Background theory
According to ASA 315 :gaining an
understanding of the client is necessary to assess the
risk that the financial report contains a material
misstatement due to:
The nature of the clients business
The industry in which the client operates
The level of competition within that industry
The clients customers and suppliers
The regulatory environment in which the client
operates
Selection and application of accounting policies
The entitys objectives and strategies and related
business risk
(ASA 315 para.11)
With the access to prior financial report, the auditor can use the
information to perform an analytical procedures thus gaining
the understand of the entitys ratios, trends thus assisting in
assessing risk of material misstatement (ASA 315, Para.
A14,15).
In addition, accessing to the entitys financial reports can also
provide information regarding the selection and application of
accounting policies such as revenue recognition, accounting for
fair value, source of finance, ownership structure, nature of
employment contract, provision for warranties
Measure and review of entitys financial performance thus
helping auditor consider whether the pressures to achieve the
target goal may result in management action that increase the
risk of fraud.
-Related risks that the company is facing that could result in
risks of material misstatement.
Anticipated result for the current year could
assist the auditor in understanding the clients
expectations regarding growth (decline).
The auditor can also examine whether the actual
change reflected in the account (new bank loan
used to purchase equipment or expansion).
The report can be used to understand the
difference between peaks and off-peaks period
and how it affects profit of the company
The reports also identify some issues regarding
provision for annual leave or other leaves
associated with senior staffs retirement related
provision.
By accessing to industry comparisons, auditor
can compare the firm to other firms in the
industry especially whether the firm is
following the current major trends in the
industry as economic condition changes.
The auditor also can obtain information about
the occupancy rate, visitors numbers, staff
numbers and compare them to financial data.
The regulatory environment and level of
competition in tourism industry
According to ASA 240, auditor has the
responsibility to assess risk of material
misstatement due to fraud .
During the audit, the auditor is responsible
for :
-Maintaining professional scepticism
-Considering the potential for management
override of controls
- Recognising that audit procedures may
not effective in detecting fraud (ASA 240.
Para 8).
Misstatement in financial report can arise
The accounts that are at risk including
Revenue in PL
Account receivable in BL
Cash from operations in Cash flow statement
This fraud is a misappropriation of asset fraud
-Unauthorised discount to customers.
The collusion resulted in reduced fees for
patients thus revenue is understated for
various medical and other services as well as
room charges.
As a result of this, account receivable on the
balance sheets and cash in cash flow
statement are also affected cause they would
be understated.
Effect of the fraud on the
entity
Garden Nursing Home appears less
profitable than it is.
As a result, this could impact on staffing
decisions, equipment purchase, loan
covenants .
Due to poor internal control,
The ramifications on control environment
Conditions lead to fraud
Other controls are inadequate
Management and supervision
Effect of the fraud on
auditor
External auditor will focus on how the fraud
affect the financial statements where are the
likely misstatement (revenue, account
receivable, cash) and how poor internal control
systems affected the quality of the accounts
Internal auditors will focus on wider implication
of internal system breakdown
- How are management objective achieved if
controls are week.
-Implications on future business plan or
operations.
Background theory
Material guides audit planning, testing and
assessment of information in the financial
report
Two characteristics:
Qualitative materiality: information that
impacts a users decision-making process for a
reason other than its size. such as a fraud, noncompliance with laws
Quantitative materiality: information exceeds an
auditors preliminary materiality assessment
Auditor has to uses professional judgement
in setting materiality based on inherent risk
and control risk ( opposite direction).
Discovering evidence that the client is having
ongoing cash flow issues is relevant to the audit
because the audit can assess which accounts could
possibly be at risk for material misstatement. Eg:
Debt may fall due earlier then it must be classified
as current debt instead of non current.
In addition, suppliers request cash on deliver
meaning if not enough cash the client may suffer
loss of safe thus leading to negative effect on the
clients financial positions and greater risk on
undetected errors.
Moreover, the auditor is required to assess
the going concern assumption of the client
thus more evidences would be needed to
assess the validation of the assumption
since there are more risks indicators
including :
Long term fall due
Suppliers problem
Problem obtaining raw materials etc (ASA
570)
As a result, materiality level at a
quantitative perspective needs to be
set at a lower level since it is
expected that there are more
misstatement in the accounts.
Background theory
Audit strategy: set scope, time and direction of
the audit based of preliminary assessment of the
IR and CR.
-Low CR/IR = auditor will to rely on internal
control to detect material misstatement and must
conduct control test to find out if the internal
control are operative (control testing)
-High CR/IR = auditor will to rely on substantive
testing (checking accounts, transactions and
balances) to detect material misstatement.
The initial strategy of the auditor is
to rely on the internal control to
detect material misstatement
because the assessment of control
risk is low.
The strategy is conducted by testing
the effectiveness of the internal
control to see if it is operating
correctly associated with some
substantive test to back up.
However, during the subsequent test
of internal controls, the auditor has
found that there are deviations in the
operation of the internal control thus
the preliminary assessment of
control risk needs to be adjusted to a
higher level
Therefore the initial strategy for low
control risk is no longer appropriate.
As a result, the auditor needs to
- Set a higher level of control risk thus
the detection risk is heading toward
low
- Reports the deviations to the
governance
- Therefore, auditor needs to conduct
more amount of substantive testing
along with the internal control.
Background theory
-Inherent risk is the possibility that material
misstatement could occur in an assertion either
individually or when aggregated with other
misstatements, assuming there are no related controls
(ASA 200, para 13(n))
-Control risk is the risk could occur in an assertion,
either individually or aggregated with other
misstatements and not be prevented, detected,
corrected by entity s internal control (ASA 200, para 13
(n))
-The auditor shall perform risk assessment procedures
to provide a basis for the identification and assessment
of risks of material misstatement at the financial report
and assertion levels (ASA 315 . Para 5).
Inherent risk
Cheese is perishable risk of spoilage- affecting
inventory valuation- affecting inventory
Boutique cheese operation- required high skilled
staff- affecting sales, debtors, inventory
Export sale, foreign exchange transactioncomplex transaction and exposed to incorrect
pricing affecting sales
Tourism sales based at caf and shop- fluctuating
demand affecting sales
Heavy reliance on exporting sales exposes the
business to this source of revenue- affecting sales
Control risk
Effectiveness over quality control of cheese
operation affecting saleability of product
( although this is a low risk)- affecting inventory
Risk of product spoilage -> inventory valuation
Control of document, pricing, sale allowances
made by Jim affecting sales, debtors
Lack of communication between Jim and his
brother and other staff affecting sales, debtors.
Adjustment to debtors is inadequate -> affecting
debtors
The poor communication between Jim and other
management and staff is poor thus the control
over sales and debtors are at high risks.
The validity of sale transactions including terms
and amount is at risk.
There is also a risk that sale amount is not
entered correctly
Adjustment made to debtors is not correctly
controlled
Therefore, it is likely that substantive control
would be eligible for debtors and sales.
Control over product quality appears to be
good and inventory quality seems to be
high.
However, the inherent risk of spoilage is
great
Thus it is suggested that control test could
be adopted to inventory but substantive
test is still required as back up.
However, if under control test , deviations
are detected then it will require more
substantive test for inventory.
Background theory
-Inherent risk is the possibility that material
misstatement could occur in an assertion
either individually or when aggregated with
other misstatements, assuming there are no
related controls (ASA 200, para 13(n))
-The auditor shall perform risk assessment
procedures to provide a basis for the
identification and assessment of risks of
material misstatement at the financial report
and assertion levels (ASA 315 . Para 5).
Source of inherent risk
Nature of clients business
Nature of data processing system
Complexity, lack of integrity, sloppy
management practice.
Clients motivation
Results of previous audit
Related party transactions
Non-routine transaction
High judgement
Susceptibility to theft.
Industry level
The competitive market tendering to
win government contracts- involve
complexity, high judgement.
Defense industry- sensitive to
product information, customer
information, highly regulated.
Susceptibility to theft
Entity level
High reliance on one product, export
customers creates risk to revenue stream.
Pricing of sophisticated product designed
to meet customers requirement- high
judgement
Sophisticated product designed and
costing information thus risks of standard
costing, inventory movement.
Risk of foreign exchange dealings
