PLANNING AN AUDIT OF
FINANCIAL STATEMENTS
BY: Swedi Zakaria
5.1. Introduction
Planning is an essential part of
any function, managerial or otherwise, auditing being no exception. Planning an
audit of financial statements is done under the provisions of ISA 300. The
purpose of ISA 300 is to establish standards and provide guidance on the
considerations and activities applicable to planning an audit of financial
statements. ISA 300 gives guidance for planning of recurring audits as well as
laying down matters the auditor should consider in initial audit engagements.
The requirement of the ISA 300 is clear, that “The auditor should plan the audit so that
the engagement will be performed in an effective manner”.
Planning an audit
involves:
i]
establishing the overall audit strategy for the
engagement, and
ii]
developing an audit plan
All these are done in order to
reduce audit risk to an acceptably low level, as is clear in the above ISA 300
requirement.
Audit planning is a three-step iterative process undertaken
by the auditor, and evaluated by the audit committee, each audit cycle. Audit
planning, as defined in International Standards on Auditing (ISA) No. 300,
includes:
1. Obtaining an understanding of the
entity, its environment and its internal control system; 2. Assessing
the risk of material misstatement in the financial statements; and
3. Designing audit procedures commensurate
with the assessed level of risk.
5.2. Benefits of Adequate audit planning Adequate planning helps
to ensure that:
i]
Appropriate attention is devoted to important areas of
the audit,
ii]
Potential problems are identified and resolved on a
timely basis and
iii]
The audit engagement is properly organized and managed
in order to be performed in an effective and efficient manner. Adequate
planning also assists in:
i]
Proper assignment of work to engagement team
members,
ii]
Facilitating the direction and supervision of
engagement team members and the review of their work, and,
iii]
Where applicable, coordination of work done by auditors
of components and experts.
5.3. To What Extent Should an Audit be Planned?
According to ISA 300, the nature
and extent of planning activities will vary according:
i]
Size and complexity of the entity,
ii]
The auditor’s previous experience with the entity,
and
iii]
Changes in circumstances that occur during the audit
engagement.
5.4. When to Plan
As is common in planning for
any other activity, it should be noted that Planning is not a discrete phase of
an audit, but rather a continual and iterative process that often begins
shortly after (or in connection with) the completion of the previous audit and
continues until the completion of the current audit engagement. However, in
planning an audit, the auditor considers the timing of certain planning
activities and audit procedures that need to be completed prior to the
performance of further audit procedures
For example, the auditor plans
the discussion among engagement team members:
i]
The analytical procedures to be applied as risk
assessment procedures,
ii]
The obtaining of a general understanding of the legal
and regulatory framework applicable to the Entity and how the entity is
complying with that framework,
iii]
The determination of materiality,
iv]
The involvement of experts, and
v]
The performance of other risk assessment procedures
Prior to identifying and
assessing the risks of material misstatement and performing further audit
procedures at the assertion level for classes of transactions, account
balances, and disclosures that are responsive to those risks.
5.5. Preliminary Engagement Activities
Audit planning is preceded by
performance of the following activities before beginning of the current audit
engagement:
i]
Perform procedures regarding the continuance of the
client relationship and the specific audit engagement
ii]
Evaluate compliance with ethical requirements,
including independence
iii]
Establish an understanding of the terms of the
engagement
The purpose of performing these
preliminary engagement activities is to help ensure that the auditor has
considered any events or circumstances that may adversely affect the auditor’s
ability to plan and perform the audit engagement to reduce audit risk to an
acceptably low level. Performing these preliminary engagement activities helps
to ensure that the auditor plans an audit engagement for which:
i]
The auditor maintains the necessary independence and
ability to perform the engagement.
ii]
There are no issues with management integrity that may
affect the auditor’s willingness to continue the engagement.
iii]
There is no misunderstanding with the client as to the
terms of the engagement.
5.6. Planning Activities These involve:
i]
Establishment of the Overall Audit Strategy
ii]
Development of an Audit plan
5.7. Overall Audit Strategy
The overall audit strategy sets
the scope, timing and direction of the audit, and guides the development of the
more detailed audit plan. The establishment of the overall audit strategy
involves:
a]
Determining the characteristics of the engagement that
define its scope, such as the financial reporting framework used,
industry-specific reporting requirements and the locations of the components of
the entity;
b]
Ascertaining the reporting objectives of the engagement
to plan the timing of the audit and the nature of the communications required,
such as deadlines for interim and final reporting, and key dates for expected
communications with management and those charged with governance; and
c]
Considering the important factors that will determine
the focus of the engagement team’s efforts, such as determination of
appropriate materiality levels, preliminary identification of areas where there
may be higher risks of material misstatement, preliminary identification of
material components and account balances, evaluation of whether the auditor may
plan to obtain evidence regarding the effectiveness of internal control, and
identification of recent significant entity-specific, industry, financial
reporting or other relevant developments.
In developing the overall audit
strategy, the auditor should consider the results of preliminary engagement
activities and, where practicable, experience gained on other engagements
performed for the entity.
5.8. Scope of the Audit Engagement
The auditor may consider the
following matters when establishing the scope of the audit engagement:
§
The financial reporting framework on which the
financial information to be audited has been prepared, including any need for
reconciliations to another financial reporting framework.
§
Industry-specific reporting requirements such as
reports mandated by industry regulators.
§
The expected audit coverage, including the
number and locations of components to be included.
§
The nature of the control relationships between
a parent and its components that determine how the group is to be consolidated.
§
The extent to which components are audited by
other auditors.
§
The nature of the business segments to be
audited, including the need for specialized knowledge.
§
The reporting currency to be used, including any
need for currency translation for the financial information audited.
§
The need for a statutory audit of standalone
financial statements in addition to an audit for consolidation purposes.
§
The availability of the work of internal
auditors and the extent of the auditor’s potential reliance on such work.
§
The entity’s use of service organizations and
how the auditor may obtain evidence concerning the design or operation of
controls performed by them.
§
The expected use of audit evidence obtained in
prior audits, for example, audit evidence related to risk assessment procedures
and tests of controls.
§
The effect of information technology on the
audit procedures, including the availability of data and the expected use of
computer-assisted audit techniques.
§
The coordination of the expected coverage and
timing of the audit work with any reviews of interim financial information and
the effect on the audit of the information obtained during such reviews.
§
The discussion of matters that may affect the
audit with firm personnel responsible for performing other services to the
entity.
§
The availability of client personnel and data.
5.9. Reporting Objectives, Timing of the Audit and Communications
Required
The auditor may consider the
following matters when ascertaining the reporting objectives of the engagement,
the timing of the audit and the nature of communications required:
§
The entity’s timetable for reporting, such as at
interim and final stages.
§
The organization of meetings with management and
those charged with governance to discuss the nature, extent and timing of the
audit work.
§
The discussion with management and those charged
with governance regarding the expected type and timing of reports to be issued
and other communications, both written and oral, including the auditor’s
report, management letters and communications to those charged with governance.
§
The discussion with management regarding the
expected communications on the status of audit work throughout the engagement
and the expected deliverables resulting from the audit procedures.
§
Communication with auditors of components
regarding the expected types and timing of reports to be issued and other
communications in connection with the audit of components.
§
The expected nature and timing of communications
among engagement team members, including the nature and timing of team meetings
and timing of the review of work performed.
§
Whether there are any other expected
communications with third parties, including any statutory or contractual
reporting responsibilities arising from the audit.
5.10. Direction of the Audit
The auditor may consider the
following matters when setting the direction of the audit:
§
With respect to materiality:
o Setting
materiality for planning purposes. o Setting and communicating materiality
for auditors components. o Reconsidering materiality as audit
procedures are performed during the course of the audit.
o Identifying
the material components and account balances.
§
Audit areas where there is a higher risk of
material misstatement.
§
The impact of the assessed risk of material
misstatement at the overall financial statement level on direction, supervision
and review.
§
The selection of the engagement team (including,
where necessary, the engagement quality control reviewer) and the assignment of
audit work to the team members, including the assignment of appropriately
experienced team members to areas where there may be higher risks of material
misstatement.
§
Engagement budgeting, including considering the
appropriate amount of time to set aside for areas where there may be higher
risks of material misstatement.
§
The manner in which the auditor emphasizes to
engagement team members the need to maintain a questioning mind and to exercise
professional skepticism in gathering and evaluating audit evidence.
§
Results of previous audits that involved
evaluating the operating effectiveness of internal control, including the
nature of identified weaknesses and action taken to address them.
§
Evidence of management’s commitment to the
design and operation of sound internal control, including evidence of
appropriate documentation of such internal control.
§
Volume of transactions, which may determine
whether it is more efficient for the auditor to rely on internal control.
§
Importance attached to internal control
throughout the entity to the successful operation of the business.
§
Significant business developments affecting the
entity, including changes in information technology and business processes,
changes in key management, and acquisitions, mergers and divestments.
§
Significant industry developments such as
changes in industry regulations and new reporting requirements.
§
Significant changes in the financial reporting
framework, such as changes in accounting standards.
§
Other significant relevant developments, such as
changes in the legal environment affecting the entity.
The process of developing the
overall audit strategy helps the auditor to ascertain the nature, timing and
extent of resources necessary to perform the engagement. The overall audit
strategy sets out clearly:
i]
The resources to deploy for specific audit areas, such
as the use of appropriately experienced team members for high risk areas or the
involvement of experts on complex matters;
ii]
The amount of resources to allocate to specific audit
areas, such as the number of team members assigned to observe the inventory
count at material locations, the extent of review of other auditors’ work in
the case of group audits, or the audit budget in hours to allocate to high risk
areas;
iii]
When these resources are deployed, such as whether at
an interim audit stage or at key cutoff dates; and
iv]
How such resources are managed, directed and
supervised, such as when team briefing and debriefing meetings are expected to
be held, how engagement partner and manager reviews are expected to take place
(for example, on-site or off-site), and whether to complete engagement quality
control reviews.
Once the overall audit strategy
has been established, the auditor is able to start the development of a more
detailed audit plan to address the various matters identified in the overall
audit strategy.
5.11. The Audit Plan
The audit plan is more detailed
than the overall audit strategy and includes the nature, timing and extent of
audit procedures to be performed by engagement team members in order to obtain
sufficient appropriate audit evidence to reduce audit risk to an acceptably low
level. Documentation of the audit plan also serves as a record of the proper
planning and performance of the audit procedures that can be reviewed and
approved prior to the performance of further audit procedures.
The audit plan includes:
i]
A description of the nature, timing and extent of
planned risk assessment procedures sufficient to assess the risks of material
misstatement,
ii]
A description of the nature, timing and extent of
planned further audit procedures at the assertion level for each material class
of transactions, account balance, and disclosure. The plan for further audit
procedures reflects the auditor’s decision whether to test the operating
effectiveness of controls, and the nature, timing and extent of planned
substantive procedures; and
iii]
Such other audit procedures required to be carried out
for the engagement in order to comply with ISAs (for example, seeking direct
communication with the entity’s lawyers).
5.12. Changes to Planning Decisions During the Course of the Audit
As planning is not static. the overall audit strategy and
the audit plan should be updated and changed as necessary during the course of
the audit. It is acknowledged by ISA 300 that as a result of unexpected events,
changes in conditions, or the audit evidence obtained from the results of audit
procedures, the auditor may need to modify the overall audit strategy and audit
plan, and thereby the resulting planned nature, timing and extent of further
audit procedures. Information may come to the auditor’s attention that differs
significantly from the information available when the auditor planned the audit
procedures. For example, the auditor may obtain audit evidence through the
performance of substantive procedures that contradicts the audit evidence obtained
with respect to the testing of the operating effectiveness of controls. In such
circumstances, the auditor re-evaluates the planned audit procedures, based on
the revised consideration of assessed risks at the assertion level for all or
some of the classes of transactions, account balances or disclosures.
AUDITING
5.13. Planning for the Direction, Supervision and Review
ISA 300 requires the auditor to
plan the nature, timing and extent of direction and supervision of engagement
team members and review of their work.
The nature, timing and extent
of the direction and supervision of engagement team members and review of their
work vary depending on many factors, including:
i]
The size and complexity of the entity,
ii]
The area of audit,
iii]
The risks of material misstatement, and
iv]
The capabilities and competence of personnel performing
the audit work.
The auditor should plan the
nature, timing and extent of direction and supervision of engagement team
members based on the assessed risk of material misstatement. As the assessed
risk of material misstatement increases, a given area of the audit, the auditor
ordinarily increases the extent and timeliness of direction and supervision of
engagement team members and performs a more detailed review of their work.
Similarly, the auditor should plan the nature, timing and extent of review of
the engagement team’s work based on the capabilities and competence of the
individual team members performing the audit work.
In audits of small entities, an audit
may be carried out entirely by the audit engagement partner (who may be a sole
practitioner). In such situations, questions of direction and supervision of
engagement team members and review of their work do not arise as the audit
engagement partner, having personally conducted all aspects of the work, is
aware of all material issues.
The audit engagement partner
(or sole practitioner) nevertheless needs to be satisfied that the audit has
been conducted in accordance with ISAs. Forming an objective view on the
appropriateness of the judgments made in the course of the audit can present
practical problems when the same individual also performed the entire audit.
When particularly complex or unusual issues are involved, and the audit is
performed by a sole practitioner, it may be desirable to plan to consult with
other suitably-experienced auditors or the auditor’s professional body.
5.14. Documentation of the planning activities
ISA 300 requires the auditor to
document the overall audit strategy and the audit plan, including any
significant changes made during the audit engagement.
The documentation of the
overall audit strategy records the key decisions considered necessary to
properly plan the audit and to communicate significant matters to the engagement
team. For example, the auditor may summarize the overall audit strategy in the
form of a memorandum that contains key decisions regarding the overall scope,
timing and conduct of the audit.
The documentation of the audit
plan is sufficient to demonstrate the planned nature, timing and extent of risk
assessment procedures, and further audit procedures at the assertion level for
each material class of transaction, account balance, and disclosure in response
to the assessed risks. The auditor may use standard audit programs or audit completion
checklists. However, when such standard programs or checklists are
used, the auditor appropriately tailors them to reflect the particular
engagement circumstances.
The documentation of any
significant changes to the originally planned overall audit strategy and to the
detailed audit plan includes the reasons for the significant changes and the
auditor’s response to the events, conditions, or results of audit procedures
that resulted in such changes. For example, the auditor may significantly
change the planned overall audit strategy and the audit plan as a result of a
material business combination or the identification of a material misstatement
of the financial statements. A record of the significant changes to the overall
audit strategy and the audit plan, and resulting changes to the planned nature,
timing and extent of audit procedures, explains the overall strategy and audit
plan finally adopted for the audit and demonstrates the appropriate response to
significant changes occurring during the audit.
The form and extent of
documentation depend on such matters as the size and complexity of the
entity, materiality, the extent of other documentation, and the
circumstances of the specific audit engagement.
5.15. Communications with Those Charged with Governance and Management
The auditor may discuss elements
of planning with those charged with governance and the entity’s management.
These discussions may be a part of overall communications required to be made
to those charged with governance of the entity or may be made to improve the
effectiveness and efficiency of the audit. Such discussions ordinarily include
the overall audit strategy and timing of the audit, including any limitations
thereon, or any additional requirements. Discussions with management often
occur to facilitate the conduct and management of the audit engagement (for
example, to coordinate some of the planned audit procedures with the work of
the entity’s personnel). It is cautioned that although these discussions often
occur, the overall audit strategy and the audit plan remain the auditor’s
responsibility.
It is important to note that
when discussions of matters included in the overall audit strategy or audit
plan occur, care is required in order to not compromise the effectiveness of
the audit. For example, the auditor considers whether discussing the nature and
timing of detailed audit procedures with management compromises the
effectiveness of the audit by making the audit procedures too predictable.
5.16. Additional Considerations in Initial Audit Engagements
The auditor should perform the
following activities prior to starting an initial audit:
i]
Perform procedures regarding the acceptance of the
client relationship and the specific audit engagement
ii]
Communicate with the previous auditor, where there has
been a change of auditors, in compliance with relevant ethical requirements.
The purpose and objective of
planning the audit are the same whether the audit is an initial or recurring
engagement. However, for an initial audit, the auditor may need to expand the
planning activities because the auditor does not ordinarily have the previous
experience with the entity that is considered when planning recurring
engagements. For initial audits, additional matters the auditor may consider in
developing the overall audit strategy and audit plan include the following:
i]
Unless prohibited by law or regulation, an arrangement
to be made with the previous auditor, for example, to review the previous
auditor’s working papers.
ii]
Any major issues (including the application of
accounting principles or of auditing and reporting standards) discussed with
management in connection with the initial selection as auditors, the
communication of these matters to those charged with governance and how these
matters affect the overall audit strategy and audit plan.
iii]
The planned audit procedures to obtain sufficient
appropriate audit evidence regarding opening balances [ISA 510, “Initial Engagements—Opening
Balances”].
iv]
The assignment of firm personnel with appropriate
levels of capabilities and competence to respond to anticipated significant
risks.
Other procedures required by the
firm’s system of quality control for initial audit engagements (for example,
the firm’s system of quality control may require the involvement of another
partner or senior individual to review the overall audit strategy prior to
commencing significant audit procedures or to review reports prior to their
issuance).
TUTORIAL QUESTIONS
QUESTION 1
Your firm has been the auditor
of MTWANGO ASSOCIATES products, a listed company for a number of years. The
engagement partner has asked you to describe the matters you would consider
when planning the audit for the year ended 31st Jan 2007.
During a recent visit to the
company you obtained the following information.
I.
The management accounts for the 10 months to 30
November 2006 show sales of dollar 130 million and profit before tax of dollar
4 million. Assume sales and profit accrues evenly throughout the year. In the
year ended 31st January 2006 MTWANGO ASSOCIATES products had sales
of dollar 110 million and profit before tax of dollar 8million
II.
The company installed a new computerised inventory
control system which has operated from 1st June 2006. As the
inventory control system records inventory movements and current inventory
quantities, the company is proposing;
•
To use the inventory quantities on the computer
to value the inventory at the year end and
•
Not to carry out an inventory count at the year
end.
III.
You are aware there have been reliability problems with
the company’s products, which have resulted in legal claims being bought
against the company by customers, and customer refusing to pay for the
products.
IV.
The sales increase in the 10 months to 30 November 2006
over the previous year has been achieved by attracting new customers and by
offering extended credit. The new credit arrangements allow customer three
months credit before their debt becomes overdue, rather than the one month credit
period allowed previously. As a result of this change, receivables age has
increased from 1.6 to 4.1 months
V.
The chief financial officer and purchasing manager were
dismissed on 15 August. A replacement purchasing manager has been appointed but
it is not expected that a new chief financial officer will be appointed before
the year end of 31 January 2007. The chief accountant will be responsible for
preparing the financial statements for audit.
Required:
a) Describe the reasons why it is important
that auditors should plan their audit work
b) Describe the matters you will consider in
planning the audit and the further action you will take concerning the matters
listed in (i) to (v) above.
QUESTION 2
(A) Analytical
procedures are an important and powerful tool for auditors in explaining the
performance of the business.
They are used at the planning, testing and review stages of
the audit.
Required;
Preliminary analytical
procedures are often performed on accounting ratios. Explain the possible
reasons for the following changes found at the planning stage of the audit.
I.
An increase in the current ratio
II.
Decrease in the gross profit margin
III. Increase
in the inventory holding period
IV. Increase
in the dividend cover
V.
Increase in the capital gearing (leverage)
(b) The concept of materiality
is fundamental to the work of auditors. Matters that are immaterial are not reported in the
financial statements.
Required;
i.
Explain the concept of materiality
ii.
Describe how materiality affects the audit work
performed by auditors
iii.
Give an example of qualitative materiality
QUESTION 3
Amongst matters required to be
considered by the auditor when planning the audit in accordance with the
requirement of ISA 300 planning an audit
of financial statement are those of materiality and the direction,
supervision and review of the audit.
Materiality is further the
subject of ISA 320 Audit materiality. Direction, supervision and review are
considered in more detail within other Auditing standards.
Required;
a)
Explain the concept of materiality and how materiality
is assessed when planning the audit. Your answer should include consideration
of materiality at the overall financial statement level and in relation to
individual account balances.
b)
Explain the nature and significance of direction,
supervision and review both in planning the audit and subsequently during the
performance of the audit on a particular engagement.
SOLUTION 1
a) ISA 300
Planning an Audit of Financial statement says that
•
Auditor should plan the audit so that the
engagement will be performed in an effective manner
•
Planning means that developing a general
strategy and a detailed approach for the expected nature, timing and extent of
audit.
As
this is the continuing audit, the general strategy will probably be similar to
last year’s audit. However it will be modified by problems experienced in last
year’s audit and significant events which have taken place in the country since
last years audit.
The timing of the audit work is important as will influence
the make up of the audit staff during the audit.
It
will be necessary to agree a timetable with the company of when the information
will be available and this will determine when the audit work is carried out,
on this the following dates will be important;
i.
The inventory count
ii.
When the full financial statements are available for
audit
iii.
When the financial statements are agreed and signed by
the directors and the auditor
iv.
The date of the annual general meeting when the
financial statements are approved by the shareholders.
Budget will be
prepared which suggests the time which should be spent on each aspect of the
audit and the completion dates of each part of the audit.
During the audit, progress will be compared with the audit
plan. Any variances against the plan will be investigated and the plan amended
if it is considered appropriate
Importance;
•
Ensures senior audit staff have considered the
work which is required to complete the audit, and the timing of that work so
that it fits in with the dates information available from the company
•
Enables auditor to take more considerable
approach to the audit which will improve the quality of the audit and thus both
minimize the time spent on the audit and the overall audit risk.
b) Matters to be considered
i.
The company’s sales for 10 month are dollar 130 mill
which given an annualised sales of dollar
156 mill, is a 41.8% increase over the previous year.
The annualised profit before tax is dollar 4.8 mill,
compared with dollar 8 mill, last year , this is the fall of 40%.
It appears the company is increasing sales at the expense
of profits.
ii.
Audit work have to be carried out on the new computerised inventory control system. Computer audit specialists
within the audit firm will probably have to be used.
It
may be appropriate to carry out this work before the year end so that any
problems with the system ca be highlighted and either overcome or allowed for
at the year end.
I
will have to determine from the company how frequently they count they count
the inventory, the proportion of the inventory counted, and the checks they
make to the inventory quantities on the computerised system.
iii. Reliability problems with the
company’s products could create the following problems;
•
Certain inventory being unselable and thus worth less than cost
•
Legal claims against the company
•
Customers not paying for the product.
The audit risk with these problems includes;
•
The difficult of estimating the costs
•
The risk that there may be more claims and bad
debts which relates to the year under review, but may not become apparent until after the audit report is
signed
•
The value of faulty inventory held at the year
end. The selling price of inventory sold between the year end and the audit
will have to be checked to ensure it is valued at the lower of cost and net
realisable value
iv. The
large increase in receivables age will have resulted in a large increase in
receivables from dollar 14.7 mill at 31st
Jan 2006 to an estimated dollar 53.3 mill at 31st Jan 2007.the
increase of dollar 38.6 mill will probably have been financed by increased
borrowing.
Thus the increase in credit period and sales to new
customers will result in the following audit risk;
§
New customers tend to have a higher risk than
existing ones, thus increasing the risk of bad debts
§
Increasing the credit period tends to attract
the customers who are a poor credit risk. Two reasons for this, longer credit
limit will reduce the customer’s cash flow problems, and attract customers who
already have cash flow problems
§
A potential bad receivable may not become
apparent until after the credit period is exceeded. Thus it will probably take
at least 3 months before the doubtful receivable becomes apparent, rather than
one month with the previous credit period. So doubtful receivables from sales
immediately prior to the year end may not become apparent until after the audit
report has been signed.
§
With the large increase in receivables, the
company is probably experiencing liquidity problems. Are the company’s
borrowing facilities adequate and is there a risk the company may not be a
going concern?
v. The
reasons for the dismissal of the chief financial officer and purchasing manager
will have to be ascertained. Were they carrying out a fraud? Or were they
contravening financial procedure? If
this was happening, what are the financial consequences? Is it possible for this type of fraud to
recur? Could our audit firm be liable for not detecting these events?
If
the dismissed employees are claiming unfair dismissal and compensation from
company, the likely outcome from these claims would have to be investigated and
appropriate provision included in the financial statements………
SOLUTION 2
a)
Possible reasons for changes
i.
Increase in current ratio.
An
increase in current ratio may indicate increase in inventory, cash or
receivables levels. The implications for this may be that the company is
expanding, or alternatively that it is experiencing trading difficulties and is
unable to sell its inventory or to collect its receivables. Any increase may
also be due to a decrease in payables or other current liabilities.
ii.
Decrease in gross profit margin
Indicate
that the cost of raw materials or bought in goods has increased, or that
discounts or selling prices have decreased. This may not be a bad thing if the
reason for this is an overall increase in sales revenue.
iii.
Increase in inventory holding period.
The
inventory holding period indicates the number of days the company could
continue to trade if supplies were to cease. The longer the period, the higher
the level of inventory held. Inventory holding involves expenditure. Generally,
the lower the figure the better provided that the company does not run out of
inventory.
•
An increase can indicate that the company is
unable to sell its inventory.
•
An increase can also indicate that the company
is expecting additional sales or simply that the business is expanding.
iv. Increase in dividend cover
Shows how many times a company could pay the dividends it
has decided to pay to shareholders. If a company’s dividend cover is
increasing,
•
it may simply mean that it is making greater
profits in relation to the dividends it pays out
•
it may also mean that the company could pay out
more dividends in future,
•
or that the company is paying out a reduced
dividend and is investing more in business
v. An increase in capital gearing (leverage)
Gearing
is the relationship between equity and borrowings. A high level of gearing
generally indicates that the company must service (pay the interest on) fixed
interest borrowings. This means that there is less available for shareholders
but it may also mean that company is expanding, which means greater returns for
shareholders in the future. A high gearing ratio may mean that the company is
at risk of going concern problems.
b)
Materiality
i. Concept
• Information
is material if its omission or misstatement could influence the economic
decisions of users taken on the basis of financial statements.
•
Materiality depends on the size of the item or
error judged in the particular circumstances of its omission or
misstatement.
•
So what might be material in one year might not
be material the next and what might be material to one company might not be to
another.
ii. Audit work
•
The quantitative aspect of materiality is often,
in practice, calculated as a percentage of revenue, profit before tax or assets,
or a particular class thereof. Auditors calculate materiality for individual
account areas and for the financial statements as a whole. They look at the
aggregate effects of misstatements and omissions for the financial statements
as a whole. Companies sometimes adjust the accounting records and financial
statements for immaterial items, sometimes they do not.
•
Materiality is related to risk and is used in
the calculation of sample sizes and tolerable error, and in the performance of
analytical procedures. Less work is performed in immaterial areas than in
material areas, although some work is always performed because an area that may
appear to be immaterial may, when tested, prove to be material.
iii. Qualitative example
•
The disclosure of accounting policies is a
qualitative aspect of materiality if accounting policies are not adequately
described in the financial statements, the financial statements will not fairly
present the position in all material respects, even though the figures are
‘correct’.
•
The description of an operation as discounted
when it is not is another example of a matter that is material.
SOLUTION 3
a) Materiality
Financial
statement are materially misstated when they contain errors or irregularities
whose effect, individually or aggregate, is important enough to prevent the
statements from being fairly presented. In this context, misstatements may
result from;
o misapplication
of applicable Accounting Standards, o departure
fro fact or o Omissions
of necessary information.
ISA 320, Audit materiality, requires auditor to consider
materiality when determine the nature, timing and the extend of audit
procedures.
In
complying with this requirement ISA 320 recommends that auditors make
preliminary judgements about materiality levels in planning the audit at the
following two levels.
•
The financial statement level (overall
materiality), because the auditors’ opinion on fair presentation extends to the
financial statement taken as a whole.
•
The account balance level ( testing
materiality), because the auditors verify account balances in reaching an
overall conclusion that the financial statements are fairly presented
Materiality at the overall financial statement level
There may be more than one level of materiality relating to
the financial statements. For the income statement, materiality could be
related
to revenue or to
profit (usually before tax). For the balance sheet, materiality could be based
on shareholders’ equity, assets or liability class totals.
IAS 320 offers on guidance for determining this
relationship but, where an item has effect on profit, a widely used rule of
thumb states that
o
An amount which is equal to or greater than 10%
of profit is presumed to be material
o
An amount which is equal to less than 5% of
profit is presumed to not to be material
o
To determine whether an amount between 5% and
10% is material is a matter of judgement.
Qualitative
consideration
The
emphasis in planning materiality is on qualitative considerations. ISA 320
acknowledges that in designing the audit plan, the auditor establishes an
acceptable materiality level so as to detect quantitatively material
misstatements. Since the errors are not yet known, their qualitative effect can
be considered only during the testing phase of the audit, as evidence becomes
available
Qualitative
considerations relate to the causes of misstatements or to misstatements that
do not have a quantifiable effect. A misstatement which is quantitatively
immaterial may be qualitatively material. This may occur for instance, when the
misstatement is attributable to an irregularity or an illegal act by the
entity. Discovery of either occurrence might cause the auditors to conclude
there is a significant risk of additional similar misstatements. b) direction,
supervision and review
direction
an
important function in planning the audit is the generation of material
necessary for the direction of staff assigned to the audit. Staff needed to
receive adequate guidance as to the nature of the business and in particular as
to any particular matters affecting the audit determined during the planning
phase, such as recent or proposed changes in the nature of the business, its
management or its financial structure. Assistants assigned to an audit must
receive direction as to such matters to enable them to carry out the audit work
delegated to them.
Supervision
The
assignment of staff to the audit as part of the planning process should ensure
that they are subject to an appropriate level of supervision. The more junior
or inexperience the staff, the more supervision they will require. On small
audits supervision is usually in the form of daily contact with the staff members
at the client’s premises by a supervisor usually the audit manager with regular
visits to the client’s premises during the course of the audit
Review
Supervision also involves review
of the work performed. All work must be reviewed to ensure that
o The
work has been performed in accordance with the program o The
evidence has been properly documented o All outstanding matters have been
satisfactory resolved o Conclusions
drawn are consistent with the evidence and support the audit opinion.
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