Chapter 4 Overview of elements of the financial report audit process | Auditing and Assurance Services in Australia

lOMoAR cPSD| 47206071 Page 135 CHAPTER 4
Overview of elements of the financial report audit process
LEARNING OBJECTIVES (LO) 4.1
Explain the difference between accounting and auditing and the
importance of professional scepticism and professional judgment to auditing. 4.2
Outline the logical process of identifying financial report assertions,
developing specific audit objectives and selecting auditing procedures. 4.3
Explain the relationships between audit procedures and evidence, and
describe common audit procedures used in an audit of a financial report. 4.4
Define sufficient appropriate audit evidence and its relationship to auditing procedures.
4.5Outline the audit risk model.
4.6Explain the concept of materiality.
4.7Define types of audit tests.
4.8Explain how an auditor may use the work of an expert or component auditor. 4.9
Describe the general requirement to document audit work and the contents of audit working papers. RELEVANT GUIDANCE ASA 200/ISA 200
Overall Objectives of the Independent Auditor and the
Conduct of an Audit in Accordance with Australian
(International) Auditing Standards Audit Documentation ASA 230/ISA 230 ASA 315/ISA 315
Identifying and Assessing the Risks of Material
Misstatement through Understanding the Entity and Its Environment
Materiality in Planning and Performing an Audit ASA 320/ISA 320 lOMoAR cPSD| 47206071 ASA 330/ISA 330
The Auditor’s Responses to Assessed Risks
Evaluation of Misstatements Identified during the Audit ASA 450/ISA 450 Audit Evidence ASA 500/ISA 500 ASA 501/ISA 501
Audit Evidence—Specific Considerations for Inventory and
Segment Information/Audit Evidence—Specific Considerations for Selected Items
Auditing Accounting Estimates, Including Fair Value ASA 540/ISA 540
Accounting Estimates, and Related Disclosures
Written Representations ASA 580/ISA 580
Special Considerations—Audits of a Group Financial ASA 600/ISA 600
Report (Including the Work of Component Auditors)
Using the Work of an Auditor’s Expert ASA 620/ISA 620
Forming an Opinion and Reporting on a Financial Report ASA 700/ISA 700
AUASB Glossary/Glossary of Terms AUASB/IAASB
Third Party Access to Audit Working Papers GS 011 Page 136 lOMoAR cPSD| 47206071 CHAPTER OUTLINE
Although a financial report audit is only one type of assurance engagement, it is the
most common. Therefore, in this chapter an overview of the elements of the financial
report audit process is provided.
While a financial report audit of a complex entity is a complicated process, even the
most complex audit has certain basic elements. This chapter compares financial report
auditing with accounting, and explains the basic elements of the audit process,
including professional scepticism and professional judgment. These building blocks are
necessary to understand how an audit is accomplished in conformity with Australian
auditing standards. Most of the auditor’s work in forming an opinion on the financial
report consists of obtaining and evaluating evidence about the assertions in the
financial report by applying auditing procedures. It is important to understand each of
the elements—audit evidence, materiality, assertions and audit procedures—in order
to comprehend the audit of a financial report, which will be conducted within the
framework of the audit risk model and the client’s business risk.
The auditor must also prepare and maintain adequate audit working papers to
document their work. This chapter explains the function and content of audit working papers.
How this chapter fits into the overall financial report audit is illustrated in Figure 4.1
, which is an expansion of part of the overall flowchart provided in Chapter 1 . lOMoAR cPSD| 47206071 lOMoAR cPSD| 47206071
FIGURE 4.1 Flowchart of planning and risk-assessment stage of a financial report audit lOMoAR cPSD| 47206071 Page 137
LO 4.1 Accounting and auditing contrasted
As a process, financial report auditing is linked with accounting principles and procedures
used by businesses and other entities. An auditor renders an opinion on the financial
report of an entity. The financial report is the product of the entity’s accounting system
and of judgments made by those charged with the governance and management of the entity.
As indicated by ASA 200.3 (ISA 200.3), the purpose of an audit is to enhance the degree of
confidence of intended users of the financial report. Therefore, the ultimate objective of
the audit process is to present an opinion on the presentation of results of operations for
a given period and on the financial position at the end of this period. To form such a
judgment about the financial report of an entity, the auditor must look behind the
financial report to the data and the allocations of the data.
Therefore, there is a close relationship between accounting and auditing. Auditors work
primarily with accounting data. They attempt to satisfy themselves that the data
summarised in the financial report are the data arising from transactions and events that
the entity actually experienced. Further, they must make judgments about the allocations
of data that have been made by those charged with governance and management, and
decide whether the financial report presentation is appropriate or misleading. To make
these judgments, auditors cannot limit themselves to the records and accounts of the
entity. They must be concerned with the total entity, because non-accounting activities,
including the behaviour of the participants in the entity, influence not only the data but
also the judgments of those charged with governance and management relating to the
accounting for and reporting of the data. The audit function focuses on accounting, and
the auditor must first be a competent accountant, but the audit function also extends
beyond accounting (see Figure 4.2 ). lOMoAR cPSD| 47206071
FIGURE 4.2 Relationship between accounting and auditing Professional scepticism
The end product of an accountant’s work is a financial report. The financial report may
simply be the results of this work, or it may be adjusted according to the desires of those
charged with governance and management who might wish to classify and report Page
138 data in particular ways. As indicated by ASA 200.A48 (ISA 200.A48), it is possible to
prepare different financial reports from the same data, because accounting standards
allow a choice between several acceptable accounting methods, and because judgment
will be exercised in determining the amounts for some accounts, such as for various
provisions. Also, as discussed in Chapter 1 , the preparers of the financial reports are
potentially biased, as they have a vested interest in the information contained in the
financial report. Therefore, ASA 200.15 (ISA 200.15) requires the auditor to plan and
perform the audit with professional scepticism , recognising the possible existence of
material misstatements in the financial report. Professional scepticism is critical to the
audit process (see Auditing in the global news 4.1 ). lOMoAR cPSD| 47206071
4.1 Auditing in the global news ...
Professional scepticism lies at the heart of a quality audit
In 2015, the International Auditing and Assurance Standards Board (IAASB),
International Ethics Standards Board for Accountants (IESBA), and the International
Accounting Education Standards Board (IAESB) convened a small, cross-
representational working group—the Professional Scepticism Working Group—to
formulate views on whether and how each of the three
boards’ sets of international standards could further contribute to strengthening the
understanding and application of the concept of professional scepticism as it applies to an audit.
Today, the topic of professional scepticism is featured prominently in each of the
board’s strategic considerations, and all three boards have important initiatives
related to professional scepticism. All three boards see the opportunity for shorter
term actions as well as the need for longer term considerations, in consultation with each other.
The importance of professional scepticism to the public interest is underscored by
the increasing complexity of business and financial reporting, including greater
use of estimates and management judgments, changes in business models
brought about by technological developments, and the fundamental reliance the
public places on reliable financial reporting.
Source: IAASB, IESBA; IAESB (2017) ‘Towards Enhanced Professional Scepticism’, IFAC, August, New
York, p. 3. This text is an extract from ‘Towards Enhanced Professional Scepticism’ Observations of the IAASB-
IAESB-IESBA Professional Skepticism Working Group, published by the International Federation of Accountants
(IFAC) Aug 14, 2017 and is used with permission of IFAC. Such use of IFAC’s copyrighted material in no way
represents an endorsement or promotion by IFAC. Any views or opinions that may be included in Auditing &
Assurance Services in Australia 7e are solely those of McGraw-Hill Education and do not express the views and
opinions of IFAC or any independent standard setting board associated with IFAC.
The Auditing and Assurance Standards Board (AUASB) Glossary describes professional
scepticism as ‘an attitude that includes a questioning mind, being alert to conditions
which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence’. lOMoAR cPSD| 47206071
Professional scepticism needs to be exercised throughout the planning and performance
of the audit. ASA 200.A20–A22 (ISA 200.A20–A22) indicate that professional scepticism includes:
questioning the reliability of documents, information and management
explanations being alert to possible contradictory evidence questioning the
sufficiency and appropriateness of audit evidence being alert to conditions
that may indicate risks of fraud critically challenging management judgments, assumptions and estimates.
Further, with the rapid changes in technology in recent years, such as data analytics,
which have not as yet been incorporated into the auditing standards, there is a need for
the auditor to consider whether circumstances exist that indicate a need for audit
procedures Page 139 to be applied in addition to those required by the auditing standards.
Professional scepticism is essentially a mindset. A sceptical mindset drives auditor
behaviour to adopt a questioning approach when considering information and in forming
conclusions. As a result, professional scepticism is linked to the fundamental ethical
principles of objectivity and auditor independence discussed in Chapter 3 and is an
inescapable element in the exercise of professional judgment. Professional judgment
ASA 200.16 (ISA 200.16) requires the auditor to exercise professional judgment in
planning and performing the audit. The AUASB Glossary defines professional judgment as
‘the application of relevant training, knowledge and experience, within the context
provided by auditing, accounting and ethical standards, in making informed decisions
about the courses of action that are appropriate in the circumstances of the audit engagement’.
Further, ASA 200.A25 (ISA 200.A25) emphasises that professional judgment is essential to
conducting an audit, as it is required for decisions such as determining materiality,
assessing audit risk, evaluating audit evidence, assessing the reasonableness of
accounting estimates and evaluating management judgments concerning the application
of the applicable financial reporting framework, including the appropriateness of
accounting treatments and policies and the appropriateness of the going concern basis. lOMoAR cPSD| 47206071
As indicated by ASA 200.6 (ISA 200.6), the concept of materiality is applied by the auditor
in planning and performing the audit and in evaluating the effect of misstatements on the
financial report. Materiality will be discussed in detail later in this chapter in relation to
planning and in Chapter 11 in relation to completion of the audit. Areas of audit interest
Separating the audit process into understandable parts requires a definition of the areas
of audit interest. The auditor is interested in the accountable activity of the entity; the
organisation of the entity, that is, its organisational structure ; and the risks arising from
its business strategy and the environment in which it operates, that is, its business risk .
Accountable activity of the entity
From an auditing perspective, there are three stages in the accounting process:
1. The collection of original data The original accounting data are exchanges of
consideration between an entity and other entities or individuals. These transactions
take the form of sales of product, purchases of raw materials, purchases of labour,
lending of money, borrowing of money, repaying of money and being repaid. These are
the basic data of accounting and the first and most basic areas of interest to the auditor.
The auditor must understand the flow of transactions through the accounting system.
Therefore, one of the important parts of the audit is a review of the accounting system,
because a substantial part of the effort in an audit is concerned with the operation of that system.
2. The allocations and reclassifications of accounting data Accounting journals are often
called the ‘books of prime entry’, because the first stage of the accounting process
consists of recording the exchange transactions of an entity in a journal. However,
accounting journals also contain entries that do not represent exchange transactions.
These entries are made to allocate and reclassify original exchange data to other
accounts in preparation for placement in the financial report. All the allocations and
reclassifications in an entity’s journals are made according to procedures and practices
that have been developed by accountants over the years. For example, there are both
acceptable and unacceptable ways of depreciating fixed assets, amortising other
longlived assets and allocating labour and materials costs to periods. This part of the
audit depends on the auditor’s knowledge as an accountant. As an accountant, the
auditor knows which allocation and reclassification methods are acceptable, and must
observe what the entity has done and decide whether it has followed acceptable
methods Page 140 and made acceptable choices where judgment is involved. As discussed
earlier, this will involve the auditor applying professional scepticism to client choices, judgments and estimates. lOMoAR cPSD| 47206071
3. The presentation of the results of the accounting process As discussed in Chapter 1 ,
in order to add credibility to a report, the auditor needs to examine that the subject
matter is prepared in accordance with suitable criteria and provide an assessment to
accompany the report prepared by the responsible party. Hence, in accordance with ASA
700 (ISA 700) and the Corporations Act 2001, in a financial report audit the auditor is
required to report on whether the financial report presents fairly the financial position
and operating results (or gives a true and fair view) in accordance with Australian accounting standards.
There are rules that govern the placement of various items in the financial report and
the terminology used to present them. The auditor must use accounting knowledge, at
the allocation stage, to decide whether the client has properly prepared the financial
report. Further, the auditor must review the accompanying notes to the financial report
and judge their adequacy and completeness. Guidance on these issues is available by
reference to accounting standards and other professional statements and to the
disclosure requirements contained in the Corporations Act 2001. Organisation of the entity
The auditor also has the internal organisational structure of the entity with which to work.
In auditing terminology this is referred to as internal control . The auditor can make
enquiries of client personnel and review the system of documentation used by the entity;
trace various types of transactions from initial to ultimate disposition in the system to
observe its functioning; and, finally, make an evaluation of the system to identify strengths
and weaknesses. These activities are part of the auditor’s evaluation of the controls over
the accounting system. The accuracy and reliability of the accounting system depends on how it is controlled.
The objectives of internal control are linked with the auditor’s concern with the flow of
transactions through the accounting system and the impact of business risk on the entity’s
ability to achieve its objectives. Internal control is designed and implemented to address
identified business risks that threaten the achievement of any of these objectives. Internal
control will be discussed further in Chapter 7 . Business risk
The auditor needs to understand the entity’s business strategy, its business environment
and the risks it faces to determine whether these might affect the financial report.
Auditors use their understanding of the client’s business, industry and risks to develop a lOMoAR cPSD| 47206071
more efficient and effective audit. Business risk will be discussed later in this chapter and in detail in Chapter 5 . QUICK REVIEW 1.
Accounting is concerned with measuring and recording data, while auditing
is concerned with obtaining sufficient appropriate evidence as to their propriety and accuracy. 2.
Accounting involves the preparation of the financial report, while auditing
involves giving an opinion on the financial report. 3.
Professional scepticism and the exercise of sound professional judgment are
critical to a high-quality audit. 4.
One key area of audit interest is the accountable activity of the entity, which
includes the collection of original accounting data, the allocation and
reclassification of accounting data and the presentation of the results in the financial report. 5.
A second key area of audit interest is the organisation of the entity, including internal control. 6.
A third key area of audit interest is the entity’s business risk. lOMoAR cPSD| 47206071 Page 141
LO 4.2 Financial report assertions and audit objectives and procedures
In effect, by presenting a financial report, those charged with governance and management
are stating certain things about the entity’s financial position and operations. These
assertions by those charged with governance and management that are embodied in the
financial report are referred to as financial report assertions . The auditor uses assertions
to assess risks, by considering the different types of potential misstatements that may occur
and then designing appropriate audit procedures that address these risks. The assertions
deal essentially with recognition and measurement of the various elements of the financial
report and related disclosures. ASA 315 (ISA 315) has two categories of assertions: classes
of transactions and events and related disclosures, and account balances and related
disclosures. These are set out in ASA 315.A128 (ISA 315.A128), as follows in Exhibit 4.1 . lOMoAR cPSD| 47206071 EXHIBIT 4.1
TWO CATEGORIES OF FINANCIAL REPORT ASSERTIONS lOMoAR cPSD| 47206071
1. Assertions about classes of transactions and events, and related disclosures, for the period under audit (a)
Occurrence —transactions and events that have been recorded or
disclosed have occurred and pertain to the entity. (b)
Completeness —all transactions and events that should have been
recorded have been recorded and all related disclosures that should have
been included in the financial report have been included. (c)
Accuracy —amounts and other data relating to recorded transactions and
events have been recorded appropriately and related disclosures have been
appropriately measured and described. (d)
Cut-off —transactions and events have been recorded in the correct accounting period. (e)
Classification —transactions and events have been recorded in the proper accounts. (f)
Presentation —transactions and events are appropriately aggregated or
disaggregated and clearly described, and related disclosures are relevant and understandable.
2. Assertions about account balances, and related disclosures, at the period end (a)
Existence —assets, liabilities and equity interests exist. (b)
Rights and obligations —the entity holds or controls the rights to assets,
and liabilities are the obligations of the entity. (c)
Completeness —all assets, liabilities and equity interests that should have
been recorded have been recorded, and all related disclosures that should
have been included in the financial report have been included. (d)
Accuracy, valuation and allocation —assets, liabilities and equity
interests are included in the financial report at appropriate amounts and
any resulting valuation or allocation adjustments are appropriately
recorded, and related disclosures have been appropriately measured and described. (e)
Classification —assets, liabilities and equity interests have been recorded in the proper accounts. (f)
Presentation —assets, liabilities and equity interests are appropriately lOMoAR cPSD| 47206071
aggregated or disaggregated and clearly described, and related disclosures
are relevant and understandable.
Source: Extracted from Australian Auditing and Assurance Standards Board (AUASB), 2015 ASA 315
Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its lOMoAR cPSD| 47206071
Environment. (c) 2018 Auditing and Assurance Standards Board (AUASB). The text, graphics and layout of this
publication are protected by Australian copyright law and the comparable law of other countries. No part of the
publication may be reproduced, stored or transmitted in any form or by any means without the prior written
permission of the AUASB except as permitted by law. For reproduction or publication permission should be sought
in writing from the Auditing and Assurance Standards Board. Requests in the first instance should be addressed to
the Technical Director, Auditing and Assurance Standards Board, PO Box 204, Collins Street West, Melbourne, Victoria, 8007.
The auditor needs to obtain evidence that supports each of the assertions for every
material component of the financial report. A component of the financial report may be
an account balance (or group of account balances), a class of transactions or a disclosure.
The categories of assertions provide a framework for developing specific audit Page 142
objectives for each material account balance, class of transactions or disclosure. An audit
objective is an assertion translated into terms that are specific to the particular balance
or class of transactions, the entity’s circumstances, the nature of its economic activity
and the accounting practices of its industry. Consider Global example 4.1 , which
shows some specific audit objectives. lOMoAR cPSD| 47206071
GLOBAL EXAMPLE 4.1 Assertions and objectives for the account balance of
inventory of a manufacturing company Financial report assertion Illustrative audit objectives Existence
Inventories included in the statement of financial position physically exist.
Inventories represent items held for sale in the normal course of business. Rights and
The company has legal title or similar rights of ownership obligations to the inventories.
Inventories exclude items billed to customers or owned by others. Completeness
Inventory quantities as per the accounting records
include all products, materials and supplies owned by the company that are on hand.
Inventory quantities include all products, materials and
supplies owned by the company that are in transit or stored at outside locations. Accuracy,
Inventories are properly stated at the lower of cost and valuation and net realisable value. allocation
Slow-moving, excess, defective and obsolete items
included in inventories are properly identified and valued. Classification
Inventory costs are recorded in the correct accounts. Presentation
Accounting policy for inventory is clearly described in the financial report.
A number of accounting pronouncements now contain complex measurement and
disclosure provisions based on fair value, which need to be considered by the auditor. For
example, ASA 540 (ISA 540) Auditing Accounting Estimates, Including Fair Value
Accounting Estimates and Related Disclosures addresses audit considerations relating to
the valuation and allocation, accuracy, presentation and disclosure of material financial lOMoAR cPSD| 47206071
report items presented or disclosed at fair value. These include understanding the entity’s
process for determining fair value, assessing its appropriateness and considering the use of an expert. QUICK REVIEW
1. Those charged with governance and management make assertions about the
entity’s financial position and operations, and these are embodied in the financial report.
2. The auditor obtains evidence to support these assertions for material
components of the financial report. lOMoAR cPSD| 47206071
LO 4.3 Audit procedures and evidence
Audit procedures are the actions that an auditor takes in acquiring evidence. The
procedures are not evidence in themselves; they are the means of acquiring evidence.
ASA 500.5 (ISA 500.5) defines audit evidence as all of the information used by the
auditor in arriving at the conclusions on which the auditor’s opinion is based. It includes
Page 143 all the data and information underlying the financial report and
corroborating information. Audit evidence includes evidence obtained from audit
procedures performed during the audit and may also include evidence obtained from
other sources, such as previous audits. However, ASA 500.A11 (ISA 500.A11) states that
where evidence from a prior audit is used the auditor must perform audit procedures to
ensure its continuing relevance.
The audit equation can be expressed as:
audit evidence = underlying accounting data + corroborating information
The auditor needs to test the propriety and accuracy of the underlying accounting data in
order to be able to express an opinion on the financial report. However, some
corroborating information for material assertions within the financial report is essential.
This audit equation is illustrated in Figure 4.3 .
FIGURE 4.3 The audit equation
The use of audit procedures to obtain evidence to corroborate accounting data can be
illustrated by focusing on one type of transaction. Consider the diagram of a cash
purchase transaction in Figure 4.4 . The auditor may inspect the documentary evidence
in the entity’s records. The item received is recorded as an increase in inventory. A copy of
the purchase order is sent to the supplier and a receiving report is prepared to indicate
receipt of the merchandise. The item given up is recorded as a cash reduction, and there