Auditing and Assurance Services in Australia - (Chapter 5 Planning understanding the entity and assessing business ris

Page 185 CHAPTER 5
Planning, understanding the entity and assessing business risk LEARNING OBJECTIVES (LO) 5.1
Explain why the decision to accept a client is important, and
describe the primary features of client acceptance and
continuance, including the purpose and content of an audit engagement letter. 5.2
Explain the importance of planning to the audit process. 5.3
Identify the important aspects of the auditor’s understanding of an entity and its environment. 5.4 Assess entity business risk. 5.5
Explain how an auditor develops an overall audit strategy and
prepares a detailed audit plan or audit program. 5.6
Describe the process of assigning and scheduling audit staff. 5.7
Outline the types and uses of analytical procedures and
distinguish those that are useful in obtaining an understanding of
an entity and assessing business risk.
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Created from cdu on 2020-08-27 00:34:19. RELEVANT GUIDANCE ASA 210/ISA 210
Agreeing the Terms of Audit Engagements ASA 220/ISA 220
Quality Control for an Audit of a Financial Report and
Other Historical Financial Information ASA 300/ISA 300
Planning an Audit of a Financial Report ASA 315/ISA 315
Identifying and Assessing the Risks of Material
Misstatement through Understanding the Entity and Its Environment ASA 330/ISA 330
The Auditor’s Responses to Assessed Risks ASA 510/ISA 510
Initial Audit Engagements—Opening Balances ASA 520/ISA 520 Analytical Procedures ASA 710/ISA 710
Comparative Information—Corresponding Figures and Comparative Financial Reports ASQC 1/ISQC 1
Quality Control for Firms that Perform Audits and Reviews
of Financial Reports and Other Financial Information,
Other Assurance Engagements and Related Services Engagements APES 110/IFAC
Code of Ethics for Professional Accountants APES 305 Terms of Engagement APES 320 Quality Control for Firms Page 186
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Created from cdu on 2020-08-27 00:34:19. CHAPTER OUTLINE
Before commencing an audit, the auditor must determine whether to accept the
client and undertake the audit. This requires an understanding of the entity and
its environment. After the audit commences, the planning and conduct of the
audit are influenced by the auditor’s understanding of the entity’s operations,
trends within its industry and the effects of economic and political influences on
the entity. The auditor uses this knowledge to identify existing or potential
accounting and auditing problems and to develop an overall audit strategy and
a detailed audit plan or program for the conduct and scope of the audit.
The major topics covered in this chapter are acceptance and continuance of
audit clients, including evaluation of potential clients, communications with a
previous auditor, engagement letters and preliminary conferences with the
client; audit planning, including obtaining an understanding of the entity’s
organisational structure, its operations and its industry; assessing client
business risk; developing an overall audit strategy and a detailed audit plan or
program; assigning and scheduling audit staff; and using analytical procedures
for identifying and investigating unusual changes in account balances or
transaction totals, for planning purposes.
How this chapter fits into the overall financial report audit is illustrated in Figure 5.1
, which is an expansion of part of the overall flowchart provided in Chapter 1 .
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FIGURE 5.1 Flowchart of planning and risk-assessment stage of a financial report audit
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LO 5.1 Client acceptance and continuance
The auditor’s need to understand the client starts when considering acceptance of an
engagement and continues throughout association with the client. The steps in accepting an
audit client are shown in Figure 5.2 .
FIGURE 5.2 Steps in accepting an audit Obtaining clients
Since the services of public accounting firms are of a highly personal nature and involve
individual character traits such as competence and integrity, the auditor’s services cannot
be offered in the same manner that commercial goods and services are sold. The most
effective way of obtaining recommendations is to render services of a high quality.
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APES 110 section 250.2 permits advertising provided that its content and nature is not
false, misleading or deceptive and does not otherwise reflect adversely on the profession.
As a result, an auditor should not:
make exaggerated claims for services offered, qualifications possessed or experience gained
make disparaging references or unsubstantiated comparisons to the work of another
falsely advertise or mislead potential clients.
Potential clients may be approached personally or through direct mailing to make known
the range of services that the audit firm offers. However, follow-up communications must
be terminated when requested by the recipient or this will be considered harassment, which is unprofessional conduct.
An issue that has been around for a number of years, but continues to occur frequently in
practice and has caused some concern within the audit profession, is the calling by
companies for competitive tenders for audit appointments, and the active involvement by audit firms in the tendering
process. This issue is symptomatic of the increased
competition for audit work. While acknowledging the right of companies to choose their
auditors in order to obtain the most cost-efficient audit, there is a major danger for Page 188
the profession in the potential loss of credibility that could result from a real or
perceived loss of independence of the auditor, by being placed in a position where there
may be an unreasonable threat of dismissal as a result of the auditor’s actions. An example
is the practice of opinion shopping
. This may occur where an audit is put out to tender
following the issue of a modified opinion by the previous auditor or where a new issue
arises that may involve consideration of the issuing of a modified opinion and the client
seeking the views of potential new auditors as to how they would interpret the client’s
action in terms of the application of a certain accounting practice. APES 110 section 230.2
indicates that when an auditor is requested by an entity to give an opinion on an actual or
hypothetical accounting issue, they should consider the potential effect on the professional
responsibilities of the auditor, the purpose of the request and the intended use of any
response. The auditor whose opinion is requested is also required to communicate with the
existing auditor and provide a copy of the opinion to them. Tendering may also subject an
auditor to undue pressure because of the cost of the audit examination and the ability to
conduct the necessary audit procedures and the impact of low-balling (discussed in Chapter 3
), where firms bid an unreasonably low fee to win the tender. While it is
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likely that the practice of audit tendering will continue, audit firms must recognise that the
tender they submit needs to reflect the level of professional skill, knowledge and
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responsibility required for the audit work. Auditors and management should also be aware
of the increased audit risk and hidden costs associated with changes of client as a result of
the tendering process—for example, the loss of audit continuity and the extensive
knowledge of a client’s business and personnel by the audit firm, which are beneficial to an
effective audit process. On the other hand, the tendering process appears to have led to
some increases in audit efficiency as auditors have implemented more efficient and effective audit techniques. As indicated in Chapter 3
, audit tendering received recent support in the European
Commission Green Paper, which recommended mandatory rotation of audit firms
accompanied by mandatory tendering with full transparency with regard to the criteria
according to which the auditor will be appointed. The Green Paper recommended that
quality and independence should be key selection criteria in any tendering procedure.
Subsequent legislation has provided for the rotation period for audit firms for European
Union companies to be extended if a public tender is held after 10 years.
Quality control policies and client evaluation procedures
APES 320 section 38 and ASQC 1.26–28 (ISQC 1.26–28) require an audit firm, as part of
its quality control, to establish policies and procedures for investigating potential clients
and acceptance of an engagement and for periodically reviewing continuance of clients.
Policies and procedures for client acceptance and continuance are important because an
audit firm needs to take precautions to avoid association with a client whose management
lacks integrity. This will include consideration of the identity and business reputation of the
client’s principal owners, key management, related parties and those charged with its
governance, as well as the nature of the client’s operations, including its business practices. As discussed in Chapter 3
, care should also be exercised to avoid situations where the
auditor–client relationship lacks independence and where there are other impediments to
undertaking the audit function, such as an inability to serve the client properly owing to a
lack of competence, time or resources. In addition, an auditor needs to consider the effect
of a client’s reputation on its image in the financial community, as well as the increased
risk of litigation, which was discussed in Chapter 2 .
ASA 220.12 (ISA 220.12) requires that the engagement partner be satisfied that
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appropriate procedures have been followed regarding the acceptance and continuance of
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clients. Procedures that may be used to establish the appropriateness of accepting clients include:
obtaining and reviewing available financial information concerning the prospective
client, such as annual reports, interim financial reports and income tax returns
making enquiries of third parties, such as the client’s bankers, legal advisers or
investment banker, concerning the integrity of the prospective client and its management
communicating with the previous auditor
considering circumstances in which the engagement would require special attention or present unusual risks
evaluating the firm’s independence and ability to serve the client, including Page 189
technical skills, knowledge of the industry and personnel
determining that acceptance of the client would not violate the Code of Ethics for Professional Accountants.
APES 320 section 43 and ASQC 1.A21 (ISQC 1.A21) indicate that when deciding whether
to continue a client relationship, the auditor needs to consider significant matters that have
arisen during the current or previous period and their implications for continuing the
relationship. Examples of significant matters include:
a major change in ownership, directors, management, legal advisers, financial condition,
litigation status, scope of the engagement and/or nature of the client’s business
the existence of conditions that would have caused the auditor to reject the client had
such conditions existed at the time of the initial acceptance.
Much of the information relevant to this process should be available to the auditor through
the records and working papers of the audit itself.
Communication with a previous auditor
Normally, an auditor who accepts a new client is replacing another auditor. Therefore,
when approached by a potential client, an auditor should enquire about the client’s present
arrangements for accounting and auditing work. If the previous financial report has been
audited, the ethical rules of the Australian accounting profession, which were discussed in Chapter 3
, require that the prospective auditor has the opportunity to ascertain whether
there are any professional reasons why the appointment should not be accepted.
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APES 110 sections 210.13–14 require that, before accepting a nomination, an auditor must:
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request the prospective client’s permission to communicate with the previous auditor
if permission is refused, carefully consider such refusal when determining whether to accept the engagement, or
on receipt of permission, ask the previous auditor in writing for all information necessary
to enable a decision as to whether the nomination should be accepted.
The auditor should treat the reply from the previous auditor in the strictest confidence and
judge whether the factors precipitating the proposed change are unusual, or whether they
indicate that the previous auditor is being treated unfairly.
APES 110 section 210.12 points out that the previous auditor is bound by a duty of
confidentiality, as discussed in APES 110 section 140. Therefore, in the absence of the
client’s permission to do so, the previous auditor should not volunteer information about
the client’s affairs. However, where the previous auditor does provide information, APES
110 section 210.13 requires that it should be provided honestly and unambiguously.
APES 110 section 210.13 requires that if the proposed auditor is unable to communicate
with the previous auditor, the proposed auditor should try to obtain information about
possible threats by other means, such as enquiries of third parties or background
investigations on senior management and those charged with the governance of the prospective client.
As a result of this process of communication, the interests of three groups are protected:
An auditor does not accept an appointment in circumstances of which they are not fully aware.
Shareholders are fully informed of the circumstances in which the change is proposed.
The existing auditor cannot be easily removed or interfered with in the conscientious
exercise of their duty as an independent professional.
While enquiries of the previous auditor about matters that bear on acceptance of the client
are required prior to acceptance, the auditor may also make enquiries of the previous
auditor after acceptance. For example, the auditor needs to consider the relationship of the
financial report of the previous period to the financial report of the current period on which
the auditor will express an opinion.
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After accepting an appointment, ASA 210.9 (ISA 210.9) and APES 305.3.1 require the
auditor and the entity to agree on the terms of engagement. ASA 210.10–11 (ISA 210.10–
11) require that the agreed terms of the engagement shall be recorded in an engagement letter
or other suitable form of written agreement, unless law or regulation prescribes in
sufficient detail the terms of the audit engagement. The auditor should document the
arrangements made with the client and clarify any matters that may be misunderstood. This
should help protect the audit firm and ensure that the client fully understands the auditor’s position.
The form and content of the audit engagement letter vary for each client. It should
generally include reference to the following matters set out in ASA 210.10 (ISA 210.10):
the objective and scope of the financial report audit
the auditor’s responsibilities
management’s responsibilities
the identification of the applicable financial reporting framework
the form and contents of any reports, and a statement indicating that there may be
circumstances in which the form and content may differ.
An example of an audit engagement letter is contained in Appendix 1 to ASA 210 (ISA
210). A sample of an audit engagement letter prepared on this basis is presented in Exhibit 5.1
. The letter may need to be modified in accordance with the circumstances.
Other matters that could be included are: specification of the schedules to be prepared by
the client; arrangements concerning the involvement of other auditors, experts or internal
auditors; and the method and frequency of billing of fees.
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Created from cdu on 2020-08-27 00:34:19. EXHIBIT 5.1
SAMPLE AUDITOR’S ENGAGEMENT LETTER Jan Smith & Associates Chartered Accountants 30 Banks St Newtown The Managing Director ABC Ltd 15 Queen Street Newtown Dear Mr Spencer Scope
You have requested that we audit the financial report of ABC Ltd as of and for the
year ending 30 June 20X5. We are pleased to confirm our acceptance and our
understanding of this engagement by means of this letter. Our audit will be conducted
pursuant to the Corporations Act 2001 with the objective of expressing an opinion on the financial report.
Responsibilities of the auditor
We will conduct our audit in accordance with the Australian auditing standards.
These standards require that we comply with ethical requirements and plan and
perform the audit to obtain reasonable assurance about whether the financial report is
free from material misstatement.
An audit involves performing procedures to obtain audit evidence about the amounts
and disclosures in the financial report. The procedures selected depend on the
auditor’s judgment, including the assessment of the risks of material misstatement of
the financial report, whether due to fraud or error. An audit also includes evaluating
the appropriateness of accounting policies used and the reasonableness of accounting
estimates made by management, as well as evaluating the overall presentation of the financial report.
Because of the inherent limitations of an audit, together with the inherent limitations
of internal control, there is an unavoidable risk that some material misstatements may
not be detected, even though the audit is properly planned and performed in
accordance with the Australian auditing standards.
In making our risk assessments, we consider internal control relevant to the Page 191
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entity’s preparation of the financial report, in order to design audit
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procedures that are appropriate in the circumstances, but not for the purpose of
expressing an opinion on the effectiveness of the entity’s internal control.
However, we will communicate to you in writing concerning any significant
deficiencies in internal control relevant to the audit of the financial report that we identify during the audit. Responsibilities of management
Our audit will be conducted on the basis that management and directors acknowledge
and understand that they have responsibility: (a)
for the preparation of the financial report that gives a true and fair view in
accordance with the Corporations Act 2001 and the Australian accounting standards (b)
for such internal control as management determines is necessary to enable the
preparation of the financial report that is free from material misstatement, whether due to fraud or error (c) to provide us with: (i)
access to all information of which the directors and management are
aware that is relevant to the preparation of the financial report, such as
records, documentation and other matters (ii)
additional information that we may request from the directors and
management for the purpose of the audit (iii)
unrestricted access to persons within the entity from whom we
determine it necessary to obtain audit evidence.
As part of our audit process, we will request from management and, where
appropriate, directors written confirmation concerning representations made to us in connection with the audit.
Other matters under the Corporations Act 2001 Independence
We confirm that, to the best of our knowledge and belief, we currently meet the
independence requirements of the Corporations Act 2001 in relation to the audit of
the financial report. In conducting our audit of the financial report, should we
become aware that we have contravened the independence requirements of the
Corporations Act 2001, we shall notify you on a timely basis. As part of our audit
process, we shall also provide you with a written independence declaration as
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required by the Corporations Act 2001.
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The Corporations Act 2001 includes specific restrictions on the employment
relationships that can exist between the audited entity and its auditors. To assist us in
meeting the independence requirements of the Corporations Act 2001, and to the
extent permitted by law and regulation, we request you discuss with us:
the provision of services offered to you by Jan Smith & Associates prior to
engaging or accepting the service
the prospective employment opportunities of any current or former partner or
professional employee of Jan Smith & Associates prior to the commencement of
formal employment discussions with the current or former partner or professional employee. Annual general meetings
The Corporations Act 2001 provides that shareholders can submit written questions
to the auditor before an annual general meeting, provided that they relate to the
auditor’s report or the conduct of the audit. To assist us in meeting this requirement
in the Corporations Act 2001 relating to annual general meetings, we request that you
provide to us written questions submitted to you by shareholders as soon as
practicable after the question(s) has been received and no later than five business
days before the annual general meeting, regardless of whether you believe the questions(s) to be irrelevant.
Presentation of audited financial report on the internet
It is our understanding that the entity intends to publish a hard copy of the audited
financial report and auditor’s report for members, and to electronically present the
audited financial report and auditor’s report on its internet website. When
information is presented electronically on a website, the security and Page 192
controls over information on the website should be addressed by the entity to
maintain the integrity of the data presented. The examination of the controls over the
electronic presentation of audited financial information on the entity’s website is
beyond the scope of the audit of the financial report. Responsibility for the electronic
presentation of the financial report on the entity’s website is that of the governing body of the entity. Fees
We look forward to full cooperation with your staff and we trust that they will make
available to us whatever records, documentation and other information we request in
connection with our audit. Our fees, which will be billed as work progresses, are
based on the time required by the individuals assigned to the engagement, plus out-
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of-pocket expenses. Individual hourly rates vary according to the degree of
responsibility involved and the experience and skill required.
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We will issue an auditor’s report expressing our opinion on the financial report of
ABC Ltd in accordance with the Australian auditing standards. The form and content
of our report may need to be amended in the light of our audit findings.
Please sign and return the attached copy of this letter to indicate that it is in
accordance with your understanding of the arrangements for our audit of the financial
report, including our respective responsibilities. Yours faithfully Jan Smith Partner 15 September 20X5
Acknowledged on behalf of ABC Ltd by Jim Spencer Managing Director 30 September 20X5
On recurring audits, ASA 210.13 (ISA 210.13) requires the auditor to assess whether
circumstances require the terms of the engagement to be revised and whether it is
necessary to remind the entity of the existing terms of the audit engagement.
Conferences with the client’s personnel
Soon after acceptance of an engagement, the auditor should meet with key client personnel,
including the principal administrative, financial and operating officers, the chief internal
auditor, and the IT (information technology) manager, to discuss matters expected to have a
significant effect on the financial report or on the conduct of the audit.
Good relations with client personnel are important. An audit usually causes considerable
inconvenience and disruption to some personnel, and their assistance is often needed to
obtain documents, records and explanations of various matters. Effective early conferences
establish a foundation for a good working relationship with all client personnel.
Effective communications with top management are particularly important. The auditor
should have an opportunity to consider the accounting implications of important planned
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transactions, such as merger negotiations or lease or purchase decisions. The chief
executive officer should be informed on a regular basis of new accounting and disclosure
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