHGE\WKHDXGLWRU7KLVWHFKQLTXHLVFDOOHG´SDUVLQJµDQGLWLQYROYHVUHDGLQJ
data in a text format and then re-ordering it into rows and columns to provide a working paper
in either paper or electronic format. This prevents the auditor from having to manually
prepare schedules of data to be tested, thus saving time.
M any audit firms have moved in recent years to prepare their audit working papers on
notebook com puters rather than on handwritten sheets of paper. The advantages are greater
legibility and the possibility of transferring files sw iftly to a central reviewer (eg, using a
wireless LAN) rather than having to look after hundreds of sheets of paper.

8 $QDO\WLFDOSURFHGXUHV±,6$
The assessment of what is reasonable in the financial statements is done by analytical procedures
which is the study of ratios, trends and com parators.

Graphs and accounting ratios can be used to bring out the key features of accounting data. For
example, the quarterly sales for each of the three divisions of a business might be as follow s:

82
 Chapter 5 Planning

100
Sales
($000) 80

60 East
40 West

20 North

0
1st 2nd 3rd 4th
Qtr Qtr Qtr Qtr

Clearly the third quarter sales in the East division deserve a closer inspection.
Some of the key ratios used by auditors are as follows:
¨ Gross profit/sales
¨ PBIT/sales
¨ 'HEWVKDUHKROGHUV·IXQGV
¨ Inventory age in days
¨ Receivables age in days
¨ Current ratio
¨ Quick asset ratio
¨ Year by year % changes
The bar chart of quarterly divisional sales above could alternatively be shown as a graph as
below. This identifies the third quarter surge in Eastern sales even more clearly.

90

70
East
50
Sales ($000) West
30 North
10

-10 1 2 3 4 (Quarters)

The importance of the technique of analytical procedures in audit planning is affirmed by

ISA 520.

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RIWKHDXGLWµ

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(a) between items of financial data, or between items of financial and non-financial data,
deriving from the same period; or

(b) between comparable financial information deriving from different periods or different
entities.

to identify consistencies and predicted patterns or significant fluctuations and unexpected

relationships, and the results of investigations thereof.

The analytical procedures carried out are designed prim arily to assist in planning the audit and
as part of the evaluation of the financial statements. Analytical procedures may also be
performed as substantive procedures designed to obtain audit evidence directly.

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XQGHUVWDQGLQJWKHEXVLQHVVDQGLQLGHQWLI\LQJDUHDVRISRWHQWLDOULVNµ

83
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Analytical procedures at the planning stage are usually based on interim financial information,
budgets and management accounts. However, for those entities w ith less formal means of
controlling and monitoring performance, it may be possible to extract relevant financial
information from the accounting system (perhaps when preparing the draft financial
statements), and bank statements. Discussions with management, focused on identifying
significant changes in the business since the prior financial period, may also be useful.

$SSOLFDWLRQRIDQDO\WLFDOSURFHGXUHVPD\LQGLFDWHDVSHFWVRIWKHHQWLW\·VEXVLQHVVRIZKLFKWKH
auditors were previously unaware and assist in determining the nature, timing and extent of
other audit procedures.

Practice question 1 (The answer is in the final chapter of this book)

Arnold

Arnold Lim ited is a long-established family company w hich manufactures cosmetics. These are
sold to customers who package and market them under their own trade name. The company
has three manufacturing units in Hull, N orwich and Cardiff.

The company has recently undergone some management changes follow ing the death of its
elderly managing director. Gill Hadden, formerly the sales director, is the new managing
director. A new sales director from outside the company has been appointed.

The finance director and company accountant, Dick Patel, is 65 and has recently negotiated a
part-time contract of employment w ith the company. The com pany w ill appoint a full-tim e
accountant to replace Dick after the next financial year end.

Profits have declined in the last two years and the company is seeking to improve profitability
prior to a possible listing on the local Stock Exchange. An incentive scheme has recently been
implemented w ith the aim of improving productivity w ithin the company. Certain managers,
and all directors, will be paid a bonus based on production achieved above a predetermined
level.

You are the auditor of Arnold Limited and you are about to com mence planning for the audit.

84
 Chapter 5 Planning

Required

(a) Explain w hat is meant by the following term s.

(i) Audit risk

(ii) Inherent risk
(iii) Control risk
(iv) Detection risk (6 marks)

(b) List and explain the factors that you w ould consider when assessing the inherent risk
of the company. (10 marks)

(c) ([SODLQ KRZ DQ DXGLWRU·V DSSURDFK PLJKW EH DIIHFWHG LI KH FRQFOXGHV WKDW WKHUH LV D
high inherent risk. (4 marks)

7RWDO²PDUNV

Approach to the question

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define.

Look to the scenario for examples of the various types of risk. W herever possible illustrate
definitions using examples in the question. This will enable you to answer subsequent sections
of the question using the same illustrations.

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such as the recent managerial changes, gives you the first point for part (b).

3DUWEVD\V¶OLVWDQGH[SODLQ·VRPDNHVXUH\RXGRERWK2XWRIWKHDYDLODEOHPDUNVWKHVSOLW
between list and explain is probably 5:5 or 4:6 so you have to do both in order to gain a decent
mark.

Practice question 2 (The answer is in the final chapter of this book)

Norbert

Norbert Lim ited is a UK com pany based in Cornwall which designs and builds yachts. It also
has a small yard in Scotland w hich it purchased recently. M ost of the yachts are built to
customer specification. H owever, as trade has been slack recently, the company is building
some yachts without orders in the hope of obtaining buyers when the market picks up. M ost of
WKHFRPSDQ\·VRXWSXWLVIRUH[SRUWDQGLWTXRWHVLWVSULFHVLQ86GROODUV

You are asked to act as senior in charge of the audit. The com pany has a year end of 30
6HSWHPEHU,WLVDSSDUHQWIURPWKHSUHYLRXV\HDU·VDXGLWILOHWKDWWKHFRPSDQ\ KDVDOZD\V KDG
weak internal controls.

The company is currently amending its designs to take advantage of new technology and has
invested a considerable amount of time and m oney in this. Consequently it is heavily indebted
to the bank. The bank overdraft facility is to be reviewed in N ovember 20X8 and the managing
director wishes to ensure the continuing availability of the overdraft facility before attending a
major trade fair in late November 20X8.

Required

(a) Identify, from the situation outlined above, circumstances particular to Norbert
Limited that must be taken into account w hen planning the audit. (10 marks)

(b) Explain clearly w hy such factors must be taken into account. (10 marks)

85
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7RWDO²PDUNV

Approach to the question

You should not begin writing about audit risk and its com ponent parts without defining them.

Remember also that the question asks about general planning considerations. But the question
also restricts you to using the case scenario only. So take points from the question and discuss
WKHPZLWKUHIHUHQFHWR\RXUWHFKQLFDONQRZOHGJHUDWKHUWKDQWURWWLQJRXWWHQJHQHUDO´SODQQLQJ
FRQVLGHUDWLRQVµZLWKRXWUHODWLQJWKHPWRWKHTXHVWLRQ

9 $SSHQGL[±DXVHIXODUWLFOH
The article below was first published in the ACCA 6WXGHQWV· 1 HZVOHWWHU in October 1999 and is
reproduced here by kind permission of the ACCA, amended where necessary to reflect the
International Stream for this exam.

Inherent risk and the control environment

The purpose of this article is to clarify the role of inherent risk and the control environment in
determining the audit strategy in accordance w ith ISA 400 Risk Assessments and Internal Control.
The link between control procedures and the likelihood of errors in the accounting records is
reasonably direct and readily appreciated by students. Inherent risk and the control
environment have a less direct impact on the accuracy of the accounting records and their
significance is less apparent.

This article will exam ine the factors making up inherent risk and the control environment and
explain w hy they are important in determining audit strategy.

Inherent risk: W hat is it?

The ability to assess inherent risk improves the efficiency of the audit process. At an
elementary level, suppose we consider the control procedure requiring that invoice pricing be
independently checked. Such a procedure may either be present or not present. If it is not
present the auditors have to assume that every invoice could be mispriced and assess control
risk at 100%. Experience tells us otherwise. Even in the absence of an effective control it would
be unreasonably pessimistic to assume that every invoice will be mispriced. W e need to
consider other factors such as the com petence of the invoicing clerk, the com plexity of invoice
calculations, or incentives on the invoicing clerk to misprice invoices such as a bonus based on
invoice value. These are referred to collectively as inherent risk which is the susceptibility of
misstatements occurring in an account balance or transaction. W e may have reason to believe
that fewer than 20% of invoices are likely to be erroneously priced in the absence of a control
and assess inherent risk at 20%. Thus, the combined assessment of control risk at 100% and
inherent risk at 20% is 20%, significantly reducing the required level of detection risk.

Assessment of inherent risk is, at present, too imprecise to enable it to be applied to individual
control procedures. Present techniques enable auditors to form an overall assessment of
inherent risk at the entity level and a more specific assessment at the level of each account
balance or transaction class. Because of the imprecision of its assessment, auditors tend to be
fairly conservative, rarely assessing inherent risk at less than 50%. However, assessment is
rarely time consuming and can yield substantial savings through reducing the level of m ore
time consuming substantive procedures.

Inherent risk at the entity level

ISA 400 suggests the following examples of factors affecting inherent risk at an entity level.

1 Integrity of directors and management

2 M anagement experience
3 Unusual pressures on management

86
 Chapter 5 Planning

4 Nature of the business

5 Conditions w ithin the industry

$OWKRXJK UHIHUUHG WR DV WKH ´HQWLW\ OHYHOµ WKHVH IDFWRUV PD\ EH PRUH ORFDOLVHG VXFK DV WR D
division or other operating unit within the entity where local management has a considerable
degree of autonomy over accounting matters.

Integrity

Auditors need to be sensitive to the integrity of management and the possibility they may seek
to manipulate the financial reporting process.

Management experience

Inexperienced management may result in accounting errors such as a failure to make necessary
provisions or to make relatively complex calculations correctly such as on finance leases or
long-term contracts. This is particularly likely to happen with a change in management w ithin
the accounting and finance functions.

Unusual pressures

These can include a need to produce financial statements in a shorter than normal time period
or pressure to show improved results such as in anticipation of a public listing. The former
makes it more likely for m istakes to be made in preparing the financial statements w hile the
latter might induce managem ent to err unduly on the side of optimism. Auditors need to be
aware of any such factors that might currently affect an entity and revise their assessment of
inherent risk accordingly.

Nature of the business

From experience auditors are aware that certain types of business are prone to a higher
incidence of financial reporting irregularities. These include factors such as the complexity of
its contractual relationships with customers or suppliers, geographical spread and changing
technology.

Conditions within the industry

Occasionally an industry may be subject to a major upheaval. For example, in the UK, the
termination of duty free shopping at airports and on ferries is causing some turm oil in entities
associated with that trade. Other examples include the demutualisation of building societies
DQG LQVXUDQFH FRPSDQLHV WKH SULYDWLVDWLRQ RI IRUPHU VWDWH²RZ QHG HQWHUSULVHV DQG WKH LPSDFW
RQERRNDQGPXVLFUHWDLOLQJRIH²FRP PHUFH

Other

The above is not intended to be a comprehensive listing. Auditing firms have detailed
checklists to guide staff, during the planning phase, in identifying factors affecting inherent
risk.

Inherent risk at the entity level is pervasive and needs to be taken into consideration in
assessing inherent risk at the level of individual financial statement assertions.

Inherent risk at the account balance and transaction class level

ISA 400 suggests the following examples of factors affecting inherent risk at this level.

¨ Susceptibility to misstatement.
¨ Complexity.
¨ Degree of judgement involved.

87
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¨ Susceptibility of assets to loss or misappropriation.

¨ Unusual or complex transactions at or near the year end.
¨ Transactions not subjected to ordinary processing.

The sections below identify inherent risks typically associated with major account balances and
transactions classes.

Sales and cash receipt transactions and receivable balances

Factors that may affect sales and accounts receivable include the following.

¨ Pressure to overstate sales in order to report that announced sales or profitability targets
were achieved when, in fact, they were not. Such reporting includes the following.

- Recording fictitious sales.

- Holding the books open to record subsequent period sales in the current year
(improper cut-off).

¨ Pressure to overstate cash and receivables or understate the allowance for bad debts in
order to report a higher level of working capital in the face of liquidity problems or going
concern doubts.

Other factors that might contribute to the possibility of misstatements in sales and receivables
assertions include the follow ing.

¨ The volume of sales, cash receipts and sales adjustment transactions, resulting in numerous
opportunities for errors to occur.

¨ Contentious issues relating to the timing of revenue recognition, such as the effect of
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¨ Susceptibility to misappropriation of liquid assets generated by cash receipts.

¨ Use of sales adjustment transactions to conceal thefts of cash received from customers by
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as uncollectable.

Purchases and payroll transactions and payables balances

Pervasive factors that m ight m otivate management to m isstate expenditure include the
following.

¨ Pressures to understate expenses in order to report, falsely, the achievement of announced

profitability targets.

¨ Pressures to understate accounts payable in order to report a higher level of w orking

capital in the face of liquidity problems or going concern doubts.

These factors primarily affect the com pleteness assertion and reduce acceptable detection risk,
particularly in testing for understatement of liabilities.

Other factors that might contribute to misstatements include the following.

¨ The high volume of transactions, w hich affects all assertions.

¨ Temptations for employees to make unauthorised purchases and payments, or to

misappropriate purchased assets, relating to the existence or occurrence assertions.

¨ Contentious accounting issues, such as w hether a cost should be capitalised or expensed

(for example, the treatment of repairs and maintenance costs or the classification of a lease
as an operating or finance lease), which relate to the valuation assertion.

¨ Complexity of payroll computations for factory workers, whose gross earnings may be
based on time and/or productivity, affecting the measurement of payroll costs.

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Payroll fraud is a major concern for the auditors. It may occur at tw o levels. Employees
involved in preparing and paying the payroll may process data for fictitious employees or for
employees w hose services have already been term inated, and then divert the wages or pay
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occurrence assertion for payroll.

Inventories

There are numerous factors that contribute to the risk of misstatements in the assertions for
inventories; these include the following.

¨ The volume of purchase, manufacturing and sale transactions that affects these accounts is
generally high, increasing the opportunities for misstatements to occur.
¨ There are often contentious valuation issues such as the following.
- The identification, measurement, and allocation of indirect materials, labour and
manufacturing overhead.
- Joint product costs.
- The disposition of cost variances.
- Accounting for scrap and wastage.
¨ Special procedures are sometimes required to determine the quantity or value of inventory,
such as geometric volume measurements of piles of inventory using aerial photography,
and estimation of value by experts.
¨ Inventories are often stored at multiple sites, leading to difficulties in maintaining physical
control over theft and damage, and in accounting for goods in transit between sites.
¨ Inventories are vulnerable to spoilage, obsolescence, and general economic conditions that
may affect demand and saleability, and thus their valuation.
¨ Inventories may be sold subject to right of return and repurchase agreements.

As an asset, management has a greater incentive to overstate inventory than to understate it.
This may be achieved either by inflating the quantity or overstating its value. In planning the
audit, the auditors will be aware that inherent risks are greater with respect to the existence
and valuation assertions. There are numerous instances of such frauds discovered (and not
discovered) by auditors. Because of a lack of third party evidence, it is also often easier to
overstate inventories than assets such as cash or receivables. Inventory is also subject to theft
both by employees and outsiders. The depletion of inventory as a consequence of shoplifting is
well known.

Tangible non-current assets

There may be variations in the inherent risk assessments for non-current asset accounts in
different situations. For example, inherent risk for the existence assertion may be low in a
merchandising entity because the plant and machinery are not normally vulnerable to theft.
However, it may be moderate or high in a manufacturing entity because of the likelihood that
scrapped or retired machinery may not be written off in the books, or that small tools and
equipment used in production may be stolen. Similarly, inherent risk in valuation may be low
when equipment item s are purchased for cash, but high for item s acquired under finance
leases.

Cash

The high volume of cash and bank transactions contributes to a significant level of inherent risk
for cash balance assertions, particularly existence or occurrence and completeness. In addition,
the nature of cash balances makes them susceptible to theft, as numerous kinds of fraudulent
schemes involving cash have borne out. In contrast to receivables or inventories, how ever, the

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risks pertaining to the rights and obligations, valuation, and presentation and disclosure
assertions for cash are minimal ow ing to the absence of complexities involving these assertions.

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 Chapter 5 Planning

Assessment of inherent risk

Assessment of inherent risk is dependent on professional judgement to a greater extent, even,

than control risk. M oreover, recognising these risks, management frequently adopts extensive
internal controls to address them. Thus, the auditors need also to consider the extent to which
inherent risks are properly addressed by the internal control system. The auditors may find it
preferable to determine a combined assessment of the two risks in deciding on the appropriate
audit strategy.

Control environment

The control environment is defined by ISA 400 as the overall attitude, awareness and actions of
the directors and management regarding internal controls and their importance in the entity.
Readers familiar with the concept of general controls over a centralised computing department
can think of the control environment as having a similar pervasive effect over the accounting
system.

Numerous factors comprise the control environment. Am ong these are the following.

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- Integrity and ethical values.

- Com mitment to competence.

¨ Organisational structure and assignment of authority and responsibility.

¨ M ethods of imposing control including the following.

- Boards of directors and audit com mittee.

- Internal audit.
- Personnel policies and practices.

These factors are discussed in the sections that follow.

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have an impact on the control environment include the follow ing.

¨ Approach to the taking and m onitoring of business risks.

¨ Reliance on informal face-to-face contacts w ith key managers versus a formal system of
written policies, performance indicators and exception reports.

¨ Attitudes and actions towards financial reporting.

¨ Conservative or aggressive selection of accounting principles from available alternatives.

¨ Conscientiousness and conservatism in developing accounting estimates.

¨ Attitudes towards information processing and accounting functions and personnel.

The last four characteristics are of particular significance in assessing the control environment
over financial reporting.

Integrity and ethical values

In order to em phasise the im portance of integrity and ethical values am ongst all personnel of
an organisation, the chief executive officer and other members of top management should
apply the follow ing principles.

¨ Set the tone by example, by dem onstrating integrity and practising ethical behaviour.

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¨ Com municate to all employees that the same behaviour is expected of them, that each
employee has a responsibility to report know n or suspected violations to a higher level in
the organisation, and that violations will result in penalties.

¨ Reduce incentives and temptations that m ight lead individuals to engage in dishonest,
illegal or unethical acts. Incentives for undesirable behaviour include placing undue
emphasis on short term results or on meeting unrealistic performance targets, and offering
bonus and profit-sharing plans that, in the absence of necessary controls, might encourage
fraudulent financial reporting practices. Examples of temptations include the absence of
factors regarded as essential for a good control environm ent eg, the board of directors may
be ineffective, or there may be a lack of clarity in the assignment of authority and
responsibility.

Commitment to competence

Personnel at every level in the organisation must possess the knowledge and skills needed to
perform their jobs effectively. Commitment to competence includes consideration of both the
knowledge and skills needed, and the mix of intelligence, training and experience required to
develop that competence. For example, meeting financial reporting objectives in a large
publicly held company generally requires higher levels of competence on the part of chief
financial officers and accounting personnel than would be the case for a small privately held
company.

Organisational structure

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DQ RYHUDOO IUDPHZRUN IRU SODQQLQJ H[HFXWLQJ FRQWUROOLQJ DQG PRQLWRULQJ WKH HQWLW\·V
activities. Developing an organisational structure for an entity involves determining the key
areas of authority and responsibility and appropriate lines of reporting.

The assignment of authority and responsibility is an extension of the development of an

organisational structure. It includes the particulars of how and to whom authority and
responsibility are assigned, and should enable each individual to know the following.

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¨ For w hat he or she will be held accountable.

Segregation of duties and supervisory controls could be listed as falling within this aspect of
the control environment. In practice auditors assess these factors as part of each separate
accounting system.

M ethods of imposing control

The composition of the board of directors and the audit committee and the manner in which
they exercise their governance and oversight responsibilities have a major impact on the
control environment. Factors include the following.

¨ Proportion of outside directors and the establishment of an audit comm ittee.

¨ Experience and stature of their members.
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¨ Degree to w hich they raise and pursue difficult questions w ith management.
¨ Nature and extent of their interaction w ith internal and external auditors.

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Internal audit

Establishment of an internal audit function strengthens the control environment. To be

effective, internal audit personnel need the following.

¨ To be sufficiently skilled.

¨ To possess integrity.

¨ To have appropriate access to the board of directors and the audit comm ittee, and to the
external auditors.

Personnel policies and practices

A fundamental concept of internal control is that it is effected or implemented by people. For

the accounting and internal control systems to be effective, human resource policies and
practices must ensure that entity personnel possess the expected integrity, ethical values and
competence. Such practices include the following.

¨ Developing appropriate recruiting policies.

¨ Screening prospective employees.

¨ Developing training policies that communicate prospective roles and responsibilities.

¨ Exercising disciplinary action for violations of expected behaviour.

¨ Evaluating, counselling and promoting people based on periodic performance appraisals.

¨ Implementing compensation programmes that motivate and reward superior performance

while avoiding disincentives to ethical behaviour.

Control environment and the auditor

It is a requirement of ISA 400 that auditors obtain an understanding of the accounting system
and control environment sufficient to determ ine their audit approach. Procedures for obtaining
and documenting the understanding of the accounting system, such as flowcharting and walk
through tests, are well developed. Like inherent risk, identifying and evaluating the control
environment requires a much higher degree of professional judgement on the part of the
auditor. Auditing firm s have developed checklists to assist staff but these need to be
supplemented by an appraisal by an experienced staff member.

The control environment is the gateway to assessing control risk. No matter how effective the
accounting system and control procedures m ight appear in minim ising the extent of
misstatements, the assessment of control risk must always include consideration of the control
environment. If management is indifferent to the importance of controls then, no matter how
effective the system might appear to be, control risk must be assessed as higher than in an
identical system where the control environment is strong.

Conclusion

ISA 400 rightly stresses the importance of assessing inherent risk and the control environment.
As yet, techniques for their evaluation are less well developed than techniques applicable to
understanding and assessing the accounting system and control procedures. On occasions this
leads to their being overlooked with adverse consequences for both the effectiveness and
efficiency of the audit.

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10 Summary
An auditor m ust plan his work so that it is effective and carried out as quickly as possible.
M ost firms prepare an audit planning memorandum in a standard format, before the audit
starts, to ensure that the planning is structured.

A key part of audit planning is the management of audit risk. The three components of audit
risk are inherent risk, control risk and detection risk. If an acceptable level of overall audit risk
is 5%, and the levels of inherent risk and control risk for an audit assignment are estimated,
detection risk emerges as the balancing figure in

AR = IR ´ CR ´ DR

The extent of necessary audit procedures is then tailored to meet the required detection risk.

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