application of analytical procedures

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CHAPTER 5 – TUTORIAL SOLUTIONS
5.3 Planning activities that need to be considered prior to the performance of further audit procedures
according to ASA 300.A2 (ISA 300.A2) are:
• application of analytical procedures as risk-assessment procedures
• obtaining a general understanding of the legal and regulatory framework applicable to the entity
and how the entity is complying with that framework
• determination of materiality
• involvement of experts
• performance of other risk assessment procedures.
5.4 The auditor needs to have knowledge of the client’s business to enable them to obtain an understanding of
the events, transactions and practices that in their judgment might have a significant effect on the financial
report. Understanding the business and using this knowledge appropriately assists the auditor in assessing
risks and identifying problems; planning and performing the audit effectively and efficiently; evaluating
audit evidence; and providing better service to the client.
The audit judgments facilitated by knowledge of the client’s business include:
• identifying accounting or auditing matters that need special attention
• assessing the conditions under which accounting data are prepared
• evaluating the reasonableness of management’s estimates and other representations
• making judgments about management’s selection and application of accounting principles.
5.5 As per ASA 315.11 (ISA 315.11), the auditor’s understanding of the entity and its environment consists of
an understanding of:
• industry, regulatory and other external factors, including the applicable financial reporting
framework
• the nature of the entity
• the entity’s selection and application of accounting policies
• the entity’s objectives and strategies, and those related business risks that may result in risks of
material misstatement
• the measurement and review of the entity’s financial performance.
5.7 Examples of matters that the auditor may consider when obtaining an understanding of the entity’s
objectives, strategies and related business risks that may result in a risk of material misstatement of the
financial report include:
• industry developments (a potential related business risk might be, for example, that the entity does
not have the personnel or expertise to deal with the changes in the industry)
• new products and services (a potential related business risk might be, for example, that there is
increased product liability)
• expansion of the business (a potential related business risk might be, for example, that the demand
has not been accurately estimated)
• new accounting requirements (a potential related business risk might be, for example, incomplete
or improper implementation, or increased costs)
• regulatory requirements (a potential related business risk might be, for example, that there is
increased legal exposure)
• current and prospective financing requirements (a potential related business risk might be, for
example, the loss of financing due to the entity’s inability to meet requirements)
• use of IT (a potential related business risk might be, for example, that systems and processes are
incompatible)
• the effects of implementing a strategy, particularly any effects that will lead to new accounting
requirements (a potential related business risk might be, for example, incomplete or improper
implementation).
5.18 (Medium)
Major audit concerns to be addressed in the planning documents include the following.
(a)
The software should be reviewed to assess whether it can be used to make the audit more efficient,
particularly in the area of analytical procedures.
The veracity of the output from the system should be examined before any reliance is placed on
reports generated. The extent of management’s use and reliance may give some indication of its
reliability; however, management’s reliance may be misplaced. Management may have been
making erroneous decisions if the output is unreliable.
Consider areas of potential use, such as:
• ratio analysis
• comparative analysis to prior period and budget
• trend analysis.
Consider reports that may be run specifically for the auditors, such as:
• stratification of account balances
• special report formats not previously available; for example, sales history on each inventory
line to assess inventory obsolescence.
(b) Going concern/cash flow
• Consider the ability of Luxury Apartments to remain a going concern if projects cannot
readily be realised for sufficient cash.
Valuation of work in progress
• Consider the ability of Luxury Apartments to recoup construction costs on the sale of
buildings.
• Obtain recent independent valuations considering depressed market conditions. Value of
work in progress should be provided against if a deficiency exists.
Profit recognition
• The audit must address the recognition of profit. Forecast costs to complete must be closely
scrutinised. For example, the downturn in the industry may cause go-slows by labour on site,
as future work may be perceived to be difficult to find, thereby causing overruns in labour
budgets.
(c) Points to consider:
• materiality of the overseas branch in Singapore to the company
• verification of existence of inventory
○ stocktake attendance (other auditors)
○ inventory in transit
• valuation of inventory
○ transfer pricing
○ internal profit in inventory
○ net realisable value; samples may be given away free and some inventory lines may
be discounted as part of marketing campaigns
○ obsolescence—dumping of inventory to branch
○ exchange rate fluctuations.
5.22 (Medium)
(a) Business risk
(b) How it might lead to risk of material
misstatement
Pressure from larger, aggressive competitors
Inventory may be overstated, as goods may
be being sold below cost, requiring a write
down to net realisable value
Significant reduction in gross margins has resulted in
a movement away from its core business to new
products in an attempt to claw back margins.
Movement away from its core business has had
limited success to date and may distract management
from the core business
Going concern may be affected due to
reduced margins
Apparent deterioration in terms of trade with two
major suppliers reducing their credit limits. This may
create liquidity problems and also may indicate the
supplier’s concern about Whisky & Wines
Going concern may be affected due to
tighter terms of trade putting pressure on
liquidity

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