LECTURE AND TUTORIAL OUTLINE: LECTURE 3: WEEK OF MARCH 18th 2019

FUNDAMENTAL AUDIT CONCEPTS (CONTINUED)

1: INTRODUCTION
In Lecture 3 we continue our coverage of fundamental audit concepts. We begin by
examining the procedures that auditors apply during an audit. We then explore audit testing,
which is the application of audit procedures to specific items in order to draw conclusions
based on evidence. Following this, we consider how the auditor determines just what
constitutes sufficient appropriate evidence in any given audit by applying the Audit Risk
Model. (Recall that we defined the concept of sufficient appropriate evidence in Lecture 4:
“sufficiency” refers to the quantity of evidence collected by the auditor, while
“appropriateness” refers to its quality). We see, in this lecture that the application of the
Audit Risk Model leads to the development of an audit strategy and an audit program. We
define these also. We then explore materiality in an audit, a concept that closely associated
with audit risk.

AUDIT PROCEDURES
Audit procedures are the actions an auditor takes in acquiring evidence. There are seven
audit procedures: inspection; observation; inquiry; re-calculation; re-performance; external
confirmation and analytical procedures. Audit procedures are defined at ASA 500. A 14-A25.
It is important to know how each is defined and to understand how and in what
circumstances each procedure can be used.

AUDIT TESTS
Audit tests are the application of audit procedures in order to draw conclusions based on
evidence. There are two broad categories of audit tests: (1) tests of internal controls; and (3)
substantive tests.

Test of internal controls are tests in which the auditor obtains evidence about the
effectiveness of the design or operation of the client’s internal controls. For example, an
auditor can test whether or not an authorisation (an internal control) has been performed in
the sales process; or whether or not a three-way document match has been performed in the
purchasing process.

Substantive tests of details are used to determine the validity of ending balances, transaction
classes and disclosures.
Substantive tests are classified as either tests of details or analytical procedures. Tests of
details are classified in one of three ways:

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 Tests of details of balances Tests to obtain evidence about the validity of a general
ledger account balance. For example, an auditor can obtain evidence that the
balance of accounts payable is complete.

Tests of details of transactions Tests to obtain evidence about the validity of

transaction classes. For example, the auditor can test whether sales recognized in
the financial statements actually occurred during the period and pertain to the entity.

Tests of disclosures Tests to determine that required disclosures are made and that
the overall presentation of the financial statements is satisfactory. For example, the
auditor can test that the disclosures required by paragraph 73 of AASB 116 are
made by the client in respect of property plant and equipment

Substantive analytical procedures Tests in which the auditor compares relationships between
accounting data and related information to determine the reasonableness of relationships,
and to identify unusual fluctuations. For example, the auditor can calculate the receivables
turnover ratio to determine whether or not the client’s debtors are paying in the required
timeframe and use this information to evaluate the provision for doubtful debts that the client
has made.

THE AUDIT PROGRAM

The overall combination of audit tests, who will perform them and when, together with who
will supervise the testing is documented in the Audit Program

THE AUDIT RISK MODEL

The concept of, “sufficient appropriate evidence”, was introduced in Lecture 3. In that
lecture we defined the term and noted that, in order to provide a sound conclusion, the
auditor must collect sufficient appropriate evidence. I.e. the auditor must have enough
evidence and ensure that the evidence is of good quality. However, we did not discuss how,
in a given audit, the auditor determines exactly what constitutes sufficient appropriate
evidence. We consider this in Lecture 4. To determine what constitutes sufficient appropriate
evidence in any given audit, auditors apply an audit tool called, “the audit risk model”. The
audit risk model provides the auditor with a framework for identifying and responding to
those factors that are likely to cause the financial statements to be misstated. When
using the audit risk model the auditor is applying the principle that the greater the risk of
material misstatement, the greater the amount of appropriate evidence required. (Recall our
definition of the “Business Risk” approach to auditing, which was introduced in Lecture 1.)
The audit risk model expresses the relationship between audit risk, inherent risk, control risk
and detection risk. We state it in two ways:

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(1) Audit Risk (AR) is a function of Inherent Risk (IR); Control Risk (CR) and
Detection Risk (DR).

I.e. AR = IR x CR x DR

Audit Risk is the risk that the auditor gives an inappropriate audit opinion when the financial
report is materially misstated.

Inherent Risk is the risk of material misstatement due to the nature of the client’s business
and or its environment, without taking into account the effects of the internal control system.

Control Risk is the risk that the client’s internal controls will fail to detect a material
misstatement

Detection Risk is the risk of the auditor’s substantive procedures failing to uncover a
material misstatement in an account balance or transaction class, when one exists.

In summary, the ARM holds that the risk that the auditor would give an unqualified opinion
when, in fact, the client’s financial statement are materially misstated, is higher when the
preparation of the client’s financial statements is subject to greater risk of misstatement
because of the nature of the entity and its environment; the client’s internal controls are
ineffective and the auditor’s substantive procedures are less than optimum.

(2): We can also express the audit risk model by rearranging the elements such that:

DR = AR
IR x CR

We call this the “Planning Form” of the audit risk model. We isolate Detection Risk, and posit
that, for a given level of Audit Risk, the risk that our substantive procedures will fail to detect
a material misstatement when one exists is inversely proportional to Inherent Risk and
Control Risk. Therefore, if we evaluate Inherent Risk and Control Risk, we can determine an
appropriate level of Detection Risk. When we determine Detection Risk, we are, in effect,
making decisions about the nature, timing and extent of our audit testing, i.e. we are
determining what constitutes sufficient appropriate evidence for the audit.

Note: Inherent Risk and Control Risk arise because of decisions made by the client (the
nature of the entity and the business that it is in, and the effectiveness of the client’s internal
control system respectively). While the auditor evaluates Inherent Risk and Control Risk,

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he/she cannot influence them. However, Detection Risk can be controlled by the auditor
through choices about the nature, timing and extent of audit testing.

Application of the Audit Risk Model allows the auditor to establish the audit strategy, which is
the overall mix of tests that we plan to perform.

MATERIALITY
We then explore the concept of materiality, which is closely associated with audit risk. An
item is material if it makes a difference to a user of the financial statements. Auditors specify
a level of materiality at the planning stage of the audit, which drives their determination of the
nature, timing and extent of the audit procedures performed. Where an item is considered to
be more critical to a user of the financial statements, a lower level of materiality is set. For a
given level of audit risk, this means that more evidence is required. We see also the
importance of professional judgement when determining materiality.

The last of the fundamental audit concepts to be explored is audit sampling. Audit sampling
is the application of audit procedures to less than 100% of the items within a population to
obtain audit evidence about the characteristics of the population. Audit sampling is important
because the auditor provides the audit opinion on tests applied, in most cases, to only a
sample of the auditee’s control processes, transactions and account balances. I.e., the tests
of evidence are commonly applied to a sample. Sampling is defined, and fundamental
concepts are outlined. (The application of sampling in testing of controls and substantive
testing is explored in Lectures 7 and 8 respectively.) In next week’s lectures we commence
our exploration of the audit methodology, whereby we go through each step of an audit,
beginning with client acceptance, and ending with the audit report.

2: LEARNING OBJECTIVES
1. Understand the procedures applied by an auditor.
2. Understand the various types of audit tests.
3. Define the Audit Risk Model.
4. Apply the Audit Risk Model when planning an audit.
5. Understand the concept of materiality, as it is applied in an audit.
6. Understand the nature of audit planning, and how an audit program relates to the audit
strategy.

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REQUIRED READING:

Textbook: Audit and Assurance (First Edition), pp.342-349; pp. 265-266; pp.307-310; and
pp. 325-333.

Handbook:
 ASA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit
in Accordance with Australian Auditing Standards ,paragraph 13,17 and A28-A46
 ASA 230 Audit Documentation
 ASA 320 Materiality in Planning and Performing an Audit
 ASA 500 Audit Evidence, paragraph 6 and A1-A25
 ASA 530 Audit Sampling, paragraphs 5-15 and Appendices 2 and 3
 ASA 620 Using the Work of an Auditor’s Expert paragraphs 1-15

Films: A Few Minutes With…Film 3 “Materiality “

A Few Minutes With… Film 4 “Documentation”

4: WEEKLY QUESTIONS (To be completed prior to tutorial in week of March 25th)

QUESTION 1
Identify the type of procedure that is being used in each of the ten situations listed below as
either (a) analytical review procedures; (b) external confirmation; (c) inquiry; (d) inspection;
(e) observation; or (f) reperformance.
1. The auditor compared the client’s inventory turnover ratio with that for the industry
average.
2. The auditor examined entries in the Purchases Journal for the month of June.
3. The auditor attended the client’s office to obtain direct evidence that there was a
separation of duties between taking custody of the cash and recording receipts.
4. The auditor questioned the senior accountant about a debtor’s ability to pay.
5. The auditor examined large sales invoices for a period of two days before and after
year end to determine if sales were recorded in the proper period.
6. The auditor checked the figure for sales commission that was recorded by the client
by multiplying total sales for the period by the sales commission rate.
7. To determine how effectively the accounts clerk performed bank reconciliations, the
auditor selected three reconciliations and repeated the steps undertaken by the
accounts clerk.

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 8. The auditor sent a letter to the client’s solicitor and asked her to state whether or not
the amount recorded by the client as an estimate of the expected settlement was
reasonable.
9. The auditor determined the reasonableness of the client’s recorded interest expense
for the period by comparing it with the amount recorded in each of the past five years.
10. The auditor wrote to one of the client’s debtors and asked her if she agreed with the
figure recorded by the client as an outstanding receivable.

QUESTION 2
(a) When an auditor performs a test of controls, what is it that she want to know?
(b) When an auditor performs a substantive test of a balance, what is it that she want to
know?
(c) When an auditor performs a substantive test of transactions, what is it that she want to
know?
(d) Classify each of the following as either a Test of Control; a Substantive Test of
Transactions; or a Substantive Test of a Balance. For each, explain the basis of the
classification. Test #1 has been completed as an example.

(1) The auditor selected a sample of purchase orders. He inspected them, counted
the number that had been authorised by the manager (as evidenced by the
presence of the manager’s initials), and expressed the error rate as a
percentage.

(2) The auditor selected a sample of sales invoices and inspected them for evidence
(initials) that an accounts clerk had checked the prices charged against the
authorised price list.

(3) The auditor selected a sample of entries in the sales journal, and traced them to
the corresponding goods shipping order in order to dermine whether or nit the
recorded transactions had actually occurred.

(4) The auditor inspected a sample of receiving notes from the file for evidence that a
sequence check had been performed.

(5) The auditor requested confirmation from the client’s bankers about the client’s
cash deposits held by the bank.

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 (6) The auditor calculated the inventory turnover ratio and used this information to
test the ending balance of inventory.

Item Type of Test Explanation

1 Test of control The auditor has gathered and evaluating evidence about the
effectiveness of a control over the processing of transactions
(authorisation by the manager).

QUESTION 3
(a) For the test of control stated below, answer the following questions.
(i) What is the procedure?
(ii) What information is used to verify?
(iii) Which assertion has been tested?

Tests of Control For the audit of Brown Pty ltd, a wholesaler of shoes, the auditor
selected 30 sales orders to determine if each had been authorised (initisalled) by the
credit manager

(b) For the substantive test stated below, answer the following questions.
(i) What is the starting point?
(ii) What is the direction of testing?
(iii) What is the procedure?
(iv) What information is used to verify?
(v) Which assertion has been tested?

Substantive Tests of Transactions For the audit of Green Pty ltd, a manufacturer of
doors, the auditor selected 40 sales transactions that were recorded in the sales journal,
vouched them to the corresponding shipping order to determine that each recorded
sale was bona fide.

(c) For the substantive test stated below, answer the following questions.
(i) What is the starting point?
(ii) What is the procedure?
(iii) What information is used to verify?
(iv) Which assertion has been tested?

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 Substantive Tets of Details of Balances For the audit of Red Pty Ltd, the auditor the
auditor seleted for testing all debtors with an outstanding balance of more than $1m.
He wrote to each of them and asked them to confirm the specific balance that was
recorded by the client.

QUESTION 4:
(i) Define the audit risk model
(ii) Explain each of the terms in the audit risk model
(iii) Provide two examples for each of the three components of audit risk.
(iv) Explain how the auditor uses the audit risk model in planning an audit.

QUESTION 5:
For each situation listed below, identify the component of audit risk that is most directly
exemplified. (From Auditing and Assurance Services in Australia, 6th ed. Revised. Gay and
Simnett, 2017)
Situation Component
of Audit
Risk
1 Technological innovations within the industry have caused some items
of inventory to become obsolete
2 Cash is more succeptibel to theft than cement
3 Segregation of duties is inadequate
4 Cash disbursements have occurred without proper consent
5 A necessasry substantive audit procedure was ommitted
6 Bank accounts are not reconsiled monthly, resulting in a client failing to
discover employee theft on a timely basis
7 Confirmation of receivables by an auditor fails to detect a material
misstatement
8 Notes receivable are succeprible to material misstatement, assuming
there are no related internal controls
9 A client, Lemon Ltd, has insufficient working capital to continue its
operations

QUESTION 6:
Describe the relationship between audit risk and materiality.

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TUTORIAL WORKSHOP QUESTIONS (FOR DISCUSSION IN TUTORIALS IN THE WEEK
OF MARCH 25th 2019)

QUESTION 1: Classify the following tests as either a test of control, a substantive test of a
balance, a substantive test of a disclosure, a substantive test of a transaction or substantive
analytical procedure.

Test Type of test

1 Confirm loan balances with financial institutions
2 Examine the financial report to determine whether
all related party loans are properly presented
3 Vouch sales recorded in the sales journal to
shipping documents
4 Examine a sample of sales invoices for initials
which would indicate that prices and extensions
have been checked
5 Compare payroll expense to previous year and
budget
6 Examine a sample of purchase orders to determine
whether or not they were authorised

LEARNING OBJECTIVE Lecture 3: Learning Objectives (2) Understand the various types of
audit tests.
REFERENCES: Lecture Slides: Lecture 3, slides 25-40
Textbook: pp. 342-349

QUESTION 2: Blue Pty Ltd (Blue), a car parts wholesaler, has a warehouse in Adelaide from
which it ships parts to its stores in each capital city. Before goods can be loaded onto a
delivery truck the Senior Stores Clerk checks that the goods against the Purchase Order.
She signs the Shipping Note (Shipping Order) to show that she has checked the goods.

Required:
(a) What is the benifit to Blue of the Senior Stores Clerk performing this task?
(b) Specify a Test of Control for the internal control descibed above.
(c) For the test of control you have sepcified, answer the following questions.
(iv) What is the audit procedure?
(v) What information has been used for verification?
(vi) Which assertion has been tested?

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LEARNING OBJECTIVE: Lecture 3: Learning Objectives (2) Understand the various types of
audit tests.

REFERENCES: Lecture Slides: Lecture 3, slides 25-40

Textbook: pp. 342-349

QUESTION 3: Determine the effect of each of the following independent events on Control
Risk, Inherent Risk and Planned Detection Risk, by circling the correct letter.
I = increase in the risk factor,
D = decrease in the risk factor
N = no change in the risk factor
C = cannot determine the effect on the risk factor from the information provided.

Please Note: In some cases it is arguable whether N or C is correct. Where there is

doubt, the conservative approach should be taken such that C is selected.

(a) Difficult trading conditions for the client’s customers provided increased uncertainty for
the financial controller when estimating any provision for doubtful debts.
Control Risk I D N C

Inherent Risk I D N C

Planned Detection Risk I D N C

(b) This is the second year of the engagement. There were few misstatements found in the
previous year’s audit. The auditor decided to increase reliance on internal control.
Control Risk I D N C

Inherent Risk I D N C

Planned Detection Risk I D N C

(c) The client began selling products online to customers through its web page during the
year under audit. The online customer ordering process isn’t integrated with the
company’s accounting system. Client sales staff print out customer order information
and enter that data into their sales accounting system.
Control Risk I D N C

Inherent Risk I D N C

Planned Detection Risk I D N C

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(d) There has been a change in key management personnel. You believe that the new
management team is somewhat lacking in integrity compared with the previous
management team. You still believe that it is appropriate to undertake the audit.
Control Risk I D N C

Inherent Risk I D N C

Planned Detection Risk I D N C

(e) In auditing inventory, you obtain an understanding of the internal control structure and
perform tests of controls. You find it significantly improved compared with that of the
preceding year. You also observe that, due to technology changes in industry, the
client’s inventory may be somewhat obsolete.
Control Risk I D N C

Inherent Risk I D N C

Planned Detection Risk I D N C

LEARNING OBJECTIVES: Lecture 3: Learning Objectives (3) Define the Audit Risk Model
and (4) Apply the Audit Risk Model when planning an audit.

REFERENCES: Lecture Slides: Lecture 3, slides 43-69

Textbook: pp. 307-310
Handbook: ASA 200 Paragraphs 17 and A32 to A44

FOCUS Factors that influence IR and CR. DR is determined by an analysis of IR and CR. DR
is inversely proportional to R and CR

QUESTION 4 : (From Auditing and Assurance Services in Australia, 6th ed. Revised. Gay
and Simnett, 2017)

Required: Read the following scenario and determine the impact on preliminary materiality
for the issues identified in (a), (b) and (c). Explain your answer.

Scenario: Fast Feet Pty Ltd (Fast Feet) manufactures and distributes a range of sports shoes
across Australia, and has done so since 2004. Fast Feet was originally owned by the Tam
Family, but over the past 12 months the Tams have taken a new investor to inject capital into
the business.

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It is now August 2015 and and you are undertaking the audit fieldwork for the 2015 financial
year audit of Fast Feet, You becaome aware of the following three issues, which were not
known At the planninG stage of the audit, when preliminary materility was established.

(a) The board of Fast Feet is comprised of members of the Tam family, who also
occupy key management positions. Following the recognition of two independent
directors on 30 June 2014, there were no independent directors on the board
during the 2015 financial year.

(b) The remuneration structure of Fast Feet’s sales staff changed for the 2015
financial year, whereby base salaries were reduced and commission components
substantially increased.

(c) The Tam family intends to list on the Australian Stock exchange by way of initial
public offering in the following (2016) financial year.

LEARNING OBJECTIVE: Lecture 3, Learning Objectives (5) Understand the importance of

materiality in an audit; and

REFERENCES: Lecture Slides: Lecture 3, slides 70-84

Textbook: pp. 325-333

Handbook: ASA 320

FOCUS A key issue when considering materiality in the context of an audit is that when an
item is considered to be of greater interest to users of the financial statements, we decrease
materiality because we want to be more sure about its validity. (By lowering materiality we
are being more specific)

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