ACCT442 Auditing

Understand the Business

Learning objective

As part of the planning process, the audit team needs to gain an understanding of Alpine Bags Ltd.�s structure and its business environment. By understanding the client�s business, the audit team can identify potential risks that may have a significant effect on the financial statements. This will assist the team in planning and performing the audit, including making inherent risk assessments.

This assignment will help you learn to identify those potential risks of misstatement and evaluate which of those risks are classified as significant risks (CAS 315.27).

Required

Josh Thomas, Audit Senior, has asked you to research the retail and wholesale backpack industries and report back to the audit team. Your report will form part of the overall understanding of Alpine Bags� structure and its environment.

You should concentrate your research on providing findings from those areas that have a financial statement impact and are considered probable given Alpine Bags� operations. In conducting your research, you should consider the following key market forces, as they relate to Alpine Bags� operations.

For each area listed below, consider whether that factor could increase the risk of material misstatement in Alpine Bags� financial statements.

List your potential risks in the table provided.

General and industry-specific economic trends and conditions

� What is the current condition of the economy?

� Is the business affected by developments in other countries, foreign currency fluctuations, or other global forces?

� If the industry is labour-intensive, are there unusual or unique labour relations issues?

� How does the company�s growth and overall financial performance compare with the industry, and what are the reasons for any significant differences?

� What is the volume and type of transactions in the business?

� Are the client�s operations centralized or decentralized?

� Is the client�s business cyclical or influenced by seasonal fluctuations in the market?

� What is the susceptibility to fraud and theft? (Is the product something that can easily be stolen and has an active market?)

Competitive environment

� What products does the client sell, and have there been significant changes with respect to:

a. major products or brands?

b. selling strategies?

c. sales/gross margin by product?

� Who are the client�s major competitors, and what share of the market does each hold?

� Is there significant differentiation between the client�s and competitors� merchandise?

� What is the effect on the client of potential new entrants into the market? Are there any significant barriers to entering the market?

Product information

� Is there a specific life cycle for the product?

� Is the product dependent on trends or styles?

Customer information

� Are there specific customers on whom the client is highly dependent?

� What is the overall profile of the client�s customers? Have there been significant fluctuations in the client�s customer base?

Supplier information

� Who are the key suppliers?

� Are the materials subject to significant price movements or influenced by external market forces?

Technological advances and the effect of the Internet

� How does the industry use technology?

� What technological trends are affecting the industry?

Laws and regulatory requirements

� Are the client�s operations affected significantly by local or foreign legislation?

� What new laws and regulations recently enacted (or pending) may have significant effects on the company?

Calculate materiality

Learning objective

One of the underlying principles in auditing is the concept of materiality. An auditor designs procedures in order to identify and correct errors or irregularities that� would have a material impact on the financial statements. Such errors or irregularities are considered material if they would impact the decision-making of the users of� the financial statements. Materiality is used in determining audit procedures, selecting samples, and evaluating differences from client records to audit results. It is the maximum amount of misstatement, individually or in aggregate, that can be accepted in the financial statements.

In selecting the base figure to be used to calculate materiality, an auditor should consider the key driver of the business. They should ask themselves, �What are the end users (such as shareholders and banks) of the financial statements going to be looking at?� For example, will shareholders be interested in the net income that can be used to pay dividends and increase share price?

Planning materiality

W&S Partners� audit methodology dictates that one planning materiality (PM) amount is to be used for the financial statements as a whole. Further, only one basis should be selected�a blended approach or average should not be used. The basis selected is the one determined to be the key driver of the business.

W&S Partners uses the following percentages as starting points for the various bases. These starting points can be increased or decreased by taking into account qualitative client factors, which could be:

� the nature of the client�s business and industry (such as rapid change, either through growth or downsizing, or unstable environment)

� the fact that it is a publicly listed entity (or subsidiary of one) subject to regulations

� the knowledge of or high risk of fraud.

�

Typically, profifit before tax is used; however, it cannot be used if the entity is reporting a loss for the year or if profifitability is not consistent.

When calculating PM based on interim figures, it may be necessary to annualize the results. This allows the auditor to properly plan the audit based on an approximate projected year-end balance. Then, at year end, the figure is adjusted, if necessary, to reflect the actual results.

Note: Adjustments to the starting points are made by an experienced auditor using their professional judgement. The aim is to set PM at a high enough level that appropriately balances the amount of testing, while still keeping the audit risk to an acceptable level.

Performance materiality

W&S Partners also dictates that performance materiality be determined for each audit engagement. Performance materiality is an amount less than planning� materiality that reduces the likelihood that any uncorrected and undetected misstatements within a class of transactions, account balances, or disclosures in aggregate exceed overall planning materiality.

W&S Partners� policy is to use 70 percent of planning materiality to determine performance materiality.

Required

Using the working paper provided (A2�1):

� Select the basis for planning materiality that you believe is most appropriate. Justify your selection.

� Calculate the planning materiality (PM) using the December 31, 2023, trial balance and draft Statement of Income in Appendix 2.

� Based on your determination of PM, calculate and conclude on performance materiality.

Assertions

Learning objective

In this assignment, you will extend your knowledge gained in assignment 1 by taking the significant risks you have already identified and then� conducting further analysis on their likelihood and materiality.

Risks identified from gaining an understanding of the client�s business are referred to as inherent risks. These risks are considered in the audit-risk formula. The auditor needs to identify which financial statement assertions may be affected by these inherent risks.

Identifying these risks will help determine the nature of the audit procedures to be performed.

Management implicitly or explicitly makes assertions regarding the recognition, measurement, and presentation of the various elements of the financial statements and related disclosures. Auditors use assertions for account balances to form a basis for the assessment of risks of material misstatement. That is, assertions are used to identify the types of errors that could occur in transactions that result in the account balances. Consequently, breaking� down the financial statement accounts into these assertions will direct the audit effort to those areas of higher risk.

Assertions direct the audit, and audit procedures are designed so that they are responsive to the assessed risks. Broadly, these assertions can be classified in the following categories:

� existence or occurrence

� completeness

� valuation and allocation, or accuracy

� rights and obligations

� cut-off

� classification

� presentation, disclosure, and understandability

Required

Using the risks identified in assignment 1 on working paper A1�1, complete the following information in the relevant columns of the working paper.

� Identify the assertions that would be affected.

� Give an assessment of �high,� �medium,� or �low� in relation to the likelihood and materiality of the risk occurring.
A risk should be classified as �high� if it is highly likely to be present and material. A risk should be classified as �medium� if it may be present and material. Risks should be classified as �low� if they are unlikely to be present and/or not material.

Discussion points

� Did you have any significant risks that could not be linked to an account in the financial statements and an assertion? Is it still a significant risk?

� Given your analysis�for this client�is the overall level of inherent risk �low,� �medium,� or �high�?