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Title: AUDITING AND ASSURANCE
Description: Audit This is the independent investigation into the quality of published accounting information.
Description: Audit This is the independent investigation into the quality of published accounting information.
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AUDITING AND ASSURANCE
STUDY TEXT
Copyr i ght
ALL RIGHTS RESERVED
...
ISBN NO: 9966-760-23-7
© 2009 Strathmore University Press
First Published 2009
Strathmore University Press
P
...
Box 59857, 00200,
Nairobi, Kenya
...
v
ACKNOWLEDGMENT
...
1
The General Auditing Environment
...
23
The Auditor and the Companies Act
...
47
Audit Planning, Control & Recording (ISA 300)
...
61
Fraud and Error (ISA 240)
...
93
Audit Evidence (ISA 500)
...
109
Audit Sampling (ISA 530)
...
123
Substantive Testing
...
159
Computerised Information Systems
...
177
Auditors’ Report (ISA 700)
...
195
Glossary of Terms
...
269
S T U D Y
CHAPTER FIVE
...
63
S T U D Y
T E X T
vi
A U D I T IN G AN D A S S U RAN C E
The General Auditing Environment
1
S T U D Y T E X T
S T SU TDUYD Y
T E TX ET X T
CHAPTER ONE
THE GENERAL AUDIT
ENVIRONMENT
S T U D Y
T E X T
2
A U D I T IN G AN D A S S U RAN C E
The General Auditing Environment
3
CHAPTER 1
THE GENERAL AUDIT ENVIRONMENT
Chapter Objectives:
Introduction
At the end of every financial year, company’s are expected by statute to have their financial
statements reviewed by an independent professional who after going through the accounts,
expresses an opinion as to whether the financial statements present a true and fair view of
the financial position of the company
...
This chapter gives an introduction of auditing and its benefits
...
Exam Context
This topic gives you an introduction into the auditing
...
Industry context
Audits are conducted for most businesses especially where there is separation of ownership
from management
...
An audit therefore is necessary in the
current world
...
Definition of Auditing
Distinction between auditing and accounting
Objects of an audit
What is true and fair?
Benefits of an audit to a public limited company
Types of audits
Users of audited reports
Stages of an audit
S T U D Y
••
4
A U D I T IN G AN D A S S U RAN C E
Need for an audit
Industrialization has led to growth of business through pooling together savings of investors
...
Limited liability companies were
created with the intention of having widespread shareholding
...
Also the shareholders may lack skills and the time to manage their company
...
The agents who are the directors have a total discretion over strategy,
investment and financing decisions, which have enormous implication on the shareholders
...
This situation shareholders
find themselves in entrusting their savings with the directors who can easily misuse the savings
is called the agency problem
...
This can be, through:
a
...
g
...
b
...
These are:
• Section 147 of the Companies Act requires the company to keep proper books of
accounts and other statutory records
...
• Section 159 of the Companies Act requires the directors to prepare accounts of
their financial stewardship and sent them to all the shareholders so that they can
ascertain the operation and financial position of their company
...
• Section 159 further requires the directors to call an annual general meeting (AGM)
at which the company accounts are laid before the shareholders as a group
...
g
...
The major problem is that these company accounts and reports the shareholders use to evaluate
the financial stewardship of directors and which can be used to discipline or reward the directors
are prepared by the directors themselves
...
This can tempt the directors to manipulate figures which are published in the accounts
...
The shareholders receive company accounts and other information from the directors therefore
need assurance regarding quality of the information
...
Definition of an Audit:
An audit is the independent examination of and expression of an opinion on the financial
statements of an economic entity by appointed auditor in pursuance of that appointment and in
compliance with any relevant statutory obligation
...
Since most balance sheets and profit and loss accounts
are summarized statements amplified by notes to the statements, the business community and
the accountancy profession require that a cash flow statement as well as a statement of changes
in equity be prepared
...
Financial Reporting framework: According to International Auditing Standards (ISA 200, the
framework of international standards of auditing), financial statements are usually prepared and
presented annually and are directed at common informational needs of a wide range of users
...
Therefore financial statements need to be prepared in
accordance with one or combination of:
••
••
••
International Financial Reporting Standards (IFRS)or IASs
National accounting standards
Any other authoritative and comprehensive financial reporting framework designed for
use in financial reporting and is identified in the financial statements
...
Role of IFRS and IASs in preparation of financial statements
Though not specifically set out in the preface to the statement of IFRS, it is well accepted within
the accountancy projection that IFRS do the following:
•
Though not specifically set out in the preface to the statement of IFRS, it is well accepted
within the accountancy projection that IFRS do the following:
S T U D Y
The purpose of an audit is not to provide additional information but rather it is intended to provide
the users of the accounts with assurance that the information provided to then by directors is
reliable
...
T E X T
The objective of an audit is to enable the auditor express an opinion whether financial statements
show a true and fair view of the company state of affairs in accordance with an identified financial
reporting framework
...
Where one or more methods of accounting are acceptable, they prescribe one method which
is preferred and called the benchmark treatment and the allowed alternative treatment and
conditions under which that allowed alternative is applied
...
• They increase comparability of financial statements
...
It is extremely unlikely that financial statements would give a true and fair view when appropriate
IFRS are departed from
...
Auditors can on their part refer to the departure
in their audit report and clearly indicate whether or not they concur with the departure
...
IFAC
is the worldwide organization for the accountancy profession
...
4 million accountants in public
practice, education, government service, industry and commerce
...
In addition to developing auditing standards through the IAASB, IFAC also develops
education, ethics, and public sector accounting standards
...
ISAs do not override
a country’s regulations which may be government statutes or statements issued by regulatory or
professional bodies in the country
...
AUDITING
Advantages of auditing
••
••
••
••
••
••
Dispute resolution
...
Significant changes in ownership and structure can be easily effected if past accounts
contain unqualified audit reports
...
g
...
Auditors have access to the corporate strategy of the company thus are able to give
advice on gaining competitive advantage and on improvement of business efficiency
...
Auditing protects the interests of the shareholders who are separated from the
management of their savings invested in the company
...
The General Auditing Environment
7
Disadvantages of auditing
•
•
•
Audit fees are normally high since auditors are highly qualified professionals hence small
firms such as sole proprietorships may not afford their financial statements to be audited
...
Company secrets may leak to competitors since all company information is accessible to
the auditors
...
These statements are generally prepared on
an annual basis and used by management and other interested parties to make decisions
...
•
•
•
Auditing is an independent examination of company accounts and expression of an opinion
whether they contain a true and fair view of company’s state of affairs
...
While auditing is conducted once in a financial period and usually at the end, financial
accounting is a continuous process throughout the financial period of a company
...
Similarities between Auditing and Financial Accounting
•
Both auditing and accounting are statutory requirements i
...
that companies must maintain
proper books of accounts at that their financial statement must be audited
Objectives & General principles of an Audit
ISA 200 (Objectives And General Principles Governing An Audit Of Financial Accounting) states
that the objective of an audit of financial statement is to enable auditors give an opinion on
financial statements taken as a whole thereby provide reasonable assurance that the statements
give a true and fair view and have been prepared in accordance with relevant acco unting and
other requirements
...
(See True & Fair Below)
S T U D Y
Differences between Auditing and Financial Accounting
T E X T
Auditing is a check carried out by an independent auditor to make sure that what a company
is saying about its financial statement is true
...
8
A U D I T IN G AN D A S S U RAN C E
Users of Audited Financial Statements
S T U D Y
T E X T
•
Present and potential investors
...
They need information to help them determine
whether they should buy more shares, hold on to the shares they have or sell the shares
they have
...
These and their representative groups such as trade unions are interested in
information about the stability and profitability of their employers
...
• Lenders
...
• Suppliers and other trade creditors
...
Their interest in
the company is of shorter period than lenders while they are dependent upon the continuation
of the company as a major customer
...
These have interest in information about the continuance of the company
especially when they have long term involvement and or are dependent as the company
...
The main interest of the government is allocation of resources
...
• Public
...
A company may make substantial
contribution to the local economy by employing people and obtaining supplies locally
...
Others:
••
••
••
••
••
••
••
Lawyers
Competitors
Stock brokers
Statisticians
Financial journalists
Trade unions
Credit-rating agencies
Types of Audits
•
•
•
Audits can be classified into two broadways
...
e
...
According to the approach to the work to be done/ timing
...
Statutory audits
These are carried out as per the requirements of various statutes e
...
Companies Act Cap 486
requires that all public limited companies to have their financial statements subjected to an
The General Auditing Environment
9
independent audit
...
The rights
and duties of the auditor are laid down in the relevant statute
...
Private audits
These are not governed by statutes
...
Private audits are carried out
for organizations such as non governmental organizations, partnerships and clubs and among
others
...
The scope and objective of the work as well as rights and duties of the
auditor are determined by the agreed terms between the auditor and the client
...
According to approach of the work to be done, audits can be continuous, interim
or final
...
Interim audits
This is an audit carried out halfway through the financial period
...
It is ideal for dynamic businesses, cheaper compared to
continuous audits and enhances keeping of up to date records
...
S T U D Y
This is an approach whereby an audit is carried out throughout the financial period usually
at predetermined intervals
...
g
...
The approach ensures accounts are kept up to date, errors
and frauds are discovered in early stages and better audit reports are developed since more time
is taken
...
These require examination of procedures or records for reliability and
accuracy
...
Management audits
...
It improves quality and efficiency of management in addition to checking the
budgetary system
...
This tests the strength of internal control system by working backwards
to get the initial transactions using assertion methodology
...
This activity is called internal auditing
...
Reviewing the company’s compliance with external laws and regulations and internal policies
and procedures
...
The focus of internal auditing is adding value to an organization through improvement in risk
control
...
The General Auditing Environment
11
Internal Auditing
External Auditing
Objectives
The main objective is to advice
management on whether organization
has sound internal control systems to
protect it against loss
...
Legal basis
Internal auditing is not a legal
requirement but corporate governance
advises and recommends that a
company should have an internal audit
department
...
Scope
It covers all areas of organization i
...
operational as well as financial
...
Approach
It is increasingly risk based
...
Its
increasingly
risk
based as it only tests
underlying
transactions
that form having of financial
statements
...
The responsibility is to
form an opinion on whether
financial statements show
a true and fair view
...
Ordinarily these would include:
•
•
•
•
•
•
Review of accounting internal control systems
...
The system requires proper attention and continuous
review, a function usually assigned to internal audit
...
Carrying out examination of financial and operational information
...
Review of the economic efficiency and effectiveness of operations including non financial
controls of the entity
...
The internal audit
functions checks whether procedure are in place to ensure that all relevant laws and
regulations are adhered to
...
Carrying out independent investigations into company affairs as required by management
e
...
investigation areas of suspected fraud or misuse of company’s resources
...
12
A U D I T IN G AN D A S S U RAN C E
Similarities between internal audit and external audit
•
•
•
•
S T U D Y
T E X T
•
Both auditors are concerned about the strength and proper functioning of the internal control
system
...
Both auditors have as part of their duties to ensure that the company adheres to all relevant
laws and regulations
...
The
internal auditor uses the company accounts to appraise the functioning of the internal control
system while external auditor uses them to collect audit evidence to corroborate his audit
opinion
...
The
internal auditor ensures errors or frauds are prevented and detected by having strong
internal control system while the external auditor has the incidental duty of detecting and
preventing material errors and frauds which would otherwise distort the true and fair view of
the financial statements
...
The internal auditor through
strong internal control system ensures safety of company’s assets while external auditor
must ensure that company assets are safeguarded against theft and misuse so that the true
of fair view of financial statements is maintained
...
In
evaluating internal audit function, the external auditor considers the following factors:
•
•
•
•
•
Organization status
...
To aid in its independence, the internal audit function should report to the
highest level of management
...
The internal auditor should
not have any restrictions upon him or her from management which could impair effectiveness
of doing his or her work
...
The external auditor should ascertain the nature and depth of coverage
of internal audit assignments
...
In case the management does not follow up on the
recommendations, the external auditor must reduce his reliance on work of internal audit
function as this means it is weak
...
The external auditor should assess the competence experience,
qualifications, technical training and proficiency of the staff members in the internal audit
function
...
The external auditor should ascertain whether due professional care
has been observed in doing the work of the internal audit function e
...
whether there were
work plans, supervision and documentation of audit evidence in executing internal audit
functions
...
The external auditor should consider whether the internal audit
function has adequate resources to enable it carry out its functions as expected e
...
adequate
staff and time
...
It prevents and detects errors and frauds through periodic comparison of budgets, routine
and surprise checks
...
Assists external auditor in highlighting areas of weaknesses in internal control system
...
Assists the company in achieving its objective by ensuring that all laid down rules, procedures
and policies are followed e
...
adherence to budgets and forecasts assists in decision
making
...
•
•
•
•
•
The cost of installing and maintaining an internal audit function is high and in particular for
large companies as they may require highly qualified staff while for small companies the
department may not be justifiable
...
Management may deny the internal audit function its due independence by assigning it
accounting duties or even management responsibilities
...
The internal audit department may fail e
...
if it points out problems without giving solutions
or ignoring some departments within the company
...
Factors necessitating growth in Internal Audit
•
•
•
•
Increase in business size
...
Dynamic technology– the frequent changes in technology has made some companies to
have their controls updated on a continuous basis
...
Legislation and regulatory requirements
...
Companies
are now required by regulations to have audit committees to oversee operation of controls
within the company and to which the internal audit function reports
...
High competition in business calls for efficient operations by companies so
as to survive
...
S T U D Y
•
T E X T
Limitations of an Internal Audit
14
A U D I T IN G AN D A S S U RAN C E
Risk and Materiality (ISA 320 Materiality)
ISA 320 discusses the concepts of risk and materiality
...
e
...
Materiality plays a role in each of the following two stages
...
Planning stage
...
Reporting stage (in deciding what opinion to give
...
’ Therefore materiality provides a threshold or cut off point rather than being a primary
qualitative characteristic which information must have if it is to be useful
...
If the auditor assesses the risk associated with an account balance or internal control
system to be high, it will be reflected in a lower level of materially thus additional testing will
be required
...
The auditor needs to establish an appropriate materiality level
so that quantitatively, material misstatements which are likely to destroy the true and fair
view of financial statements are identified
...
• Materiality should be considered by the auditor when;
•• Determining nature, timing and extent of audit procedures
•• Evaluating effect of misstatements
...
Any immaterial item will not affect the
truth and fair view of the financial statement and thus can be ignored
...
1
...
2
...
3
...
A figure of Kshs
...
An amount must be considered in
relation to:
•• Items on the overall financial statements level
...
g
...
•• The corresponding amount in the previous year
...
The degree of latitude allowable in deciding on the amount attributable to a particular item
...
In some
countries e
...
US, the security exchange commission estimate materiality as follows;
•• Errors greater than 10% are material
•• Errors between 5% and 10% may be material
•• Errors below 5% are not material
5
...
The auditor should reconsider all uncorrected misstatements and check whether
this total is material
...
They contain material matter and not full of needless details
...
The values attributed to the items in the financial statements are reasonable amounts within
a range in which if a major decision was taken on their basis the user would not make a
material error
...
Assertion Methodology
In preparing financial statements which show true and fair view of the company’s financial
position and performance, the management explicitly or implicitly makes certain assertions
...
vii Classification
viii Cut-off
ix Accuracy
x Allocation
S T U D Y
The true and fair view is a concept of the Companies Act
...
The companies Act requires that all limited
liability companies to appoint an auditor whose task is to express an independent opinion as to
whether financial statement show true and fair view of the financial performance and position of
the company
...
Financial statements will present a true and fair view if:
T E X T
True and fair view
16
A U D I T IN G AN D A S S U RAN C E
Existence
This is the assertion that an asset or liability exists at a given date
...
Rights and obligation
This is the assertion that an asset or liability in financial statements pertains to the entity at a
given date i
...
an asset is a right of the entity and a liability a genuine obligation of the entity
...
It is either the transaction took place as recorded or not
...
It would suggest 100% completion and accuracy however, this is impossible under accrual
basis of accounting
...
This assertion is therefore assessed for reasonableness as some transactions may be
excluded if they are not material
...
It is the
most crucial assertion of all the assertions
...
1 Overall valuation basis
...
The basis of preparing financial statement when entity is going
concern is radically different from preparing financial statement on basis that the entity is not
a going concern
...
In determining carrying amount of an asset or liability
appropriate accounting policies must be followed
...
3 Desirable qualitative characteristics
...
Since it may subjective whether an entity is a going concern or not, the
accounting policy adopted can be subsequently subjective thus the assertion of valuation
can only be assessed for reasonableness
...
Whether a transaction
brings into being an asset or liability, revenue or expense depends largely on the capitalization
policy of an entity i
...
the guidance as to what items are revenue items and capital items
...
However, where revenue or expense of an item is spread over more
than one accounting period is called allocation rather than measurement and is a component of
valuation
...
The information in financial statements should be
presented without bias, be relevant to the needs of the users and meet qualitative characteristics
of understandability, relevance, reliability and comparability
...
In conclusion, truth and fairness of financial statements can be assessed on these seven
assertions i
...
the financial statements will reflect a true and fair view of company’s financial
position and performance if the seven assertions are used as guidelines in preparing the financial
statements
...
The annual accounts and report are primarily prepared by the directors to the
shareholders
...
The appointment of the auditor is usually carried out as a private contract between the
auditor and the relevant stakeholder
...
The auditors’ rights and duties are also
laid out in the contract
...
Quiz
1 List the objectives of an audit
...
3 List the properties of a statutory audit that are different from a private audit
...
To give credibility to the financial statements
...
- An audit may assist in the prevention and detection of errors and frauds
...
2
...
This is especially the case for minority shareholders who
have little say in the management of their company
...
The various users can therefore place reliance on them
...
+ An audit assists in the prevention and detection of errors and frauds through the moral
and deterrent effect
...
Statutory Audits
a)
...
g
...
b) The scope and objective of work is defined in the Act
c) The report is addressed to the shareholders
...
159)
...
e) The auditor is liable to third parties
...
T E X T
1
...
was formed on 1 October 2006 in order to export tea and coffee to
European markets
...
The audit partner has asked you to visit the client and
explain to the directors, the fundamental aspects of the accountability of the directors and their
relationship with the auditor
...
a
...
Procedures for the appointment of an auditor of a public company under the Companies Act
...
Directors responsibilities in relation to the accounting function of the Company
...
Auditors’ statutory responsibilities in relation to the audit of the company’s financial
statements
...
The company wants the external auditors to rely
on some of the work already performed by internal audit
...
During the current year, the company has gone through a major internal restructuring in its
information services function and the internal auditors have been closely involved in the
preparation of plans for restructuring, and in the related post-implementation review
...
(b) Describe the information your firm will seek from the internal auditors in order for you to
determine the extent of your reliance
...
The General Auditing Environment
21
(d) Explain why it will be necessary for your firm to perform its own work in certain audit
areas in addition to relying on the work performed by internal audit
...
QUESTION FOUR
The purpose of an external audit and its role are not well understood
...
S T U D Y
T E X T
Draft explanation dealing with the purpose of an external audit and its role in the audit of large
companies, for inclusion in your firm’s training materials
...
The agreed terms should be recorded in an audit engagement
letter or other suitable form of contract
...
Such regulations may either be of a
statutory nature of in the form of statements issued by the regulatory or professional bodies
in the country concerned
...
Exam Context
This chapter is tested on a regular basis due to its importance
...
Ethics is increasingly becoming a key area in the running of companies and so students need
to have a good understanding of it
...
It guides the auditor as to his rights and the engagement letter
...
T E X T
Appointment-companies Act provisions
Qualifications of an auditor
Removal of an auditor from office
Resignation
Rights and duties of an auditor
Procedures before and after accepting appointment
Professional Ethics
International Standards on Auditing
Legal and professional framework
S T U D Y
••
••
••
••
••
••
••
••
••
26
A U D I T IN G AN D A S S U RAN C E
INTRODUCTION
Before an auditor is appointed to an audit, there are numerous processes and procedures that
must be completed first
...
The auditor and the client also need to agree on the terms of engagement before
hand and this is done through an engagement letter signed by both the client and the auditor
...
The auditor is also expected to be
aware of his rights and also the professional and ethical requirements that he needs to adhere to
before he starts an audit engagement
...
Notwithstanding the above,
a retiring auditor however appointed shall be deemed to be reappointed without any resolution
being passed subject to certain provisions
...
The company in annual general meeting or in the manner determined in the annual
general meeting
...
The directors can also appoint auditors to fill a casual vacancy in
the office of the auditor
...
Should the directors
and shareholders fail to exercise their right to appoint an auditor, the directors must notify the
registrar of companies within seven days of that failure and the registrar will appoint an auditor
to that company
...
If the matter is not discussed at that meeting, then the auditors are deemed to have been
reappointed automatically
...
Qualifications for appointment of an Auditor
A person shall not be qualified for appointment as an auditor of a company unless he or in the
case of a firm, every partner in the firm is a holder of a practicing certificate issued pursuant to
section 21 of the Accountants Act
...
None of the following persons shall be appointed an auditor of a company
•
•
An officer of a servant of the company
...
An employee of an officer or servant of the company
...
• A body corporate
...
In addition, users rely on auditor’s
opinion to make decisions and if the auditor’s opinion is materially wrong, the users should
be able to recover from the auditor the loss incurred to an unlimited extent
...
Section 161 (3) states that a person shall not be qualified for appointment as auditor of a company
if he is disqualified for appointment as an auditor of any other company which is that company’s
subsidiary or holding company
...
This is because in a public company there is clear
distinction between the shareholders and the management and therefore there is need to protect
the shareholders from excesses of management
...
Removal of auditors from office
According to section 160 of Companies Act, the shareholders and only the shareholders can
remove the auditor from the office before his term in office expires
...
Since the directors may want to remove the auditor because of disagreements on accounting
policies or if the auditor threatens to expose their frauds, section 160 of the Companies Act
seeks to give the auditor some protection from the directors
...
•• The auditor after receiving a copy of notice can prepare written representations
explaining his position on the matter
...
If the directors
feel that the auditor wants to publish defamatory material, they can obtain a court order
which allows them not to distribute the representations
...
If his
representations were not distributed for a reason other than a court order, he can read
them to the members at the meeting
...
A simple majority of members present and
voting is enough to remove the auditor from office
...
The auditor must be free and be seen to be free from any
influence from the directors in carrying out an audit
...
28
A U D I T IN G AN D A S S U RAN C E
An auditor may resign from office as long as a notice in writing to that effect is deposited at the
company’s registered office
...
A statement giving details of any circumstances leading to his resignations he
believes should be brought to the attention of the shareholders
...
Rights of auditors (Section 162)
••
••
••
S T U D Y
T E X T
••
••
••
••
Right to access at all times the accounting records of the company
...
Right to receive notice of general meetings, attend and speak during the general
meetings
...
This includes all information
from client’s books, vouchers and management representations
...
Right to remuneration
...
Right to legal and technical advice
...
Right to send representations to shareholders in case there are attempts by the
directors to dismiss him
...
Duties of the auditor
••
••
••
••
••
••
To report the shareholders on the financial statements laid before the company at the
annual general meeting, whether in his opinion, the balance sheet gives a true and fair
view of the company’s financial position at the balance sheet date, the profit and loss
account gives a true and fair view as to the financial performance of the company and
whether the financial statements comply with the requirements of the relevant financial
reporting framework
...
To assist investigators into the company’s affairs by providing his working papers, which
are summaries of significant matters the auditor identified during the audit
...
To include in his report any required information about the director’s remuneration which
has been omitted from the financial statements
...
The Auditor and the Companies Act
29
Client Acceptance Procedures
Accepting Appointments as company auditor
•
•
•
•
Ensure that he is professionally, legally and ethically qualified to act as auditor of that client
...
He must ensure that he is not a servant or in partnership with a servant of the company
and neither must he have any personal, family or business relationship with the prospective
client
...
This
includes whether the firm has adequate resources such as staff and time to undertake the
assignment
...
The information sought would include
reputation of the company and of its directors
...
The auditor should ask for permission from the
prospective client to communicate with the outgoing auditor
...
The outgoing auditor should also ask the client permission to communicate
with the prospective auditor
...
This process is called ethical
clearance and is just not a matter of professional courtesy but aimed at enabling the auditor
decide whether to accept appointment as well as enquire reasons for change of auditors
...
• The auditor should obtain a copy of the new resolution passed at the annual general meeting
to appoint him as the auditor
...
A member invited to undertake professional work additional to that already being carried out by
another auditor who will still continue with his existing duties, should as a matter of professional
courtesy notify the other auditor of the work he is undertaking
...
The letter of engagement (ISA 210)
It is in the interest of both the client and the auditor that the auditor sends an engagement
letter preferably before commencement of the engagement
...
Without written understanding,
there may be an implied contract created by either auditors conduct or a provision in the
articles of association which may not be in auditor’s liking
...
S T U D Y
•
T E X T
Upon receipt of a request to accept an appointment as the auditor of a company, the auditor
should:
30
A U D I T IN G AN D A S S U RAN C E
•
•
•
•
Confirms in writing any verbal arrangements between the client and the auditor
...
The letter informs the client of other services that the auditor’s firm can provide e
...
taxation
or consultancy
...
Principal contents of an engagement letter
•
•
•
The objective of the audit of the financial statements
...
The scope of the audit including references to applicable legislation or pronouncements of
professional bodies to which the auditor complies
...
• The expectation of unrestricted access to whatever records and documentations
...
The basis on which audit fees are computed or any other billing arrangement
...
Audit of components
Where the auditor of a parent company is also the auditor of its subsidiaries, the factors that
influence the decision whether to send a separate engagement letter include:
•
•
•
•
•
•
Legal requirements of disclosure in the financial statements
...
Who appoints the auditors of the component?
The extent of any work performed by other auditors
Degree of ownership in the subsidiary by the parent company
...
Recurring audits
On recurring audits, the auditor should consider whether the circumstances require the terms
of engagement to be revised and whether there is need to remind the client of existing terms
of engagement
...
However, the following factors may make it necessary to send a new engagement letter:
•
•
•
•
•
Any indication that the client misunderstands the objective and scope of the audit
...
A recent change in senior management, board of directors or ownership
...
Where legal requirements dictate so
...
Since auditors
work is relied upon by other parties to make economic decisions, the auditor has a responsibility
to do his work with reasonable care, skill and diligence
...
What is reasonable care and skill is very difficult to assess in any given case
...
As a consequence, some fraud or error may remain undetected
...
A user who relies on that work of the auditor may incur a financial loss
...
•
•
•
•
•
•
•
•
•
•
•
•
He allows any person to practice in his name as an accountant unless such a person is a
holder of a practicing certificate and he is in partnership with him or employed by him
...
He discloses information acquired in the course of professional engagement to any person
other than the client without the consent of the client or otherwise as required by law
...
He fails to observe and apply professional, technical, ethical or any other standards
prescribed by ICPAK as guidelines for practice by members of the institute
...
He expresses his opinion as financial statements of any business in which he, his immediate
family, his firm or any partner in his firm has an interest unless he discloses that interest
when expressing his opinion
...
He fails to report a material misstatement known to him and therefore causes it to appear in
financial statements with which he is concerned in a professional capacity
...
He expresses an opinion on any matter with which he is concerned in professional capacity
without obtaining sufficient information on which to base his opinion
...
S T U D Y
A member of ICPAK is guilty of professional misconduct if:
T E X T
Criminal law and the auditor
32
A U D I T IN G AN D A S S U RAN C E
Negligence
Negligence is some act or omission which occurs because the person concerned failed to exercise
that degree of a reasonable care and skill which is reasonably expected in the circumstances of
the case
...
There are no decided
cases in Kenya against auditors,
This makes it difficult to precisely determine what circumstances the auditor could be held liable
in and which parties could successfully bring an action against the auditor
...
Liability to the client company under law of contract
...
Civil and criminal liabilities
...
E
...
if he uses information acquired in course of an engagement for his financial gain or for benefit
of another party
...
2
Liability to the client company under law of contract
...
The auditor has a duty to report to the
shareholders whether the financial statements show a true and fair view
...
Under this contractual relationship, it is implied that the auditor
will carry out his work with a reasonable degree of care and skill
...
Generally if the auditor has complied
with the GAAPs and guidance from the ISAs, it would be difficult to prove that the auditor was
negligent
...
The auditor has no duty to an individual shareholder
...
Only if the company i
...
the entire body of shareholders has suffered
a loss can such a case be brought under law of contract
...
In this case third parties refer to anyone other than the client company who has used the
auditor’s report and wishes to make a claim for negligence
...
The difference between these parties and the client company is that such
third parties have no contract with the auditor and therefore no implied duty of care
...
e
...
• The duty of care was breached through auditor’s negligence
...
In Hedley Byrne and Company Limited versus Heller and Partners (1963), it was held that ‘a duty
of care exists where there is a special relationship between the parties
...
e
...
’ The implication of this statement is that, for there to exist
a duty of care, the third part must have been identified in some way to the auditor
...
g
...
•
•
•
•
•
•
By not being negligent
...
Agreeing with the client duties and responsibilities of the auditor and the client in the
engagement letter to avoid future misunderstandings
...
Stating in the engagement letter the purpose for which the report has been prepared and
that the client may not use it for any other purpose
...
Limiting or excluding liability by a term in the engagement letter or in the case of third parties
a disclaimer in the report
...
Professional Ethics
A member of a profession owes duty to the public including the employer, the profession itself
and to other members of the profession
...
In Kenya, they are issued by institute of Certified Public Accountants
of Kenya (ICPAK) in form of statements and explanatory notes
...
The following are fundamental principles
stated by ICPAK to ensure auditors are credible people before they give credibility to financial
statements
...
Integrity: A member should be straight forward, honest and sincere in his approach to
professional work
...
2
...
It is essentially an attitude of mind characterized by objectivity and integrity
...
He must be impartial and must not allow prejudice or bias to affect his judgment
...
However, this does not
diminish his duty of objectivity in relation to that work
...
Confidentiality: The guide to professional ethics states that information acquired in the
course of professional work should not be disclosed except where consent has been
S T U D Y
•
•
T E X T
Ways of minimizing potential liability for professional negligence include:
34
A U D I T IN G AN D A S S U RAN C E
S T U D Y
T E X T
acquired from the client, where there’s public duty to disclose or where there is legal or
professional duty to disclose such information
...
g
...
4
...
A member should not undertake or continue professional
work which he himself is not competent to perform unless he obtains such advice and
assistance as will enable him to perform such work
...
To be competent, he must also possess sound judgment
...
He should be a good communicator
...
Therefore, ICPAK has given guidance in the best conduct code in situations where the auditor’s
independence may be impaired
...
A new or old practice is exempted from his provision
because in the case of a new practice, he has not yet built a sufficient client base and an old
practice may be in decline
...
Where practice is deriving a significant portion of its professional fees from one client, the practice
will be hesitant to do anything that could result in losing the client i
...
an auditor may be hesitant
to qualify his report for fear of losing such a client
...
g
...
c) Beneficial shareholding
A practice should ensure that he does not have as an audit client, a company in which a partner
in practice, the spouse or minor child of such partner is the beneficial holder of shares nor should
it employ on the audit, any member of staff who is a beneficial holder of such shares
...
g
...
In such cases, the shares should be disposed off at the earliest practicable date
...
The shares cannot be used
by the member in an annual general meeting to vote on the appointment of the auditor and his
remuneration
...
e) Practice loan
A practice should not make a loan to a client or guarantee a client’s borrowings or accept a
loan from a client or have a borrowing guaranteed by a client
...
A firm
may however accept a loan from a client if it is in that client’s ordinary course of business to give
loans
...
f)
Goods and services
Acceptance of goods or services from a client may be a threat to independence
...
Acceptance of
undue hospitality poses a similar threat
...
A member should be alert to the danger posed to his
independence by providing accounting and other services which place him in an executive
position to his client
...
Competing clients: A member should frankly disclose to both clients and advice them to
choose another auditor and then disengage one of the appointments
...
An example of competing clients would be where a practice
advises one client upon the figures on which to base a tender for a contract and if knowingly
became involved in advising another rival company tendering for the same contract
...
Where a practice, his partner or his employee has during the previous
two years has had a continuing professional relationship with the company which goes into
liquidation, he should not accept an appointment as liquidator of that company
...
Additional steps to enhance auditor’s independence
•
Rotation of partners
...
A primary objective of the rotation
would be to guard against the possibility of the auditor and his staff becoming too close to
senior management and thus consequent impairment of auditor’s independence
...
The client should be informed in writing both on the fact
that commission would be received and as soon as practicable the amount and terms of such
commission
...
Prohibiting undertaking of consulting work for existing audit clients
...
The staff responsible
for consultancy have no contact with the staff responsible for the audit
...
This refers to the process through which institute of certified public accountants
(ICPAK) establishes a committee to review audit procedures and quality control policies for
members while conducting an audit
...
Enacting stringent laws, that seek to protect the auditor from being removed from office e
...
because of issuing a qualified audit opinion
...
Clearly there is need for more protection for the auditor
...
An audit committee is a committee set up with
clearly defined role in setting policies for the awarding of non-audit work to the auditor and
not only recommending the appointment of the auditor each financial year but also fixing
their remuneration
...
The purpose of such a
committee is to guard and promote the independence of the auditors
...
Advertising and Publicity
A member should not advertise professional services or skills in such a way as to show himself
to be more qualified than other practicing accountants
...
• When acting in fiduciary or similar capacity
...
A member may have paid announcements in the press for opening a new office, changing the
name, address or membership of his firm or for member’s appointment
...
From the ethical guidance, it is unethical for an accountant to seek professional work by advertising
his services
...
Advertisements should not contain comparisons with other members or firms, contain testimonies
or endorsements or bring the firm, members or the accountancy profession discredit or dispute
...
Obtaining professional work
A member should not in any circumstances obtain or seek professional work for himself or for
another party in unprofessional manner e
...
bargaining
...
However, a partner who brings in business can be paid commission by
his own practice
...
Charging Professional Work
•
•
•
•
In practice the most common mode of determination of audit fees is to compute them on the
following considerations:
The skill and knowledge required for the type of work involved
...
e
...
The time necessarily engaged on each person on the work
...
Corporate Governance
The Capital Markets Authority (CMA) developed guidelines for good practices by public limited
companies in Kenya in response to the grave importance of governance issues in both emerging
and developing economies and for developing growth in domestic and regional capital markets
...
It has the following
key aspects:
•
•
The role of the board of directors and the audit committee
...
Principles of good corporate governance
There are a number of principles essential for good corporate governance practices
...
a
...
Every company should be headed by an effective board of directors to offer strategic guidance,
lead and control the company and be accountable to shareholders
...
S T U D Y
•
T E X T
Fees should not be charged on a percentage or similar basis except where it is authorized by
the law or is generally accepted practice for certain specialist work e
...
construction work
...
g
...
This
is because auditor’s judgment should not be impaired by hope of a financial gain
...
38
A U D I T IN G AN D A S S U RAN C E
•
•
•
•
Define company mission, strategy, goals ad objectives
...
Review on a regular basis the adequacy ad integrity of the company’s accounting and
internal control system including compliance with applicable laws and regulations
...
In
addition, it should establish an audit committee
...
Director’s remuneration
...
The executive director’s remuneration should be competitive
and linked to performance
...
Board balance
...
For listed companies, the board should have at least a third of independent non executive
directors
...
Is not associated with any advisor or consultant of the company or member of the company’s
senior management or a significant customer or supplier of the company
...
He is not employed by a public limited company in which an executive officer of the company
serves as a director
...
Has not had any of the relationships described above with any affiliate of the company
...
Appointments to the board
...
All
persons offering themselves for appointment as directors should disclose any potential areas of
conflict that may undermine their position in service as directors
...
Re-election of directors
...
Executive directors should have a fixed service
contract not exceeding five years with a provision for renewal subject to regular performance
approval by the shareholders
...
Role of the chairman and the chief executive
...
This should ensure a balance of power and authority and provide checks and balances
such that no individual should have unquestionable powers over decision making
...
Approval of major decisions by shareholders
...
The board should
therefore provide shareholders with information such as major disposal of company assets, plant
restructuring, mergers and acquisitions and organization plans
...
Best practices in audit committees
An audit committee is an independent committee established by the board and mainly composed
of at least three non executive independent directors with written terms of reference which deal
clearly with its authority and duties
...
Assisting directors in meeting their responsibilities in respect of financial reporting
...
Attributes of audit committee members
•
•
•
•
•
Members of the audit committee should have the following attributes;
Broad business knowledge relevant to the company’s business operations
...
Familiarity with basic accounting principles
...
•
•
•
•
•
•
•
•
•
•
Act as an effective overseer of the financial reporting process and company internal control
system
...
g
...
Reviews quarterly, semi-annually and yearly financial statements of the company focusing
particularly on any changes in accounting practices, significant adjustments arising from
the audit, the appropriateness of the going concern assumption adopted in preparation of
the financial statements and whether the financial statements comply with IFRSs and other
relevant regulations
...
Discuss with the external auditor before the audit commences the nature and scope of the
audit and ensure that the work is properly coordinated
...
Both the audit committee and the management should assist the external auditor in
preserving his independence
...
Review any communication between the external auditor and management
...
The committee considers any related party transactions that may arise within the company
and ensure that related party transactions are appropriately disclosed in the financial
statements in accordance with ISA 24 Related Party Disclosures
...
The committee has exclusive authority to investigate any matter within its terms of reference
and management must provide access to the necessary information and any resources
required
...
S T U D Y
•
T E X T
Functions of an audit committee
40
A U D I T IN G AN D A S S U RAN C E
The audit committee is established to give additional assurance to the various stakeholders on
issues regarding the quality and reliability of financial information used by the board and financial
statements issued by the company
...
Relationship between the audit committee and the internal audit function
The management of the organization should establish an internal audit function which should
be independent of the activities that they audit as the internal audit work should be done with
objectivity, proficiency and due professional care
...
Review the internal audit function work programme and the internal audit report and where
necessary ensure that appropriate action is taken on recommendations made
...
Approve any appointment or termination of senior staff members of the internal audit
function
...
Determine effectiveness of the internal audit function and undertake all steps possible to
promote its independence
...
However this committee should be
independent of the board to be able to exercise its responsibilities
...
The audit committee reviews or provides an oversight over some of the responsibilities exercised
by the board
...
g
...
The audit committee enhances and improves communication between the external auditor and
the board and between the board and the internal audit function
...
Assists the directors meeting the responsibilities in respect to financial reporting
...
Promotes effectiveness of internal audit function by ensuring that the function has authority
and resources t carry out its responsibilities and also ensures its recommendations to the
management are implemented
...
Improves communication between directors, the eternal auditor and the management
...
A person or firm shall not be qualified for appointment as auditor of a company unless he
or, in the case of a firm, every partner in the firm is the holder of a practicing certificate
issued pursuant to s
...
The auditor and the client should agree on the terms of the engagement
...
The auditor gives credibility to financial statements and to do this he must be credible
himself
...
All directors are equal and some should not be seen as
supervising others
...
Non executive directors may be overburdened with detail and may get into management
responsibilities and possibly cause conflict
...
Audit committees are ineffective and powerless as they cannot enforce their
recommendations or report directly to shareholders
...
Audit committee incurs time and costs unless it is justified that the benefits outweigh
costs
...
Non executive directors may lack the technical skills and the know-how and in turn be
rendered incompetent
...
List the professional ethics that the auditor is expected to adhere to
...
What is the purpose of an engagement letter?
The Auditor and the Companies Act
43
S T U D Y
1
...
2
...
This helps in avoiding
misunderstandings between the client and the auditor as regards to the scope of the
work to be carried out and the respective responsibilities of both parties
...
To educate the client on:1
...
2
...
3
...
That the audit should not be relied upon to detect errors and frauds
...
To explain the the audit will be carried out on a test basis
...
Basis of charging his fees
...
•• Commit client to his obligations in an audit
...
a newly formed commercial bank
to undertake the audit for its first complete financial year ended 31 December 1996
...
You have had various discussions with
the directors about the timetable and the respective responsibilities of management and the
auditor
...
S T U D Y
T E X T
Required:
a) Explain why a letter of engagement is sent before any new audit appointment is
accepted
...
c) Itemize the actions you would take in response to the non-reply by the management to
your draft engagement letter
...
QUESTION TWO
The objectivity of the external auditor may be threatened or appear to be threatened where:
i
...
ii
...
iii
...
iv
...
Required:
a) For each of the four examples given above, explain why the objectivity of the external
auditor may be threatened, or appear to be threatened, and why the threat is
important
...
QUESTION THREE
a) Describe the matters to consider within your firm and the other procedures that must be
undertaken before accepting the appointment as auditor to a new client
...
c) Explain the purpose of an engagement letter and list its contents
...
Turnover has increased by about 20% p
...
for the last five years, to the current level of Kshs50 million
...
The internal audit department was
established last year to assist the board of directors in their control of the company and to
prepare for a possible listing on the stock exchange
...
However, he is also
aware that the other board members do not have complete knowledge of corporate governance
or detailed knowledge of International Auditing Standards
...
b) Explains the advantages and disadvantages to ZX of an audit committee
...
S T U D Y
a) Explain the situations where an auditor may disclose confidential information about a
client
...
You are preparing the engagement letter for the audit of Ancients; a public limited
liability company, for the year ending 30 June 2006
...
Ancients has
been an audit client for eight years and McKay & Co has provided audit, taxation and
management consultancy advice during this time
...
Audit personnel available for this year’s audit are most of the staff
from last year, including Mr
...
Jones, an audit senior
...
Grace has been the audit partner since Ancients became an audit client
...
Grace, has recently been appointed the
financial director at Ancients
...
T E X T
QUESTION FIVE
S T U D Y
T E X T
46
A U D I T IN G AN D A S S U RAN C E
The Auditor and the Companies Act
47
S T U D Y T E X T
S T SU TDUYD Y
T E TX ET X T
CHAPTER THREE
ONE
AUDIT PLANNING, CONTROL
& RECORDING (ISA 300)
S T U D Y
T E X T
48
A U D I T IN G AN D A S S U RAN C E
Audit Planning, Control & Recording (ISA 300)
49
CHAPTER 3
AUDIT PLANNING, CONTROL & RECORDING
(ISA 300)
chapter objectives
After you have studied this chapter, you should be able to:
••
••
••
••
••
••
Define audit planning and explain its objectives, advantages scope and timing
...
Explain the purposes of the audit planning memorandum and the audit program
...
Explain quality control procedures at an individual audit level and their objectives
...
Advantages of good audit planning
••
••
••
••
••
••
••
Establishes the intended means of achieving the objective of the audit
...
A good plan assists in the proper utilization of audit assistants and in coordination of
work done by other auditors and specialists
...
The planning
process identifies potential problematic areas e
...
areas with weak internal controls
where more detailed substantive testing should be carried out
...
Ensures proper division of work between the interim and the final audit avoiding
repetition of work already done
...
This encourages cooperation by ensuring less
disruptions of client’s work
...
The auditor should plan his work to enable him conduct an effective
audit in an efficient and timely manner
...
T E X T
ISA 300 Planning an Audit of Financial Statements:
50
A U D I T IN G AN D A S S U RAN C E
Introduction
Audit planning is a vital stage of the audit process covered under ISA 300
...
The main aim is to
reduce audit risk to an acceptably low level
...
Quality control refers to the various policies and procedures put in place by the auditor to ensure
that all audits conducted by the audit firm meet the quality standards set out by the accounting
profession and the firm’s own quality standards
...
S T U D Y
T E X T
Working papers -evidence is recorded in the form working papers of which are prepared by
the auditor or obtained during the audit
...
Exam context
This is an important area of the syllabus and the examiner may question it
...
Industry context
Audit planning is essential for every audit to direct the work of the auditor for him to allocate
resources
...
••
Scope of Audit Planning
Audit planning covers the development of an overall plan for the expected coverage and conduct
of the audit
...
An audit programme is then developed which shows the nature, timing and extent of audit
procedures to be applied at every level of audit testing
...
This is to enable the auditor appreciate which
events and transactions are likely to have significant effect on the financial statements
...
In performing an audit on financial statements, the auditor should have or obtain knowledge
of client’s business sufficient to enable him identify and understand events, transactions and
practices that in the auditor’s judgment may have significant effect on the financial statements
or the audit report
...
After accepting to act as the company’s auditor, further and more detailed information
would be obtained
...
The following may be used as sources for that information
...
It generally contains the following
...
A job timetable giving provisional dates of the timing of the audit
...
g
...
Background information about the client
...
Extent of reliance expected on internal control system
...
Discussions with people within the entity
...
Discussion with other auditors and with legal and other advisors who have provided
services to the entity
...
•• Visits to the entity’s place of business and plant facilities
...
The auditor should ensure that audit assistants in an engagement also obtain sufficient knowledge
of clients business to enable them carry out delegated work
...
Auditors develop
an audit programme for each material accounts balance or account balance assertions
...
The following is an example of an audit programme designed to gather evidence in the control
testing stage as to the effectiveness of operation of a client’s bank reconciliation procedures
...
Year end:
31 / 12/2006
Control testing:
Bank reconciliation
Prepared by: ……………………
S T U D Y
T E X T
Received by: …………………
...
Interim
visit
July reconciliation
Audit assistant
Inspect evidence of performance of
bank reconciliations by client staff
...
Ensure the reconciliations were
done by the person proposed at the
appropriate time and the supervisor
signed the reconciliation as evidence
of his review
...
reconciliations
Problems in developing and implementing audit plan
...
This will make allocation of
time and audit staff difficult
...
This especially happens when the client converts from manual accounting system
to a computerized system such changes weaken the internal control system in the short
term and call for more audit time than was previously planned for
...
g
...
This will be the major challenge for the auditor
especially with a client who does not have proper accounting and internal control
system
...
This inevitably interferes with the audit plan because it
gives rise to unplanned staff shortages
...
This is especially
so in the light of potential of being sued for negligence
...
The only way of reducing the risk of being
sued is to ensure that work performed by the firm is of the highest quality possible
...
Objectives of quality control
••
••
••
••
To meet professional requirements
...
Skill and competence
...
Assignment
...
Delegation
...
S T U D Y
1
...
This will involve obtaining a good
understanding of the nature of the client’s business
...
Discuss with management to obtain an understanding of the management structure
and a general feel of the current operating circumstances of the client and any factors
that affect client’s accounting and internal control system
...
Communicate with previous auditor of the client and obtain from him all the information
that is relevant to the audit of the new client
...
Seek to obtain a preliminary understanding of the nature of the clients accounting and
internal control system
...
5
...
6
...
E
...
dates of
the AGM, stock takes and when management reports are ready
...
The audit senior should determine the number of audit staff required, their experience
and any special skills required and the timing of the audit visit
...
Prepare an audit planning memorandum that summarizes the scope of the work under
the engagement and the strategy to be followed to meet the client’s needs
...
54
A U D I T IN G AN D A S S U RAN C E
••
Consultation
...
•• Acceptance and retention of clients
...
In making a decision to
accept or retain a client, the firm’s independence and ability to serve the client properly
and the integrity of the client’s management should be considered
...
The firm should continuously monitor the adequacy and operational
effectiveness of quality control policies and procedure’s
...
Quality control policies and procedures at individual audit level
S T U D Y
T E X T
i
...
Audit work should be delegated by the reporting partner to staff who have
appropriate experience, training, proficiency and independence
...
ii
...
Audit assistants to whom work is delegated should be given appropriate
instructions
...
It also involves informing them of
matters such as nature of client’s business and the possible accounting and auditing
problems
...
Supervision
...
Supervision also entails
identifying and addressing any significant accounting and auditing questions raised in
course of the audit and ensuring that work is being carried out in accordance with the
overall audit plan and audit programme
...
Review Work performed by each staff member should be reviewed by a person of
equal or higher competence to ensure that work has been performed in accordance
with audit programme, has been properly documented and that audit objectives have
been met
...
It is intended that the review be done by practitioners upon fellow practitioners hence
the term peer review
...
Overall total quality control policies
...
Audit Planning, Control & Recording (ISA 300)
55
Objectives of Peer Review
••
••
••
••
••
••
••
••
To promote compliance with professional standards and other technical
pronouncements
...
To promote uniform application of generally accepted methods of professional
practice
...
To establish a mechanism of continuous quality improvement in professional practice
and a self regulatory framework for policies and procedures
...
To help ensure that auditors are competent and independent and to identify potential
problems in this regard at an early stage for necessary corrective actions
...
••
••
There is desire on the part of professional bodies worldwide to ensure that members
apply and observe professional standards
...
It is better for professional bodies to be self regulating than being regulated by the
governments
...
The evidence is recorded in the form of working papers which
are prepared by the auditor or obtained during the audit
...
Audit working papers should always
be sufficiently complete and detailed to enable an inexperienced auditor having no previous
connection to the audit to ascertain work that was performed to support the conclusion reached
...
The need for good working papers
••
••
The reporting partner needs to satisfy himself that the work delegated by him has been
properly performed
...
This also aids in supervision and review of work
done by audit assistants
...
They can also serve as a good reference
point for future audit
...
•• Working papers assist in planning and performance of audit in future financial periods
...
•• Working papers can be used for training of audit staff
...
Auditing guidelines do not define precisely, the form of working papers but it indicates what might
typically be contained therein
...
•• Planned audit approach as contained in the planning memorandum
•• Auditors assessment of client’s accounting system, his review and evaluation of internal
controls
•• Details of work carried out, not as of errors or exceptions noted and action taken together
with conclusion drawn by audit staff
...
•• Record of relevant balances and other financial info that is subject to the audit
...
•• Letters of representation received form management
...
It contains:
••
••
••
••
••
••
••
••
••
Statutory material governing the conduct of the audit e
...
for companies, the companies
Act Cap 486 and for quoted companies in Nairobi Stock Exchange, the NSE booklet of
regulation are required
...
g
...
Copies of documents of continuing importance and relation to the auditors e
...
minutes
of meetings that recorded the appointment of the auditor, guarantees and indemnities
entered into
...
Organizational chart showing the principal departments and subdivision thereof and
names of officials and their responsibilities showing clearly the lines of authority
...
A list of company’s advisors, bankers, lawyers, stock brokers and valuers
...
Accounting policies used on material areas such as stock and depreciation
...
A file index showing contents of the file
...
Audit programme showing the audit objective and planned audit procedures for each of
the areas to be audited
...
The schedule also
shows details of work performed on each balance, the result and conclusion made
...
It will show the details of work
performed on each balance the result and conclusion reached
...
A record of questions raised during the audit and those raised in the previous
audit
...
A record or an abstract form minutes of all director’s meetings and of any internal
committee whose deliberations are important to the auditor
...
Letters of representation obtained from client’s management
...
They provide a means to control the quality of audit work by ensuring that minimum
quality standards are maintained
...
Disadvantages
••
••
••
••
It is not appropriate to follow mechanically, a standardized approach to the conduct and
documentation of audit work as the auditor in some cases will need to exercise his own
judgment
...
The client staff may become familiar with the method and perpetuate fraud in areas not
covered by the standard working papers
...
S T U D Y
This refers to a predetermined format of presenting and documenting audit findings formulated by
individual audit firms e
...
check lists and specimen letters which are filled with standard wording
and gaps left to fill in the relevant details of the client
...
This process ensures an effective control and review of audit work
...
b) How does audit planning assist in the conduct of an audit?
c) Explain the following controlling procedures in a well planned audit:
• Direction and supervision of work
• Review and co-coordination of work
• Quality controls
QUESTION TWO
You are an audit senior responsible for understanding the entity and its environment and assessing
the risk of material misstatements for the audit of Rock for the year ending 31 December 2004
...
Rock is engaged in the wholesale import,
manufacture and distribution of basic cosmetics and toiletries for sale to a wide range of stores,
under a variety of different brand names
...
Required:
(a) Describe the information you will seek, and procedures you will perform in order to
understand the entity and its environment and assess risk for the audit of Rock for the
year ending 31 December 2004
...
Draft financial statements have been produced
...
You have been asked to concentrate
on the proper completion of the audit working papers
...
Describe the features of those working papers that show that they have been properly
completed
...
Required:
a) List the purposes of audit working papers
...
An example of a working paper you have just reviewed is
shown below
...
Method: Select a sample of 15 purchase orders recorded in the purchase order system
...
Test details: In accordance with audit risk, a sample of purchase orders were selected from
a numerically sequenced purchase order system and details traced as stated in the method
...
Results: Details of purchase orders were normally correctly recorded through the system
...
Further investigation showed that these orders had been cancelled due to a change in spectacle
specification
...
Conclusion: Purchase orders are completely recorded in the purchase day book
...
QUESTION FOUR
International Standard on Auditing 300, (Planning an Audit of Financial Statements) states that
an auditor must plan the audit
...
S T U D Y
Audit assertion: To make sure that the purchases day book is correct
...
Types of internal control
...
Limitations in application of internal control system
...
(Evaluation of ICS)
This topic covers the internal control systems and the internal audit
...
This will help the auditor to ascertain the degree of
reliance he or she is going to place on the controls and hence the level of the level of tests the
needs to be carried on the final balances
...
The tests of control will also help the auditor have a better
understanding of the entity
...
Internal audit is normally set up by the management to help in the risk assessment process
and to ensure the company adheres to good corporate governance
...
Internal auditing is covered by the International Standard of Auditing
(ISA) 610 on considering the work of internal auditing
...
The accounting system
identifies, assembles, analyses, defines, records and summarizes transactions of an entity the
mgt requires complete and accurate accounting and other records to assist in executing their
responsibilities which are:
••
••
••
••
Safeguarding the company assets an preventing fraud and error
Selecting suitable accounting policies and applying them consistently
Ensuring that the company keeps proper accounting records as per the Companies
Act
...
•• Stating whether applicable accounting standards have been followed subject to any
material departure disclosed and explained in the financial statements
...
•• Setting up an internal control system to enable all the above responsibilities to be
carried out as required
...
The objectives of an internal control system are: ••
••
••
••
••
••
Orderly and efficient conduct of business
...
Safeguarding of company assets
...
Accuracy and completeness of accounting records
...
S T U D Y
T E X T
KEY TERMS
Accounting system: Refers to the systems and procedures that management has put in place
to ensure that the company maintains proper books of accounts
...
Internal audit: This is a control function set up by management to review the accounting and
internal control systems
...
This means that the student should be well versed with the internal controls
so as to be able to pick them out in a scenario or a lack of them
...
Industry Application
In every business enterprise, the management design controls to assist them in the achievement
of company objectives
...
This
will
The Accounting and Internal
Control Systems (ISA 400)
65
Component of accounting and internal control system
These are:1
...
Control environment
3
...
Risk assessment
Audit risk means the risk that the auditor may give an inappropriate audit opinion i
...
the auditor may
report that the financial statements show a true and fair view while in reality they are materially misstated
...
c) Detection risk
This is the risk that the auditor’s tests of balances and transactions will not detect a material
misstatement that exists in an accounts balance or class of transactions
...
Risk based audit
This audit uses a model called audit risk model
...
If inherent and control risks are assessed to be low, then the level of acceptable detection risk
may be higher leading to relatively lower level of tests of balances and transactions
...
For the audit model, audit risk equals inherent risk multiplied by the control risk and detection
risk
...
Inherent risk could increase a result of an adverse
attitude of managers on the internal control system i
...
if they view internal control system as
unimportant
...
The results appear more rational and defensible than if the model was not used
...
e
...
The increased use of computer in business has made the calculations of audit risk
easier leading to more efficient and effective audit
...
For the model to be useful, the number of items being tested need to be sufficiently
large to allow for valid statistical conclusions to be made
...
The model has a danger of adapting an overly mechanistic approach and that the
auditor may lose his ‘feel’ for the audit assignment
...
A wrong assessment of inherent and control risk will lead to over or under auditing
...
Control Environment
ISA 400 refers control environment as being the overall attitude, awareness and actions of
directors and management regarding the internal control system and its importance to the entity
...
A strong control environment i
...
one with tight budgetary control and an effective internal audit
function can significantly complement specific control procedures
...
It may be viewed
as the foundation of other components of internal control
...
The control environment
is significantly influenced by the effectiveness of the board of directors or the audit
committee
...
Management philosophy, style and ease with which managers could override controls
...
This has an impact on the overall reliability of financial
statements
...
If they
are conservative to risk, there may be no business hence low profits and this may lead
to falsification of financial statements
...
This determines how well employees understand the limits placed
The Accounting and Internal
Control Systems (ISA 400)
••
67
upon their powers and responsibilities
...
Personnel policies and procedures
...
Control procedures
These are the policies and procedures in addition to the control environment, which the
management has established to achieve the entity’s specific objectives
...
a) Organizational plan chart
Companies should have proper organization plans
...
They seek to ensure that the entity is properly departmentalized preventing
duplication of duties across departments and boosting accountability within the entity
...
••
••
••
••
Initiation of transaction
...
Authorization Different levels of management should be given limits as to what they can
authorize or to what extent they can commit company resources
...
Person’s independent from those who authorize the transactions should
execute them
...
Segregation of duties also includes an internal check which refers to the
activities of one person being complementary to those of another person
...
Direct physical controls include keeping assets under lock and key,
employment of security guards, building fences and use of closed circuit cameras
...
d) Authorization and approval
...
The limits for authorization should also be specified
...
E
...
in purchase of fixed assets, an individual should not authorize the purchase,
place the order, receive the assets, record the transaction and keep custody of the assets
...
T E X T
b) Segregation of duties
...
These are controls within the accounting function which check that transactions are authorized
and accurately recorded
...
The key features are;
••
••
••
••
••
f)
Use of pre numbered documents in processing transactions
...
Monitoring movement of documents by use of a register in which all the people in
possession of specific documents have signed that they are possession of those
documents
...
g
...
Reconciliation of different accounts and the related control accounts e
...
bank
reconciliation
...
Personnel
...
The company must therefore recruit competent staff with integrity and intelligence
...
g) Supervision
...
Supervision is necessary because it gives the chance of correcting errors and also
because lower level employees generally tend to be indiscipline if not closely supervised
...
These are controls exercised by management in addition to daily routines of the system
...
g
...
i)
Rotation of duties
...
g
...
Staff should be encouraged to take annual leave to provide an opportunity
for their work to be checked by an independent person
...
These are conducted on routine duties and operations to ensure that they are operating efficiently
...
Examples may
include surprise cash counts and physical inspection of fixed assets
...
Internal audit carries out continuous evaluation of operating effectiveness of the internal
control policies and procedures
...
The Accounting and Internal
Control Systems (ISA 400)
69
l) Limitations of internal control system
An example of internal control system over sales and debtors
When designing internal controls, it is important to identify the various stages followed in processing
the transaction and controls that address the issues that arise in each of the stages
...
Customers should be approved before a credit facility is granted
...
Such references are normally provided by banks suppliers and credit reference
bureaus
...
Customers should be approved for sales only when the customer’s credit limit has not
been exceeded
...
c
...
d
...
All dispatches should be involved
...
f
...
Price list and all trade
discounts and price deduction should be properly authorized
...
Cost-benefit analysis
...
As a result certain important controls may not be put in place due to the
costs involved e
...
a small company may not have the resources to employ efficient
staff to ensure segregation of duties
...
Limited coverage
...
g
...
c
...
Human beings are prone to carelessness, distraction, mistakes of
judgment and misunderstanding instructions
...
d
...
Senior managers could override controls thereby creating
negative perception of the internal control system to the lower level employees
...
Corruption
...
g
...
f
...
g
...
This dilutes
the extent of segregation of duties
...
This is due to the
following inherent limitations of accounting and internal control systems;
70
A U D I T IN G AN D A S S U RAN C E
g
...
To prevent fraud, there should be
proper segregation of duties such that the person who authorizes a sale is not able to
authorize the issue of a credit note or other adjustments
...
All bad debts written off should be properly authorized and recorded
...
i
...
All transactions should be accurately posted to the ledger
k
...
l
...
Overdue accounts should be identified and followed up for collection
...
S T U D Y
T E X T
Key objectives in sales and debtors internal control system
••
••
••
••
••
••
Credit should be extended to credit worthy customers
...
Overdue accounts should be promptly followed up
...
No unauthorized credit entries should be made to debtors account balances
...
Ascertaining
This refers to the auditors attempt to identify and understand the internal controls that management
has put in place
...
•• Obtaining and relying on system records and description prepared by internal audit for
organizations with inter audit functions
...
g
...
•• Relying on prior year’s system notes which can be obtained from the previous auditor’s
working papers
...
If he obtains
reasonable assurance by means of compliance tests that the internal controls are effective in
ensuring the completeness and accuracy of accounting records and the validity of entries therein,
he may limit the extent of substantive testing
...
The Accounting and Internal
Control Systems (ISA 400)
71
Recording
Having identified the controls that management has put in place, it is important to create
documented records of the internal control system
...
The following are methods used
in recording the system
...
Internal control questionnaires (ICQ)
...
ii
...
These are lists of questions that
seek to establish whether specific errors or fraud could occur rather than establishing
whether certain desirable controls are present
...
g
...
Narratives
...
They are preferable for simple systems where all the transactions
and documentation are handled by one person only
...
Narratives are too easy
to record but difficult to change
...
This is done
by use of walk through tests
...
The purpose
of walk through tests may be either for auditor to identify specific control procedures or to confirm
an existing understanding of internal control procedure in the internal control system
...
The auditor evaluates the client’s internal control system in order to decide whether
the system is suitably designed and constitutes a reliable basis for preparation of financial
statements
...
Evaluation will be
assisted by the use of documentation designed to help identify the internal controls on which the
auditor may wish to place reliance
...
T E X T
••
Flow Charts: These are diagrammatic representations of the company’s procedures
and processes and are designed to show the movement of documents and information
through the accounting system from initiation of transactions to final recording in the
books of accounts
...
This use of visual description eliminates use of
lengthy narratives in explaining the system
...
These comprise a list of questions designed to determine whether the
internal control system has desirable controls that cover each of the major transaction
cycles
...
There are two types of questionnaires:
S T U D Y
••
72
A U D I T IN G AN D A S S U RAN C E
Examples of key control questions that could be applied in evaluating internal control system for
sales and debtors are:
•• Can goods be dispatched without being involved?
•• Can goods be sold to a bad credit risk?
•• Can sales be invoiced but not recorded?
For wages and salaries
••
••
••
••
Can employees be paid for work not done?
Can bonuses or commissions be wrongly paid?
Can pay as you earn (PAYE) and other statutory deductions be inflated by inclusion of
ghost workers?
Can wages and salaries be paid at the wrong rates?
Tests of Control
After the system has been evaluated as being suitably designed the auditor then plans to carry
out tests of control which are also called compliance tests
...
e
...
Operation of the internal controls consistently throughout the financial period
...
Some of the procedures performed to obtain an understanding of the accounting and internal
control system may not have been specifically planned as tests of control but may provide audit
evidence about the effectiveness of the design and operation of the internal controls relevant to
certain assertions and consequently serve as tests of control
...
Inquiry: Inquiries about internal controls which have no audit trail need to be done e
...
inquiring whether appropriate security measures are undertaken during payment of
wages
...
E
...
reconciliation of the bank accounts to ensure
clients bank accounts to ensure clients bank reconciliation statements is accurately
prepared
...
This entails observing control procedures being performed e
...
physical
counting of stock will enable the auditor confirm that the exercise is being conducted
properly
...
When obtaining audit evidence about the effectiveness of internal controls,
the auditors considers how they were applied and the consistency with which they were
applied
...
This may be due to changes in key personnel,
human error and significant fluctuation in the volume of transactions
...
The auditor should consider changing his audit approach by increasing the level of
detailed substantive testing
...
The auditor should increase the sample size i
...
test as many entries as is considered
necessary to avoid any error or fraud undetected
...
If the internal control system is extremely weak such that he cannot depend upon it to
apply any test, then he should qualify his report or at best give a disclaimer opinion
...
In addition to this, auditors provide management with a summary of their findings concerning
strengths and weaknesses of accounting and internal control system as well as material issues
arising from review of the financial statements
...
S T U D Y
••
••
••
His past experience with the company’s internal control system
...
Changes in accounting policies and practices
...
Purposes of management Letter
••
Enables the auditor to give his comments on the accounting records that he has
examined during the course of the audit
...
•• Provides management with other constructive advice regarding areas where efficiency
may be improved
...
Incase of litigation, the auditor may rely on the management letter for
defense
...
A report to management will normally be a natural way of adding value to the client and the
auditor should incorporate the need to report in the planning of the audit
...
This eliminates the possibility that the auditor may have misunderstood
...
The management
letter should be addressed to the board of directors or the audit committee
...
It will often be useful to complete the compliance
tests before its submission, so that weaknesses in internal control system may be included
...
This may make it
necessary to submit more than one management letter
...
The management letter should be both
objective and constructive
...
Chapter Summary
S T U D Y
T E X T
••
••
••
••
••
••
The auditors need to be aware of the entity and its environment and the controls that
are operational in a system so that they can be able to determine the level of reliance
that they are going to place on the operating effectiveness and efficiency system and
thus determine the amount of testing that they need to carry out
...
The auditor must understand the information system that operates within the entity and
most importantly how the financial reporting system works
...
The internal audit department may be run by employees of the company or the function
may be outsourced
...
Quiz
1
...
List the five elements of internal control
...
What are the factors that are responsible to the growth of the internal audit function?
4
...
5
...
Dynamic business
iii
...
Competition
v
...
Flow charts
•• Narrative descriptions
•• Questionnaires
Exam questions
QUESTION ONE
List down internal control procedures for raw material purchasing system of a large manufacturing
firm
S T U D Y
3
...
Increase in size of business
T E X T
1
...
•• Scope of work: For an internal auditor the scope is determined by management whereas
for an external auditor it is laid down by statutes and professional requirements of the
institute (ICPAK)
...
The external auditor is primarily concerned with the truth and fairness of accounts
...
The external
auditor is responsible to shareholder and the public at large
...
Internal control has five elements:
•• The control environment
•• The entity’s risk assessment process
...
•• Control activities
...
76
A U D I T IN G AN D A S S U RAN C E
QUESTION TWO
Rhapsody Co supplies a wide range of garden and agricultural products to trade and domestic
customers
...
The company has an
internal audit department which provides audit reports to the audit committee on each division
on a rotational basis
...
Customers review the product list on the Internet and place orders for packets of seeds using
specific product codes, along with their credit card details, onto Rhapsody Co’s secure server
...
Order details
are transferred manually onto the company’s internal inventory control and sales system, and
a two part packing list is printed in the seed warehouse
...
In the seed warehouse, the packets of seeds for each order are taken from specific bins and
dispatched to the customer with one copy of the packing list
...
The customer’s credit card is then charged by the inventory
control and sales computer
...
Finally, the computer system checks that for each charge made to a customer’s credit card
account, the order details are on file to prove that the charge was made correctly
...
Required:
a) In respect of sales in the seeds division of Rhapsody Co, prepare a report to be sent to the
audit committee of Rhapsody Co which:
i
...
ii
...
iii
...
(b) Explain the advantages to Rhapsody Co of having an audit committee
...
ISA 500 (Audit Evidence) deals with audit objectives and audit procedures
...
You are the auditor of a small manufacturing company, Dinko, that pays its staff in cash and by
bank transfer and maintains its payroll on a small stand-alone computer
...
Internal control objectives that should be in place
...
Internal control environment and internal control procedures that should be in place to
achieve the internal control objectives
...
Describe the external auditor audit objectives
...
List the tests of control and substantive procedures that will be applied in order to
achieve the audit objectives identified in (b) (i) above
...
These
projects seek to educate children and support teachers in certain countries
...
Charity income consists of cash collections at fund raising events, telephone
appeals, and bequests (money left to the charity by deceased persons)
...
The charity employs a part-time bookkeeper and relies on volunteers for fund raising
...
Accounts have been prepared (but not audited) in the past by a volunteer who is a recently
retired Chartered Certified Accountant
...
Parker is a
new audit client
...
An initial meeting with the directors has provided the information below
...
All profits
are currently earned in the mail order division, although the Internet division is expected to return
a small net profit next year
...
a
...
In the next year, the directors plan to expand the range of
goods sold through the Internet division to include toys, garden furniture and fashion clothes
...
S T U D Y
a
...
b
...
T E X T
Required:
78
A U D I T IN G AN D A S S U RAN C E
The accounting system to record sales by the mail order division is relatively old
...
Recently errors have been known to occur, in the input of orders, and in the invoicing of goods
following dispatch
...
The company
accountant, who is not qualified and was appointed because he is a personal friend of the
directors, agrees with this view, The directors estimate that their expansion plans will require a
bank loan of approximately Kshs30 million, partly to finance the enhanced web site but also to
provide working capital to increase inventory levels
...
The directors expect an unmodified auditor’s report to be
signed prior to this time
...
T E X T
79
S T U D Y
The Accounting and Internal
Control Systems (ISA 400)
S T U D Y
T E X T
80
A U D I T IN G AN D A S S U RAN C E
Fraud and Error (ISA 240)
81
S T U D Y T E X T
S T SU TDUYD Y
T E TX ET X T
CHAPTER FIVE
ONE
AUDIT EVIDENCE (ISA 500)
S T U D Y
T E X T
82
A U D I T IN G AN D A S S U RAN C E
Fraud and Error (ISA 240)
83
CHAPTER 5
FRAUD & ERROR (ISA 240)
chapter Objectives
By the end of this chapter the student is expected to have covered the following:
I
...
III
...
Definition of errors and types of errors
Frauds, defalcations and other irregularities
Detection, correction and prevention
Errors and frauds in specific areas in a business
...
The objective of an audit is to report o whether the financial statements are free
from material misstatements
...
KEY TERMS
Error: It is an unintentional mistake in the financial information, which can occur any time during
processing and recording of transactions
...
Irregularity: is the deliberate distortion of information together with the related misappropriation
of assets
...
It can also be a
scenario whereby the student is expected to distinguish between a fraud and an error
...
These misstatements may be due to an unintentional error or one that was
committed with intent thus
...
During the planning of the audit, the auditor should expect to detect
material misstatements in the financial statements due to fraud or error if any
...
T E X T
INTRODUCTION
84
A U D I T IN G AN D A S S U RAN C E
Error
An error is an unintentional mistake in presenting the financial information which can occur at
anytime during processing and recording of transactions
...
II
...
S T U D Y
T E X T
IV
...
VI
...
These are errors that do not show in the trial balance because it
still balances
...
g
...
Errors of omissions
...
Errors of principle
...
g
...
Compensating errors
...
The errors occur
usually on opposite sides of the accounts i
...
on credit and debits sides with equal
amounts and are totally independent from each other
...
These occur when the original figure is incorrect and the double
entry system is still observed
...
These occurs where correct accounts are used but each
items shown on wrong side of the account e
...
crediting sales in debtors account and
debiting sales account
...
The main difference between a fraud and error is that a fraud is intentional
and aimed at either misleading people or misappropriating company assets
...
e
...
Fraudulent financial reporting
involves management’s override of controls that otherwise appear to operating efficiently
...
Misappropriation of company assets e
...
using a company vehicle for private
undertakings, stealing physical assets and embezzling receipts
...
g
...
Inappropriate adjusting assumptions and changing judgments used to estimate account
balances
...
g
...
Fraud and Error (ISA 240)
85
••
Suppression or omission of effects of a transaction on accounting record e
...
placing
a genuine debtor well known bad debts in the balance sheet thus misrepresenting the
financial position of the company
...
A perceived opportunity for fraudulent
financial reporting or misappropriation of company assets may exist when an individual believes
that an internal control can be overridden
...
The distinction between fraud and error is of little importance so far as audit procedure are
concerned
...
The only difference may arise where the auditor may be required by law to disclose certain
illegal acts to the regulatory authority
...
I
...
the expectation by users of financial
statements that auditor should detect and prevent error and fraud as a duty, while actually it is
not his duty but of the directors
...
e
...
•• Providing useful general assurance of the financial wellbeing of the company and its
continued profitability
...
Some other
users of the financial statements do not understand the audit opinion issue
...
This responsibility is fulfilled through the implementation and
continuous operation of adequate system of internal controls
...
The auditor on his part seeks reasonable assurance
that fraud and error which may be material to the financial statements has not occurred or if it
has occurred, the effect is properly reflected in the financial statements
...
It is important to emphasis that the auditor
cannot be held responsible for failing to detect errors and frauds
...
Failure
to detect such material errors implies that the financial statements are materially misstated
...
ISA
700 (Audit reports on financial statements) now requires auditors to include a paragraph explaining
the nature and scope of the audit conducted and also explaining the respective responsibility of
management and auditor in relation to preparation of the financial statements
...
ISA 240(fraud and error), requires that the auditor should report to the users of the financial
statements if there is material misstatements as a result of fraud and any other irregularities
...
Risk of fraud and error
In addition to weaknesses in the accounting and internal control system, events which also
increase risk of fraud and error are:
S T U D Y
T E X T
••
Questions regarding the integrity and competence of management
...
•• Unusual pressure within the company e
...
pressure on organization to attain a certain
level or profitability
...
•• Unusual transactions
...
g
...
Difficulties in obtaining sufficient, appropriate audit evidence especially where management is
reluctant to provide the necessary information to the auditor
...
If the effect is material, the auditor should perform additional
procedures to dispel the suspicion
...
The auditor should communicate his findings to management on timely basis if:
••
••
He believes fraud may exist even if the potential effect would be immaterial
...
Inherent limitations of an audit
An audit is subject to the avoidable risk that some material misstatements will not be detected,
even though the audit is properly planned and performed in accordance with ISAs
...
This is because fraud involves acts designed to conceal it
such as forgery and deliberate failure to record transactions
...
However, the auditor should plan and perform his work with professional
skepticism, recognizing that conditions or events may be found that indicate that fraud or error
may exist
...
Fraud and Error (ISA 240)
87
The following procedures could be applied as general leads to where fraud or error may have
occurred
...
Calculation of profitability, leverage, activity and performance ratios for the current and
previous years
...
Auditing in depth to establish the audit trail
...
Using surprise checks and visits
...
Errors and frauds in specific areas in business
We can detect such frauds with the help of auditors
...
If there is any weak point, he must probe
into the matter
...
Auditor should check the
counterfoils of the receipts with the cash book paying particular attentions to the dates
...
blurtit
...
html
(a) Sales & debtors
Potentials errors
••
••
••
••
••
••
Goods dispatched without being invoiced, services rendered without being
invoiced, goods in transit or a consignment not recognized in books
...
Overdue accounts without follow up
...
Cash sales not being recorded
...
Implications
••
Understated sales, wrong management accounts, loss of assets of the company and
accounts without true and fair view
...
This method of fraud is know
as short banking or delayed accounting of money received or lapping
...
If remittances are received by means of cheques, then cheques will have to be
split up
...
Because by encashing the
cheques, less amount id credited to the debtor and rest amount is misappropriated
...
When cash is received from some debtor, it is not recorded in the cash books
and is misappropriate
...
88
A U D I T IN G AN D A S S U RAN C E
••
••
••
Bad debts
Misappropriation of cash, exposure to theft and loss of interest due to delayed
banking
...
(b) Purchases and Creditor
...
Making payments without proper documents and authorization
...
S T U D Y
T E X T
Implications
••
••
••
••
••
••
Loss of company resources because of paying for goods never received
...
Paying for services and goods not received
Overstatement of expenses and creditors
...
Overstatement of purchases
(c) Wages
Potential errors
••
••
••
••
Dummy workers in the payroll or fraudulent double payment of workers, payment for
work not done and unclaimed wages being misappropriated
...
Improper deductions being made or being misappropriated
Inflation of the payroll in other ways
...
Overstatement of stocks
Misstatement of various expense accounts
Unreliable records
...
This serves to prevent fraud or error by boosting the awareness of senior
employees who will refrain from committing fraud and error by virtue of constant review
of operations
...
These limit access to the assets of the company thus preventing
them from damage, misuse or theft
...
This boosts automatic checks, accountability and supervision at
all stages of processing transactions, minimizing chances of error and fraud
...
Proper recording of transactions according to the
principles of ISAs will prevent errors and frauds such an manipulation of accounts
...
Engaging qualified, competent and efficient personnel will reduce chances
of errors
...
Routine and automatic checks
...
Chapter summary
Irregularity is the deliberate distortion of information together with the related misappropriation of
assets
...
The primary responsibility for the prevention and detection of fraud rests with management
...
Quiz
a
...
b
...
c
...
S T U D Y
•• Mathematical or clerical mistakes;
•• Oversight or misrepresentation of facts;
•• Misapplication of accounting policies
...
T E X T
Error is an unintentional mistake in the financial information, which can occur any time during
processing and recording of transactions
...
Error is an unintentional mistake in the financial information, which can occur any time
during processing and recording of transactions
...
2
...
This is achieved through;
•• Management supervision
•• Physical Controls
•• Segregation of duties
...
Both internal and external auditors are required to deal
with risks to the entity
...
b) Stone Holidays is an independent travel agency
...
It
takes commission on holidays sold to customers through its chain of high street shops
...
Well-established tour operators run the holidays that Stone Holidays sells
...
Payments by customers, including deposits, are accepted in cash and by debit and credit card
...
Describe the nature of the risks to which Stone Holidays is subject arising from fraud and error
...
Explain the responsibilities of external auditors in respect of the risk of fraud and error in an audit
of financial statements
QUESTION THREE
S T U D Y
T E X T
Compare the responsibilities of the directors and auditors regarding the published financial
statements
S T U D Y
T E X T
92
A U D I T IN G AN D A S S U RAN C E
Audit Evidence (ISA 500)
93
S T U D Y T E X T
S T SU TDUYD Y
T E TX ET X T
CHAPTER SIX
ONE
MATHEMATICAL
TECHNIQUES
S T U D Y
T E X T
94
A U D I T IN G AN D A S S U RAN C E
Audit Evidence (ISA 500)
95
CHAPTER 6
AUDIT EVIDENCE (ISA 500)
Chapter Objectives
By the end of this chapter, the student should be well versed on the following:
i
...
Reliability of audit evidence
iii
...
Management assertions
v
...
Audit sampling
vii
...
Substantive procedures - these are audit tests carried out to test the accuracy and validity of
the accounting records
...
S T U D Y
The objective of an audit of the financial statement is for an auditor to express an opinion of the
financial and state whether they present a true and fair view of the financial statements
...
The work of an
auditor is used by many users and hence before he comes up with his conclusion he needs to
have gathered sufficient audit evidence on which to base his opinion so that whatever decision
those users come up with, is the right one
...
Audit evidence is covered by ISA 500 Audit Evidence
...
It
may not form a question on its own but it will for sure be tested with other parts of the paper
...
The procedures for gathering evidence
outlined in this chapter are used on a day to day basis by the auditors, hence, by going through
this chapter the student gets a feel on how the auditor goes about the process of gathering the
audit evidence
...
1 Audit evidence
Audit evidence refers to the information obtained by the auditor in arriving at the conclusions on
which audit opinion on the financial statements is based
...
The accounting records
generally include:
••
••
••
Records of initial entries and supporting records
Records of electronic fund transfers, invoices, contracts and cheques
...
Other information the auditor can use as audit evidence are:
••
••
••
••
••
••
Minutes of meetings
Confirmations form third parties
Analysis reports
Comparable data about competitors
...
Information obtained by auditor from audit procedure such as observation and
enquiries
...
The auditor’s judgment will be influenced by the materiality
of item being examined, the relevance and reliability of evidence available from each source and
cost involved in obtaining it
...
Substantive tests are procedures carried out to test the accuracy and validity of accounting
records
...
e
...
Audit Evidence (ISA 500)
97
Qualities of audit evidence
ISA 500 requires that ‘the auditor should obtain sufficient audit evidence to be able to draw
reasonable conclusions on which to base the audit opinion
...
What is enough is a matter of
professional judgment
...
Relevance of audit evidence should be considered in relation to the overall audit objective
of forming an opinion and reporting on financial statements
...
b) Reliability
Reliability of audit evidence refers to the credibility of that evidence the credibility is influenced
by its source and its nature
Consequently, when the auditor is obtaining evidence from a substantive procedure, he is
concerned about testing or substantiating the truth of these assertions
...
Assertions about hinting of transactions and events for the period under audit i
...
••
••
••
••
••
Occurrence transaction and events that have been recorded have occurred and pertain
to the entity
...
Transactions and events have been recorded in the appropriate accounting
period
Accuracy Amounts and other data relating to the recorded transactions have been
recorded appropriately
...
Transactions and events have been recorded in the correct period
2
...
••
••
••
••
Existence
...
Assertions about presentation and disclosure
...
Disclosed events and transactions and other
matters have occurred and pertained to the entity
Completeness All disclosures that should have been included e
...
compositions of
director’s fees
...
Financial and other information are disclosed fairly and at
appropriate amounts
S T U D Y
When preparing financial statements the management makes certain implicit or explicit assertions
about the financial affairs of the company
...
Financial information is appropriately presented
and described, and disclosures are clearly expressed
The auditor may use the assertions described above or may express them differently provided
all aspects described above have been covered
...
Alternatively he may be able to obtain assurance from presence of a reliable internal
contrast system and therefore reduce the extent of substantive testing the auditor obtains
evidence in performing compliance and substantive procedures using the following methods
...
This consists of examining records, documents or tangible assets
...
Inspection of tangible assets provides evidence with the respect to the existence but not
to their value and ownership
...
g
...
c) Inquiry and confirmation
...
It ranges from formal written inquires addressed to the third parties to oral inquiries
addressed to persons within the entity
...
Confirmation is the response to inquiry to corroborate
information contained in financial statements e
...
debtors circularization
...
g
...
e) Analytical procedures
...
Analytical procedures (1SA 520)
Nature and purpose of analytical procedures
They are mainly used at 3 stages of the audit:
•• As part of the planning process
•• At the final review stage
•• As substantive procedures
Analytical procedures are involved in evaluation of financial statements information by a study
Audit Evidence (ISA 500)
99
of relationships among financial and non financial information
...
Therefore the auditor
can use these relationships to obtain evidence of the financial statements amounts
...
Essentially, the process of performing analytical
procedures consists of four steps
...
Investigate and evaluate significant ratio differences from the expectation
1
...
A variety of types of information are available to the auditor to develop an expectation for analytical
procedures including;
Methods of developing expectation on account balances and ratios
a) Trend analysis
...
g
...
This
information could assist auditor in developing an expectation of sales for the current
year
...
This involves comparison of relationships between two or more financial
statement account balances or comparisons of an account balance to non financial
data e
...
revenue per sale order
...
Because ratio analysis involves examination relationships between two or more variables and
may involve industrial data, it is often a richer analysis than trend analysis
...
This involves review of client’s ratios and trends over time
Cross sectional analysis
...
S T U D Y
Financial information for comparable priority periods
...
Relationships among elements of financial information within a period e
...
level of
debtors and credit sales
...
g
...
•• Relationships between financial and non financial data e
...
wage expenses and a
number of employees
...
To increase the precision of the analytical procedures, separate relationships may be computed
for each department or product line
...
However there may be problems
of lack of comparability among companies and inability to obtain current industry data
...
The amount of acceptable difference
...
When trend or ratio analysis is used, the auditor typically
uses professional judgment to specify an absolute amount of difference or percentage difference
that will result into investigation
...
Comparison of the account balance or ratio with the expected balance or ratio
...
4
...
S T U D Y
T E X T
The auditor must investigate any significant differences and his expectation and the client’s
financial statements balance or ratio to determine whether they represent misstatements
...
Inquiry to
management can be useful in this regard
...
If the explanations are not tallying with other audit
evidence, the editor will often be required to expand his tests of related financial amounts to
determine whether or not they are materially misstated
...
The auditor may also decide to use them during the audit on substantive tests to
provide evidence as to the reasonableness of specific account balances
...
They are also used in
understanding the client’s business at the planning stage
...
At the final review stage of an audit, the analytical procedures generally include
reviewing the financial statements and re-computing ratios if necessary to identify any unusual
or unexpected balance or that have not been previously identified and explained
...
e
...
performing analytical procedures is the
most efficient way to evaluate competence of various revenue and expense accounts
...
Precision depends on a number of factors including the predictability
of the relationship, the techniques used to develop the expectation and the reliability of the
underlying data used
...
Audit Evidence (ISA 500)
101
Management representations ISA580
a) Oral representations
...
Oral inquires are made on an endless range of topics from the location of records
and document, reasons for unusual account procedures and probability of collecting overdue
accounts receivable
...
Client replies should be carefully evaluated as
appropriate and followed up with additional questions
...
g
...
••
All accounting records, financial data and minutes of director’s meetings have been
made available to the auditor
...
•• Management believes that adjusting entries brought to the attention by the auditor and
not recorded are not material individually or collectively
...
ISA 580 requires the auditor to obtain representations letter on every engagement and provide
suggestions as to its form, content and guidance on how it is to be used as audit evidence and
actions to be taken if client refuses to provide representations
...
A client representations letter should never
be used as a substitute for performing other audit procedures
...
Purposes of representations letter
••
••
••
To remind the client’s directors of their primary responsibilities for the financial
statements
...
At times a representation letter may be the only evidence available in respect to
management future intentions e
...
whether a maturing debt is classified as a current or
long term liability will depend on whether management has both the ability and intent
to refinance the debt
...
At conclusion of the audit, the auditor obtains from the client a written
representation letter
...
Many specific items are included in this representation letter e
...
management represents that all liabilities known to exist are reflected the financial statements
...
102
A U D I T IN G AN D A S S U RAN C E
Management may be unwilling to sign letters of representation or pass minutes required by the
auditor
...
If management disagrees with the auditor’s statement of representations, discussions should be
held to clarify the matters in doubt and if necessary a revised statement prepared and agreed
...
g
...
In such circumstances, the auditor may have to conclude that he has not
received all information and explanations required and consequently may need to consider
qualification his audit report an ground of limitation in scope of the audit
...
An expert is a person possessing specialized skills, knowledge and experience in another field
other than auditing and accounting
...
Consequently, the auditor may need the advice of another
expert for example, a pharmacist when verifying stock in the laboratory or lawyers in arriving at
the legal interpretation of legal cases against a client
...
g
...
g
...
In deciding whether to use the work of an expert the auditor should consider
...
The nature and complexity of the item including the risk
...
Factors considered before relying on the work of the expert
The auditor should consider;
••
••
The skills and competence of the expert
...
The experience and reputation of the expert in the field in which the
auditor is seeking evidence is very important
...
The auditor should consider whether
the expert is independent from the client
...
In such cases he owes his loyalty
to the client because there exists a financial relationship
...
If the source of the
data can be regarded as reliable, then the auditor can reasonably use the work of the
expert as audit evidence
...
The auditor should consider whether the methods
used by the expert in arriving at his opinion are appropriate to the circumstances
...
Communication with the expert
When consulting an expert the auditor should cover:
••
Chapter Summary
The auditor should obtain sufficient appropriate audit evidence to be able to draw reasonable
conclusions on which to base the audit opinion
...
Audit evidence comprises source
documents and accounting records underlying the financial
statements and corroborating
information from other sources
...
Substantive procedures are mainly of two types i
...
analytical review
procedures and tests of details
...
The two main approaches that can be applied in sampling are:
-
-
Judgmental sampling:
Statistical sampling
T E X T
••
••
••
Objectives and scope of his work
An outline of the item the auditor expects to be covered in the report
...
The confidentiality of the client information
...
These will be evaluated for
reasonableness by the auditor
...
S T U D Y
••
••
••
104
A U D I T IN G AN D A S S U RAN C E
Quiz
S T U D Y
T E X T
1
...
List the ways of gathering audit evidence
...
List qualities of a good sample
...
Required:
a
...
Explain the meaning of the following terms;
• Relevant audit evidence
• Reliable audit evidence
c
...
One stage involves understanding the business and risk assessment, determining the
response to assessed risk, testing of controls and a limited amount of substantive procedures
...
Another stage involves further tests of
controls and substantive procedures and audit finalization procedures
...
S T U D Y
Exam questions
T E X T
1
...
Audit evidence comprises
source documents and accounting records underlying the financial statements and
corroborating information from other sources
...
- Inspection
- Observation
- Inquiry and Confirmation
- Computation
- Analytical procedures
...
- It should be random
- It should be representative
- Protective
- Unpredictable
106
A U D I T IN G AN D A S S U RAN C E
Describe and explain the main audit procedures and processes that take place during the interim
and final audit of a large entity
...
The company has a centralized
operating style and managers of individual restaurants have very limited decision-making powers
on day-to-day operational matters
...
The
company has good internal controls over purchasing
...
Your firm has recently been appointed as auditor to Curdco
...
List the account headings you would expect to find in Curdco’s schedule of accounts
payable and accrued expenditure
...
Describe and give reasons for the audit tests you would carry out to obtain audit
evidence for Curdco’s accounts payable and accrued expenditure
...
Explain the difficulties faced by auditors, and the decisions that auditors have to make,
in conducting direct confirmations of accounts payable
...
Methods include:
•• Analytical procedures
...
•• Detailed testing of transactions and balances
...
Required:
a
...
b
...
QUESTION FIVE
(a) Explain the purpose of a management representation letter
...
The directors have stated that they will not sign the letter
of representation this year on the grounds that they believe the additional evidence that
it provides is not required by the auditor
...
S T U D Y
T E X T
108
A U D I T IN G AN D A S S U RAN C E
Audit Sampling (ISA 530)
109
S
S TT SU
U TD
DUY
YD TY
TE
E TX
X ETT X T
CHAPTER SEVEN
ONE
AUDIT SAMPLING (ISA 530)
S T U D Y
T E X T
11 0
A U D I T IN G AN D A S S U RAN C E
Audit Sampling (ISA 530)
111
CHAPTER 7
AUDIT SAMPLING (ISA 530)
chapter objectives
After you have studied this chapter, you should be able to:
Introduction
ISA 530 (audit sampling and other selective testing procedures) defines auditing sampling as
application audit procedures to less than 100% of the items within an account balance or class of
transactions to enable the auditor obtain and evaluate audit evidence about some characteristics of
the items selected in order to form or amidst in forming a confusion concerning the population
...
Industry context
Audit sampling is a key aspect of obtaining sufficient appropriate evidence
...
This is done on a day to day
basis by the auditors during their work
...
Explain key terms in audit sampling such as sampling risk, non sampling risk, tolerable
error and expected error
...
Identify circumstances where audit sampling is inappropriate
...
Explain the stages in audit sampling and the main approaches to sampling
...
Identify situations where an auditor is required to use work of an expert and factors
considered before relying on such work
...
T E X T
i
...
11 2
A U D I T IN G AN D A S S U RAN C E
Terms and Definitions
Population
The population is the entire set of data from which the auditor wishes to sample in order to reach
a conclusion e
...
all items in an account balance or class of transactions
...
The essential feature of population is that it
must be homogenous i
...
must be composed of similar or uniform sampling units
...
This risk is called sampling risk
...
Non sampling risk
This risk arises from factors that because the auditor to reach an erroneous conclusion for any
reason not related to sample size e
...
use of inappropriate audit procedures leading to failure to
identify an error
...
S T U D Y
T E X T
Tolerable error
This refers to the maximum error in the population that the auditor is willing to accept and still to
conclude that the results from the sample have achieved the audit objective
...
The smaller the tolerable error expected in a balance, the larger sample size must
be
...
Stratification
This is the process of dividing population into sub populations so that items within each
subpopulation are expected to have similar characteristics in certain aspects e
...
High value
items should be grouped separately from low value items
...
Expected errors
If the auditor expects errors in the population, a larger sample size than when no error is
expected ordinary needs to be examined to conclude that the actual error in the population is not
greater than the planned tolerable error
...
Audit Sampling (ISA 530)
11 3
Reasons for sampling
i
...
ii
...
Examining all the transactions will take a lot of time
...
Also a complete check will take so long that the accounts will be ancient
history before users saw them
...
The objective of an audit is to express an opinion as to whether the financial statements
show a true and a fair view
...
The use of sampling with properly set out objectives and
properly constructed tests allows more valid conclusions to be reached than when
many transactions as possible are tested
...
iv
...
Cases where sampling is inappropriate
S T U D Y
When population is small, statistical sampling will create an unacceptable margin of
error
...
Instances where transactions or balances are small in number but material in relation to
financial statements e
...
directors fees should never be sampled and any transactions
involving a large capital expenditures
...
Any situation where the auditor is put on high alert a result of earlier tests or information
is received indicating material fraud in a certain accounting areas
...
For statutory disclosure items such as director’s salaries, a full audit check is desirable
because materiality consideration does not apply in this case
...
Where population is not homogenous and requires stratification, it is not possible to
select a representative sample
...
When the population has not been maintained in a manner suitable for audit sampling
e
...
if sales invoices are filed according to customer name as opposed to a numerical
order
...
11 4
A U D I T IN G AN D A S S U RAN C E
Stages in audit sampling
a) Planning the sample
When planning how to carry out sampling, the auditor considers the following:
i
...
g
...
ii
...
g
...
iii
...
Before
performing testing on a chosen sample, the auditor should define clearly test results and
conditions that will be considered errors or deviations by reference to audit objective
...
S T U D Y
T E X T
b) Determination of sample size
...
Sample size is determined by;
i
...
The larger the tolerable error, the smaller the sample size required
for a given test
...
Auditor’s assessment of the inherent risk
...
Higher inherent risk implies that there is a greater
risk of an account balance being misstated and this may be reduced by testing a larger
sample
...
Auditor’s assessment of control risk
...
iv
...
The greater the degree of confidence level the
auditor requires, the larger the sample size needs to be so that the results of the sample
are in fact representative of the actual amount of error in the population
...
The sample selected should be a true representative of the population so that the auditor can
draw conclusions about the entire population
...
Common sampling methods are;
i
...
This is done by use of random number tables or use computers to
select sampling units
ii
...
In this type of sampling, units in the population are divided by the
sample size to give sampling intervals e
...
if the population to be sample has 600 items
and sample size is 50, the sampling interval will be 12
...
e
...
However, the auditor needs to determine that sampling units within the population are
not structured in a way that sampling intervals corresponds to a particular pattern in the
population
...
Haphazard selection
...
The auditor should avoid conscious bias and predictability in selecting items
in attempt to ensure that all items in the population have a chance of being selected
...
iv
...
This involves selecting a group of continuous items within the population
e
...
all sales transactions for August
...
d) Testing
...
i
...
The auditor should estimate the expected error or deviation rate in the whole population
by projecting the results of the sample to the population
...
The auditor should assess the risk of an incorrect conclusion
...
Actual error may
be greater or smaller than projected error
...
Main approaches to audit sampling
a) Judgmental sampling
This is also called non-statistical sampling
...
The auditor does not rely on probability theory and uses judgment in making
sampling decisions
...
It is well understood and refined by experience
ii
...
e
...
The auditor simply uses his judgment in making
sampling deacons
S T U D Y
The following procedures should be followed
...
11 6
A U D I T IN G AN D A S S U RAN C E
ii
...
The time which could have
been spent on constructing sample and computing mathematical implications of results
obtained is spent on auditing sample units
...
Unscientific
...
It is difficult to
justify why the auditor selected some items and left out others
...
Wasteful as large simples need to be selected
...
iii
...
iv
...
b) Statistical sampling
...
ii
...
Use of probability theory to determine the sample size, evaluate quantitatively the
sample results and measure sampling risk
...
Advantages of statistical sampling
i
...
The auditor can justify the items selected because these
are selected randomly
...
Elimination of personal bias
...
iii
...
This is because
probability theory helps determine a precise sample size
...
ii
...
The need to follow a predetermined statistical report may reduce initiative and the need
to apply judgment by the auditor
...
The result may be misunderstood if audit staff are not properly trained on use of the
techniques
...
It may not be suitable for all applications
...
v
...
Factors considered before adopting statistical sampling
i
...
This is because the set up
and training costs are high
...
Whether large population exists
...
Where
organizations are small with few transactions, a statistical approach is inappropriate
...
Adequate controls must exist where they are no controls it is impossible to use statistical
techniques because of increased statistical errors
iv
...
Audit Sampling (ISA 530)
11 7
v
...
vi
...
e
...
vii
...
The level of risk allowable and the degree of risk attached to an item
being tested must be considered
...
It should be representative of the population
...
ii
...
e
...
iii
...
The client should not be able to know in advance which items will be
examined
...
Estimation sampling for variables
This method seeks the estimate the total value of some population e
...
total value of debtors,
stock or loose tools
...
This
estimate can be compared with the book value and if any difference is within the materiality limits
pre-established, the auditor has evidence for the book value of the item
...
Estimation sampling for attributes
This method seeks to estimate the proportion of a population having particular characteristic e
...
overdue debts or damaged inventory
...
Acceptance sampling
This method seeks to discover the error rate in a population to determine a maximum error rate
...
ii
...
If non compliance is greater than the acceptable
rate, the control will not be relied upon and other audit tests will have to be applied
...
If the error rate is greater
than some acceptable proportion, the auditor will have to request the client to redo the
calculations
...
Estimation sampling for variables
...
Estimation sampling for attributes
...
Acceptance sampling
...
Discovery sampling
T E X T
Sampling methods
11 8
A U D I T IN G AN D A S S U RAN C E
4
...
E
...
a system with
controls exists in an investment trust company to ensure that all bonus issues are recorded
...
This method requires a large sample
...
Monetary unit sampling
Monetary unit sampling is appropriate for use with large variance population e
...
debtors or
stock where individual units have widely different sizes or values
...
Procedure of monetary unit sampling
Determine the sample size taking into account the size of the population and the
minimum acceptable error rate
...
List the items of population e
...
list of debtors could be as
T E X T
i
...
500
500
AQ & Sons
20
520
T Ltd
1,450
1,970
W Co
...
Assume that the total numbers of debtors is 1500
...
e
...
The idea is that the population of
debtors is not 1500 but Shs 240000 with single units of Shs 1
...
iv
...
X where X
is the materiality factor chosen
...
If the conclusion is that the auditor finds that the debtors are overstated by more than
Shs X, then he may take a large sample or investigate the debtors fully
...
Does not cope easily with errors of understatement
...
Audit Sampling (ISA 530)
11 9
ii
...
g
...
Manual selection will involve adding
items cumulatively through the entire population which is very tiring
...
It is not possible to extend a sample if the error rate turns out to be higher than the expected
error
...
iv
...
e
...
Exam questions
What is audit sampling
Distinguish between audit risk and sampling risk
What conditions are necessary to carry out sampling?
What are management representations and when does the auditor seek such
representations?
e
...
Briefly explain how sampling and non-sampling risk can be controlled by the audit firm
...
The company specialises
in the sale of expensive motor vehicles
...
About 500 cars are sold each year,
with an average value of Kshs140,000, although the range of values is from Kshs130,000 to
Kshs160,000
...
All accounting and financial statement preparation is carried out by
the directors
...
The audit manager is starting to plan the audit of Tam Co
...
S T U D Y
a
...
c
...
T E X T
QUESTION ONE
120
A U D I T IN G AN D A S S U RAN C E
Comments are being made about how to select a sample of sales invoices for testing
...
‘We should check all invoices’ suggests the
audit manager ‘How about selecting a sample using statistical sampling techniques’ adds the
audit senior
...
He adds ‘taking a
random sample of invoices by reviewing the invoice file and manually choosing a few important
invoices will be much quicker
...
Briefly explain each of the sample selection methods suggested by the audit manager,
audit senior and audit junior, and discuss whether or not they are appropriate for
obtaining a representative sample of sales invoices
...
Define ‘materiality’ and explain why the auditors of Tam Co must form an opinion on
whether the financial statements are free from material misstatement
QUESTION FOUR
S T U D Y
T E X T
Audit sampling is a technique for drawing conclusions about the characteristics of a population by
testing a sample drawn therefrom
...
Required:
Describe the following:
i
...
iii
...
v
...
T E X T
121
S T U D Y
Substantive Testing
S T U D Y
T E X T
122
A U D I T IN G AN D A S S U RAN C E
Substantive Testing
123
S
S TT SU
U TD
DUY
YD TY
TE
E TX
X ETT X T
CHAPTER EIGHT
ONE
SUBSTANTIVE TESTING
S T U D Y
T E X T
124
A U D I T IN G AN D A S S U RAN C E
Substantive Testing
125
CHAPTER 8
SUBSTANTIVE TESTING
chapter objectives
After you have studied this chapter, you should be able to:
i
...
ii
...
iii
...
iv
...
v
...
vi
...
vii
...
Definition of key terms
Cut-off tests which involve selecting goods, received notes raised before the year-end and
ensuring that the related invoices have been included in the purchases daybook before year-end
as well as individual creditors’ accounts
...
Debtors’ circularization
This is a procedure by which the auditor obtains corroborative evidence regarding the
existence,ownership and the value of debtors appearing in the financial statements
...
Post Balance Sheet Events- This involves transactions that are entered into before the balance
sheet date with the sole purpose of altering the appearance of the balance sheet
...
S T U D Y
Substantive tests are those tests carried out by auditors to confirm the assertions of the
management
...
T E X T
Introduction
126
A U D I T IN G AN D A S S U RAN C E
Industry context
The auditor always encounters substantive testing during the audit where he tests debit items
for overstatement and credit items for understatement
...
Substantive Tests:
compliance tests provide the auditor with indirect evidence, the auditor therefore cannot on the
strength of compliance test alone reach a conclusion as to whether or not a balance is fairly
stated
...
S T U D Y
T E X T
Substantive tests are those tests balances and transactions and other procedures such as
analytical review, which seek to provide audit evidence as to the completeness and accuracy and
validity of information contained in the records and or the financial statements
...
e
...
Exceptions of substantive tests:
In substantive tests transactions speak for themselves therefore any error or deviation is measured
for its materiality or effect on the financial statement or the recorded balance
...
This then
reduces the extent of detailed substantive testing
...
After the substantive test the auditor can conclude that proper records have been kept and
that the accounting system is adequate and is a reliable basis for the preparation of financial
statements
...
It is also has to do with double entry system e
...
creditors and purchases
...
The techniques used are:
Review payments after balance sheet date and matching them against related invoices
specifically noting dates on invoices to ensure that the invoice was accounted for in the correct
accounting period
...
If no invoices have been received to match those goods
received notes than a reasonable liability should have been set up
...
Reviewing correspondence with professional advisers e
...
lawyers for claims that they may
have made against the company but not recorded
...
This is:
Turnover
FA (NBV)
To determine how much sales are generated for every shilling invested in FA’s
...
Global depreciation ratio is worked out which involves taking the NBV of the FA’s divided by the
depreciation charge in the profit and loss account
...
Too big a figure indicating that maybe the rates of
depreciation used are too low
...
If the two increases do not correspond, it may indicate that the provision
for obsolescence is inadequate
...
T E X T
Comparison of the present list of creditors with the previous year’s list and investigations being
carried out on those creditors on the list of the previous year missing from current years list to
confirm that they are properly excluded through settlement during the year under review
...
To ensure that we’re comparing like with like, the cost
of sales figure is used and not the sales figure
...
c) Debtors:
The percentage increase in debtors is worked out and this is compared with the percentage
increase in turnover
...
Debtors to sales ratio is also worked out to determine
the number of day’s sales are debtors
...
It measures the effectiveness of credit control and consequently the adequacy
provision for bad and doubtful debts
...
ii
...
Also the number of day’s purchases in creditors worked out of measure the difference
between credit taken and credit allowed by supplies
...
f)
The gearing ratio
This is worked out of measure the company’s exposure or the cost of external capital to the
organization
...
It is proving that the transactions
occurred, they are complete correctly measured and they relate to the correct period if they are
of a revenue or expense nature
...
In audits whose internal control is weak or non-existent
...
Method:
The vouching audit involves a consideration of each entry in the books and vouching the available
evidence to support each entry
...
•• The transaction came within the aims and objectives of the organization
...
•• The entry is correctly incorporated in the final procedures
...
Substantive Testing
129
Practical Illustrations
Interest paid
a) Ensure that transaction was authorized
••
The authority for payment of interest should be obtained prior to payment
...
•• The auditor should examine the minutes of Board of Directors (BOD) or the Minutes
of Annual General Meeting (AGM) for proper authorization to obtain the loan and to
service it
...
b) Ensure that the transaction came within the aims and the objects of the organization
...
Obtain the loan agreement and check for:
•• Re-compute the interest and ensure it is correctly calculated
...
•• Obtain the counterfoils of the cheques paid for this interest
...
d) Ensure entry is correctly incorporated in the final accounts
••
Check the amount recorded in the profit and loss account to ensure that item is properly
recorded as an expense and it relates to the correct period
...
Interest received
a) The auditor should check the investment which has borne such an interest and check the
authority for its acquisition
...
(This
is similar to number one of interest paid
...
•• compute the interest or the investment
•• Check the recording in the ledgers
•• Check the mode of payments; cash or cheque
...
d) ensure that the item is properly reflected in the profit and loss account i
...
that the amount
is correct and it relates to the correct period
...
T E X T
•• Amount
•• Interest
•• Period for interest to be paid
•• Any other matters of default
None should be prejudicial to the shareholders interest
...
This should be in accordance with the investment policy of the organization
...
c) Ensure dividends received are properly reflected in the accounts and in particular check the
cut-off for dividends received
...
•• Check the recording of the shares bought or sold cum-div (with dividend) or ex-div
(without dividend) and ensure that it is properly recorded in the ledgers
...
Compare the
cash book and the bank statement
...
Rent received
a) Check the minutes of the BOD and/ or AGM to ascertain authority for obtaining the property
and for renting the property out
...
g
...
g
...
The auditor should also check the reasonableness of the
rent on the rented property
...
e
...
Trace the item to the cashbook and bank statement
d) Ensure that the profit and loss account has the correct amount and item is for the correct
period
...
Every type of business has its audit problems but the sheer
number different types of business make it impossible to discuss these problems in other than a
general way
...
These guidelines were given at the beginning of this lesson
...
a) Obtain authority for admitting the members whose subscriptions are being audited
...
b) The auditor should obtain the constitution of the club and check:
•• Maximum number of members and the type of members
•• The subscription from each member
•• Provision for default
•• The auditor should then check the actual number of members and the rates they have
paid
c) Obtain the ledger and ensure that subscription paid have been entered properly both in
amount and the period to which they relate
...
d) Obtain the cash book and compare it to the bank statement
...
Check that it is properly recorded in the income statement
...
b) Obtain hire purchase agreement and check for:
•• Value of asset
•• Hire purchase price
•• Hire purchase installments
•• Provision for default
•• Ensure the hire purchase terms are in agreement with the policy of the organization
S T U D Y
a) Obtain the authority for accepting the cover
...
b) Obtain copies of the policies given and check
Various insurance covers
Date when insurance premiums are due
Penalties for default
These should be in accordance with the insurance company’s policies regarding insurance
covers
...
•• Check the period which relates t the premiums received and check that the premiums
received is correctly shown
...
•• Obtain copies of standing orders from the insured and ensure that entries therein agree
with those in ledgers and check for:
•• Schedule of standing order
•• Number of polices
•• Date due
•• Any defaults-check the entries in the ledger for this
...
T E X T
This pertains to insurance companies
...
132
A U D I T IN G AN D A S S U RAN C E
c) Find out the amount of installments and when they should be paid and get the ledgers
recording of these installments
...
The auditor should calculate the amounts and compare them to those that are
recorded
...
Check the profit and loss for proper recording
...
The difference is that the audit procedures lay emphasis on checking the strength
of the internal control system
...
Some of the frauds which can be perpetrated by the employees and which the auditor should
look out for include:
S T U D Y
T E X T
••
••
Dummy/ghost workers: these are workers who do not exist
...
•• Payment for work not done and unclaimed wages being misappropriated
•• Inflating payroll by wrong increments or showing increment when it is not due
...
•• Manipulation of commission
...
Check if there is possibility of this
system detecting ghost or dummy workers or any similar fraud
...
Verify that there is proper recording of wages
...
Check authorization of overtime
...
Check castings of wages
...
Check total of wages paid to control account
...
Reconcile signature of original employment to that signed on receipt of the wages
Substantive Testing
133
Verification of assets & liabilities
Verification is proving the authenticity of a recorded balance
...
ISA 500 paragraph 12 “when obtaining audit evidence from substantive procedures, the auditor
should consider the sufficiency and appropriateness of audit evidence from such procedures
together with any evidence from tests of control to support financial statement assertions”
The auditor must substantiate all the relevant management assertions for each outstanding
account balance
...
Management assertions
•• The completeness
•• The existence
•• The valuation
Whereas for plant and machinery the auditor would be interested in proving:
•• The existence
•• Ownership rights
•• Valuation
•• Completeness
•• Presentation and disclosure
This implies that the audit procedures applied in verifying these two balances will be different
...
Verification of non-current assets
In an average company, the non-current assets that will be encouraged are: freehold land and
buildings, plant and machinery, motor vehicles and fixtures, furniture and fittings
...
Therefore, we shall look at freehold property and plant and
machinery
...
This implies
that not all the seven above mentioned assertions are relevant for all account balances but rather
the auditor has to determine which ones are relevant to what account balance
...
For e
...
for debtors the auditor would be interested in proving:
T E X T
Financial statement assertions are assertions by management, explicit or otherwise that are
embodied in the financial statements
...
16, 17 or 40
Audit procedures
To be able to meet the above objectives, the auditor carries out the following audit procedures:
a) Cost and authorization
This is verified by inspecting to the appropriate documentation such as the sale agreement
and surveyors certificates
...
b) Existence
S T U D Y
T E X T
This can be verified through physical inspection of the land or the building
...
The auditor should also ensure that
such title documents are in the name of the company and are free from ant charges e
...
the land title deed should not be charged as security for loan
...
d) Valuation
Freehold land should be disclosed at cost
...
Generally buildings should be carried at the depreciated historical cost or at
depreciated revalued amounts
...
e
...
• Where buildings or land has been revalued that this is carried out by a qualified
and reputable valuer and the revaluation seems reasonable
...
e) Presentation and disclosure
For purpose presentation fixed assets should be split into appropriate classes
...
Plant and machinery
Audit objectives
••
The auditor will be aiming at proving the following assertions
Substantive Testing
1
...
3
...
5
...
Authorization
Check in the director’s minutes or AGM minutes for proper authorization for acquisition of the
asset
...
For
example if the diminution in value of an asset is largely related to time then reducing balance
method would not be appropriate but straight line method
...
Where the assets have been revalued the auditor should ascertain that an independent and
qualified valuer carried out this revaluation
...
•• Ordering or authorizing the purchase of fixed assets
...
•• Authorizing the disposal of fixed assets
...
•• Custody of readily realizable assets
...
Fixed asset number
...
Fixed asset location and responsibility for custody
...
Nature and description of the asset
...
The cost and date of purchase
...
The estimate useful life and residual value
vi
...
Accumulated depreciation
viii, The gain or loss on disposal
ix
...
S T U D Y
Existence should be checked by physical inspection
...
It becomes difficult therefore for
the auditor to be assured that the value attached to the plant and machinery represents plant
and machinery that actually exist at balance sheet date
...
T E X T
Existence
136
A U D I T IN G AN D A S S U RAN C E
Beneficial ownership
For plant and machinery, it is usually implied and unless there is clear evidence t the contrary,
proof of purchase and possession will suffice as evidence of ownership
...
The only issue here is existence and ownership
...
g
...
which are proof of its existence
...
Beneficial ownership
S T U D Y
T E X T
Ensure client’s name is the one in the logbook
...
Verification of current assets
Cash in hand
The cash in hand will mainly be composed of the petty cash float and any unbanked receipts
from customers
...
Audit objectives
The main audit objective is to ascertain the completeness and existence of the cash in hand
...
ii
...
He should count authorized
IOU’s, stamps and cheque drafts as well
...
If the company has different cash collection centers cash in all entries must be counted
simultaneously to avoid a shortage in one centre being made up with balances from
other centers
...
The counting should be in the presence of the cahier so that in case of a shortage the
auditor can ask for a certificate of shortage from the cashier which should be mentioned
in the management letter
...
The auditor should obtain a certificate of cash in hand from all branches should he be
unable to attend a cash count in those branches
...
e
...
vi
...
vii
...
viii
...
Any reported variances should be investigated and
appropriate action taken
...
The auditor should obtain the bank reconciliation statement as at the end of the period and
perform the following procedures;
i
...
Ensure that the correct balances as per the bank statement and the cash book have
been picked in the reconciliation
...
Verify that all un-presented cheques had been dispatched to the payees and that all
un-credited deposits have cleared
...
Window dressing in this context refers to attempts to overstate the liquidity
of the company by keeping the cash book open such that money received after year
end is credited to the cash book increasing the cash balance and reducing debtors
...
iv
...
2
...
The auditor should obtain the clients consent to communicate directly
with the bank
...
Auditors use a standard letter of request because of the following:
•• Use of a standard letter by all auditors facilitates the quick preparation of the reply by
the bank as they are well familiar with the contents and the required information in the
letter
...
•• It is more efficient for the auditors because all that is needed is to amend the letter to
reflect the specific details of the client
...
T E X T
The above objectives are tested by performing the following procedures:
138
A U D I T IN G AN D A S S U RAN C E
Stocks and work in progress
Stock includes:
•• Finished goods held for sales in the ordinary course of business
•• Work in progress
•• Raw materials
Stock comprises a significant portion of the company’s assets and hence has a material effect on
the presentation of the financial statements
...
ii
...
Stock has a one for one impact on the reported profits i
...
an increase in stock increase
the reported profit
...
iii
...
iv
...
v
...
vi
...
vii
...
viii
...
g
...
ix
...
Audit objectives
a
...
b
...
Adequate provisions are created for dead and slow moving stock
...
Verify the completeness and accuracy of the stock balance
...
Verify that stock is appropriately presented and disclosed in the financial statements
...
The auditor
should then check the acceptability and appropriateness of the adopted policies
...
Valuation
Stock should be valued at lower of cost and net realizable value where net realizable value
is defined as the amount that could be realized on the open market in the ordinary cause of
business less the cost of putting them into a saleable condition and less the cost of sales
...
Substantive Testing
139
Stocks should be reduced by a provision for obsolete or damaged and slow moving stock
...
The auditor is guided by the factors such as
age of stock, condition of stock, its turnover, technological advances in the industry, nature of
stock (perishable or not), prevailing economic conditions etc
...
Existence
The auditor must obtain adequate independent evidence that the stocks concerned are in
existence
...
The unfavorable decisions against the auditor
have resulted in the profession making it obligatory that where stocks are of a significant figure
in the accounts the auditor attending to observe the stock take
...
The auditor should obtain
evidence in order to enable him to draw conclusions about the validity of amounts attributable
to stocks
...
The auditor must be present during the stock take mot necessarily to count stock but
to witness and observe the way stock taking is done to obtain assurance on the existence and
value of stock in trade
...
Define instructions preferably in writing
should be issued in all cases for the guidance of those who will be engaged in the actual stock
taking
...
Identification of the sock items and their ownership
...
Counting, weighing or measuring
...
Reporting of stocks which are damaged or defective
...
These persons should be familiar with the stock but supervisors should be from different
departments
...
Stocks should be marked to facilitate counting
...
Ensure that properly qualified personnel are available where specialized knowledge is
necessary to identify, quality and quantity of stock
...
The records must be up to date
...
The auditor should examine the internal control in order
to determine the nature and extent of audit steps
...
140
A U D I T IN G AN D A S S U RAN C E
Cut off procedures should be performed i
...
dispatch documents for all goods belonging to
customers and still held by client and those that have already passed to the customers
...
Include al goods that have been purchased by client
...
Goods held in safe custody for others should not be recorded as part of the client’s stock
...
There should be procedures to identify the slow moving and obsolete/damaged stock
...
The following details should be available for the auditors during the stock take:
a
...
b
...
c
...
Auditors Duties
S T U D Y
T E X T
The procedures to be carried out by the auditor when attending stock taking are divided into:
•• Duties before stock take
...
•• Duties after stock take
...
•• Familiarization with the location of the stocks and the opportunity to plan for the work
to be undertaken
...
Review of previous year’s working papers and discussions with the managers of any significant
changes from the previous year
...
g
...
Consideration of any involvement of the internal audit department and the extent of reliance to
be placed upon their work
...
Establishing whether expert advice may be needed
...
He will do this by testing efficiency of the
counting by counting selected items
...
Details of items for cut off purposes should be noted
...
•• Record fully the work done and his impression on the stock take exercise
...
•• Get photocopied of rough stock sheets
...
•• Pay special attention to high value items
...
Note that
The auditor should conclude whether stock taking was properly carried out and can be relied
upon for determining the existence of stock
...
Duties after the stock take
This is mainly a follow up exercise and it involves:
If the auditor is unable to attend a stock take either, because he has numerous clients with similar
year ends or stock is located in remote locations, the auditor must still certify himself on the stock
take
...
Arrange for stock take to be done earlier
...
Appoint as agent
...
Examine perpetual inventory records more thoroughly
...
Ownership of stock
In January 1976 the case of Aluminium Industries Vasen BV v
...
Commercial law states that title to good
passes to the buyer once they are delivered on a valid contract, therefore if the buying company
went into liquidation then the seller company would probably lose the stock and money
...
The Romalpa case rules that transactions can be made subject t reservation of title such a time
as the buying company makes payment
...
S T U D Y
Checking the cut off with the details of last numbers of stock movement forms and
goods inwards and goods outward notes during the year and after the year end
...
He must particularly check that all the counts sheets issued were returned
...
•• The auditor should ensure that the stock records have been adjusted to amounts
physically counted and that all reported differences have been investigated
...
Inform the management of any problems
in the stock taking exercise so that they can act accordingly
...
Accounting treatment acknowledges substance over form and as a result the amounts are shown
as sales if the selling company is a going concern
...
If the amount if stock is significant then it may be necessary to disclose
in a note to the accounts that such creditors are secured by a specific stock
...
The stock should be classified in a manner which is appropriated
...
An example of a note to the accounts
S T U D Y
T E X T
The company purchases goods from certain suppliers subject to reservation of title
...
X
...
Work in Progress
This item presents greater problems of ascertainment and valuation to the directors and to the
auditor even though what applies to stocks applies to work in progress
...
Enquiry into checks that are made as part of the system on statistical data concerning
inputs of materials and output of products and expectations
Enquiry into the system of inspecting and reporting on work done so that allowance is
made for scrapping and rectification work
...
Making enquiry into the basis on which any profit elements are dealt with
...
Where the organization constructs intentionally some of its own fixed assets, the auditor
must make sure that such items as are under construction are not accounted for twice
i
...
in fixed assets and in work in progress
...
Audit objectives
The auditor will be seeking to obtain sufficient appropriate audit evidence on the following
assertions that:
••
••
••
••
Debtors are complete
Debtors exist
Debtor’s balances are accurately stated
Debtors are appropriately valued
...
•• Compute current year’s debtors’ days and compare this with that reported in the previous
period and obtain explanations for the reported trend
...
The purpose of these analytical procedures is to provide the auditor with indications as to
whether the debtor’s balances are complete and correctly valued
...
The auditor must therefore consider the following matters:
i
...
ii
...
iii
...
Cast the list
...
Compare the list to the aged debtors
listing to ensure that no debtor has provision against them greater than the total amount
due from those debtors
...
This include: debtors, payment record
and correspondence with the debtor, legal action taken against the debtor and information
from external sources such as liquidation on receiverships
...
Review the debtors not provided for to assess whether they should be in fact provided for
...
Debtors’ circularization
This is a procedure by which the auditor obtains corroborative evidence regarding the existence,
ownership and the value of debtors appearing in the financial statements
...
S T U D Y
•• Verify that the total debtors per listing agree to the ledger balance
...
c) To test the completeness, existence and ownership carry out debtors’ circularization
...
This
will confirm the existence of the debtor and will provide evidence as to the valuation
...
d) Basing of the cumulative information gathered ascertain whether the company has created
an appropriate provision for doubtful debts and where appropriate discuss with management
as to the recoverability of amounts not settled as at the balance sheet date
...
T E X T
••
144
A U D I T IN G AN D A S S U RAN C E
Purpose for circularization
••
••
••
••
••
••
To provide independent third party confirmation of the existence of the debt
...
To confirm the money amount
...
To bring to light any disputed amounts which could point out irregularities or frauds in
the area of debtors
...
Types of circularization
Negative circularization
The debtor is expected to respond to the circular if they do not agree with the contents of the
circular
...
Therefore unless the client has a very effective
system of internal control or there exists other evidence to enable the auditor satisfies themselves
with regard to the purposes of circularization the negative method should not be used
...
Accordingly the positive method if the preferred method of circularization
...
Obtain the client’s consent to send the requests to the debtors
...
Select the date at which you desire to perform the circularization
...
Select the debtors you wish to circularize and confirm management’s acceptance of
those debtors
...
Draft a circular, which should be from the client to the debtor with the request that the
debtor should reply direct to the auditors
...
Send reminders to non-repliers
...
Evaluate the replies
...
vii
...
viii
...
Selecting the debtors for circularization
A representative sample should be selected from the debtors listing
...
All large debtors would be circularized i
...
debtors above the materially level set for
debtors
...
Credit balances would also be selected to try to confirm that they are genuine credit
balances
...
iii
...
iv
...
Substantive Testing
145
v
...
The remaining accounts tend to be
selected on a random basis
...
Long outstanding balances
...
vii
...
Alternative
Where it proves difficult to get confirmations from individual debtors the following alternative
procedures can be applied:
i
...
ii
...
These include:
customer orders and acknowledgement or receipting of the goods
...
Sometimes the correspondence with the customer is also reviewed
...
Take note of the last serial number of the goods dispatch note for the period under
review
...
Verify that the sale was recorded in the current period
...
Verify that such items sold were not included as part of closing stock
...
This can also occur by colluding with the cashiers
...
The cash received is then misappropriated
...
Verification of liabilities
The auditors’ duties with regard to liabilities can be summarized as:
a
...
b
...
To verify the appropriateness of the description given in the accounts and the adequacy
of the disclosure
...
T E X T
Cut off procedures are tests performed to ascertain whether the company’s transactions are
recorded in the financial period to which they relate
...
E
...
where there is a time lag
between the dispatching of goods and the recording of these dispatches as sales, such sales
may be recorded as sales in the wrong period
...
To verify that all existing liabilities are actually included in the accounts i
...
completeness
Number (d) poses the most difficulty to the auditor
...
Examples of such liabilities include:
••
Contingent liabilities such as claims by ex-employees for unfair dismissal, pending law
suits etc
...
The procedure carried out would include:
S T U D Y
T E X T
••
••
••
••
••
••
Enquiry of the directors and other officers
Examination of post balance sheet events, which includes inspection of purchase
invoices and the cashbook etc
...
g
...
Obtain a letter of representation from the client
...
This should show the make-up
of the liability i
...
the opening and closing balance and the changes
...
Consider the reasonableness of the liability asking the question whether there may be
circumstances which ought to excite suspicion
...
Consider the liabilities at the previous accounting date
...
This applies principally to loans
...
Authority: the authority for all liabilities should be sought
...
Authority of the Articles of Association or Memorandum
may be required
...
He should examine all the relevant documents
...
The company’s Act requires that the nature of security, the item covered and
aggregate amount of debt be disclosed
...
Substantive Testing
147
••
External verification: With many liabilities it is possible to verify the liability directly with
the creditor
...
Current liabilities
Tax payable
Audit objectives
To verify that:
••
••
••
All tax liabilities have been taken up in the books i
...
completeness
Tax liabilities have been accurately computed
...
Audit procedures
Trade creditors
Audit objectives
The auditor seeks to ascertain:
•• The completeness and accuracy of the creditors balances
...
•• Creditors are properly presented and disclosed in the financial statements
...
ii) from the listing select a sample of creditors and carry out the following procedures
••
••
Obtain or prepare a reconciliation of the creditors balance per the ledger to the suppliers’
statements
...
The reconciling items
will mainly include suppliers invoices not posted in the clients ledger or payments not
reflected in the suppliers statements
...
Review the correspondence between the clients and the tax authority in case any
queries have been raised so that the auditor can determine the status of those year’s
returns
...
•• Obtain or prepare a schedule showing the year of income, the balance brought forward,
the amount paid in year under audit, charge to the P&L A/c and the balance carried
down
...
•• The amount paid in the year should be agreeing with the cash flow statement and the
cashbook
...
The auditor should ensure that disclosure is adequate
...
On the face of the P&L account the corporation
tax charge for that year should be separately disclosed
...
iv) Obtain all the pending invoices and verify that these had been accrued for
...
The correct use of these
two words is:
Provision
Any amount retained as reasonably necessary for the purpose of providing for any liability or loss
which is either likely to be incurred, or certain to be incurred but uncertain as to amount or as to
the date on which it will arise
...
Is a debit on profit and loss account (reducing profit and therefore dividends and retained
profits)
ii
...
iii
...
S T U D Y
T E X T
Reserve
That part of shareholders funds not accounted for by the nominal value of issued share capital or
by the share premium account
...
Post balance sheets events can
often cast light on the amount of provision required
...
The verification procedures are:
Verification of provisions and accruals:
a
...
b
...
c
...
d
...
e
...
Long-term liabilities
Long term liabilities mainly include term loans and debentures repayable within a period of more
than one year
...
They
may be secured by a fixed charge over a specific asset or secured by a floating charge on all the
assets or they may be unsecured in which case they are called naked debentures
...
All long-term liabilities are included in the financial statements i
...
completeness and
accuracy
...
All long-term liabilities are genuine obligations of the entity
...
All long-term liabilities are properly presented and disclosed in the financial statement
...
Verification Procedures
The auditor should carry out procedures to become aware of any material litigation or claims
involving the entity
...
Examination of the minutes of the board for reference to and indications of possible
claims
...
Inspection of bills
rendered by the solicitors
...
Written assurance in the form of a representation letter from an appropriate director that
he is not aware of any other matters referred to the lawyers other than those disclosed
...
The request must be sent by the client not the auditor
...
•• Obtain the terms and conditions of the loan as evidenced in the deed
...
•• Agree the opening balances with last year’s accounts and working papers
...
•• Repayments made should be vouched through the cash book and the register of
debenture holders and charges
...
•• If the loans are secured, confirm that the charge is registered at the registrar of
companies
...
•• Review restrictive terms of the contract and provisions relating to default in payment of
interest and principal
...
In extreme cases the
company could be put under receivership
...
•• Ensure disclosure is in accordance with companies act requirements, clearly stating
the date of redemption of the debentures
...
g
...
When share capital has been issued in a year its
verification is as follows:
S T U D Y
T E X T
i
...
ii
...
iii
...
iv
...
This will involve examining the
prospectus (if there is one) applications, applicators, application and allotment sheets,
the share register, cash received records, share certificate counterfoils and repayment
to unsuccessful applicants
...
When the issue was one which was contingent upon permission to deal being received
from stock exchange then:
• Ensure that permission has been obtained
...
• Ensure all the money was kept in a separate bank account until all conditions were
satisfied
...
If there are not enough
subscribers then the whole is returned
...
Vouch the payment of underwriting and other fees
...
Determine the total shares of each class as stated in the balance sheet and obtain a list
of shareholdings which in total should agree with the balance sheet total
...
Test the balances in the share register with the list and vice versa
...
If this is not possible at the balance sheet it may be permissible to do it earlier provided
that the auditor is satisfied with the system of control over transfers
...
When the share register is maintained by an independent firm of registrars, the auditor
should obtain a certificate that the above work (a & b) has been done
...
Secured by a fixed charge over a specific asset or secured by
a floating charge on all the assets
...
The verification procedures are:
i
...
ii
...
iii
...
iv
...
v
...
(Terms are correctly interpreted) cashbook,
register of debenture holders
...
Vouch interest payments with debenture deed, cash book and see amount paid is
correctly shown as a percentage of amounts outstanding
...
Agree total amount outstanding with register of debenture holders
...
If loans are secured, verify charge is registered at company’s house
...
Verify disclosure is in accordance with Companies Act requirements
...
Post balance sheet events considerations
Post balance sheet events are those events both favorable and unfavorable that occur between
the balance sheet date and the day the accounts are approved by the Board of Directors
...
Non- adjusting events - those that are indicative of conditions that arose after the balance sheet
date
...
•• The bankruptcy of a customer which occurs after the balance sheet date usually
confirms that a loss already existed at the balance sheet date on a debtor and that the
company needs to adjust the carrying amount of debtors by writing off the amount that
is irrecoverable
...
This can be used to revalue the stock to the lower of
cost and net realizable value
...
Examples of non-adjusting post balance sheet events
A company should not adjust the amounts recognized in its financial statements t reflect nonadjusting events after the balance sheet
...
The fall in the market value does not normally
relate to the condition of the investments at the balance sheet date, but reflects circumstances
that have arisen in the following period
...
S T U D Y
An enterprise should adjust the amounts recognized in its financial statements to reflect adjusting
events after the balance sheet date
...
T E X T
Examples of adjusting events
152
A U D I T IN G AN D A S S U RAN C E
Post Balance Sheet Events
Included under considerations of post balance sheet events are those events ordinarily referred
to as window dressing
...
They mature or
reverse immediately after the balance sheet date
...
•• Material non-adjusting events should be disclosed in the financial statements if their
non disclosure would affect the ability of the reader to reach a proper understanding of
the financial position or they include transactions which reverse or mature immediately
after the balance sheet date but were entered into before the balance sheet date with
the primary purpose of altering the appearance of the balance sheet
...
S T U D Y
T E X T
A prudent estimate of the financial effect or a statement that it is not practicable to make such a
statement
...
In
reality, an entity’s life is continuous
...
e
...
To determine the portion at the balance sheet date, reference will have to be made to the
transactions concerned
...
Audited financial statements become public knowledge well after the year end and even though
they relate to past date, they are used for making decisions in the period after become public
knowledge
...
The auditors interest in post balance sheet events
Therefore management have used post balance sheet events in preparing the financial
statements, the auditor has an interest in ensuring that the post balance sheet events have been
properly accounted for
...
Balance sheet date
...
Date the directors approve the draft accounts
...
Date the auditor signs his audit report
...
The intervening period from the date of signing the audit report to the date of dispatching
the audited financial statements to the shareholders
...
An AGM at which the members either adopt or reject the financial statements
...
The auditors’ procedures with regard to post balance sheet events
i
...
ii
...
iii
...
iv
...
Contingencies
PROBABLE means very likely to materialize
POSSIBLE means can materialize
REMOTE means unlikely to materialize
The standard then says:
Losses
If a loss is probable, and it can be estimated with reasonable accuracy it should be provided for
in the financial statements
...
If a loss possible it should be disclosed
...
Gains
If a gain is probable, do not accrue in the financial statement only disclose
...
The information to be disclosed is:••
••
••
The nature of the contingency
...
A prudent estimate of the financial effect or a statement that it not practicable to make
such a statement
...
Probable
b
...
Remote
Where:-
T E X T
The standard describes a contingency as a condition existing at the balance sheet date whose
ultimate outcome is dependent on the occurrence or non-occurrence of one or more uncertain
future events
...
The standard
then identifies 3 possible conditions of a contingency:-
154
A U D I T IN G AN D A S S U RAN C E
The Auditor’s Procedures
i
...
ii
...
iii
...
iv
...
v
...
The most common contingencies are:
•• Guarantees
•• Pending litigation or claims
•• Discounted bills
...
Discounted Bills
Again a bank letter should be obtained
...
Each
salesperson is supplied with a car which is changed every three years
...
Expenditure is on petrol, repairs and servicing the car, hotels, lunches and entertainment
...
She verifies that the claims
are supported by the vouchers
...
The total amount paid in year
ended 31/12/2006 was Kshs
...
The company made a profit of Kshs
...
Required:
a
...
b
...
c
...
What actions should the auditor take?
Substantive Testing
155
QUESTION TWO
“Action must be specifically taken to prevent the occurrence of frauds involving the assets of the
company”, Finance Director of Food All Limited addressing accounting staff of the company
...
The company’s cheque books
Issue of credit notes to debtors
...
For each of the above, explain how a fraud can occur in the area
...
What controls should be in place to prevent the occurrence of each of the frauds
described in (a) above?
Required
a
...
b
...
Required:
(a) Explain why the audit of inventory is important to auditors
...
(c) Describe the audit evidence that you would obtain for the cost and net realizable value
of finished inventory in a company that manufactures household furniture
...
S T U D Y
You have been asked by the manager in charge of the audit of Timab agencies to consider
and describe various aspects of carrying out a debtor’s circularization at its year ending 31st
December 2006
...
The accounts also show debtors of five million shillings
...
T E X T
QUESTION THREE
156
A U D I T IN G AN D A S S U RAN C E
Required:
i
...
List four examples of external confirmations
...
(b) Jayne Co has a significant number of cash transactions and recent non-current asset
purchases have been financed by a bank loan
...
Required:
Explain the procedures to obtain a bank report for audit purposes from Jayne Co’s bank
and the substantive procedures that should be carried out on that report
...
List the further substantive procedures that should be carried out on the bank balances
in Jayne Co’s financial statements
...
T E X T
157
S T U D Y
Computerised Information Systems
S T U D Y
T E X T
158
A U D I T IN G AN D A S S U RAN C E
Computerised Information Systems
159
S
S TT SU
U TD
DUY
YD TY
TE
E TX
X ETT X T
CHAPTER NINE
ONE
COMPUTERIZED
INFORMATION SYSTEMS
S T U D Y
T E X T
160
A U D I T IN G AN D A S S U RAN C E
Computerised Information Systems
161
CHAPTER 9
COMPUTERIZED INFORMATION SYSTEMS
Chapter Objectives
i
...
ii
...
iii
...
iv
...
v
...
vi
...
Auditing around the computer
viii
...
real time and on-line Systems
Industry context
With the current trend in technological changes auditors need to be updated in system use to
make their work easier
...
He also needs to understand how the controls work in such
a system
...
Programs are the instructions telling the computer how each type of transaction is to be
processed
...
Exam Context
As the world embraces the emerging technological changes, so does the audit profession
...
The questions that are likely to appear are the ones that deal with the
impact Information technology has had on audit
...
The push for companies to embrace the new technological changes has come with new
challenges for the audit environment
...
This means that the auditor has to device new means of carrying out an audit
in a computerized environment
...
In the chapter below, all this is covered so that the student can be able to understand
and appreciate the challenges and the gains in auditing in a computerized environment
...
•• Input data into the computer
...
•• Store data in machine readable form
...
For these procedures to be undertaken, a mixture of hardware and software is needed
...
Input devices
...
ii
...
These are the computers themselves
...
e
...
Storages devices include hard disk, diskettes and magnetic tapes
...
Output devices
...
The computer software consists of programs and operating systems
...
These instructions include routines of checking and controlling data, matching data
with master files and performing mathematical operations on data
...
g
...
Mathematical routines will include calculating
the total debtor’s amount and updating customer’s balance in the debtors’ master file
...
E
...
with a batch of sales transactions, the sales price
file and debtor’s file need to be on-line
...
An operating system will provide details of further processing runs within the system
...
In a batch processing system, the operating system may consist of a set of instructions provided
to the operator but increasingly the operating system is part of the computer software such that
with real time system, the computer identifies source of an incoming signal and automatically
processes that transaction using the appropriate programs and the right file
...
These are equivalent of books and records in a manual system and are described as either
transaction files or master files
...
These are equivalent of journal such as sales journal, the purchases journal or the cash book
...
A separate file is set up for each batch
...
b) Master files
...
These transactions require special consideration because an
error in such data held in a master file will cause errors in all transactions processed against the
master file
...
g
...
The audit approach in computerized information systems
The actual approach adopted by the auditor will depend on:
•• The auditor’s experience with the client
...
•• The complexity of the computerized information system
...
•• The risk of misstatements in the financial statements
...
a
...
b
...
S T U D Y
When master files are updated by processing them against a transaction file, the entire contents
of the file are usually re-written in a separate location so that after processing, the two files can
be compared and the difference agreed to the total of the transaction file
...
In practice, the old copy of the
master file and transaction file will be retained until the master file is updated again
...
If the current master file is corrupted or lost due to machine or
operator error, previous versions provide back up from which the master file can be re-created
...
T E X T
These contain what is referred as standing data
...
E
...
a debtor’s master file
the equivalent of debtor’s ledger but will also include data that in a manual system may be kept
separately such as invoicing address, discount terms and credit limits, even non accounting data
as cumulative sales to specific customers
...
Auditing round the computer
...
The benefits of this approach are that it
saves time and its justification is that computers are 100% accurate in processing transactions
and therefore material processing errors simply do not occur
...
However, major frauds and error
or system failures should be picked up in the assets and liabilities verification e
...
if processing
of sales is incorrect, verification of debtors can uncover the error
...
This approach is suitable for small businesses but
largely unsuitable for large scale entities
...
Auditing through the computer
...
These
are use of test data and use of computer audit programs which are also called CAATs (computer
assisted audit techniques)
...
What it involves is for the
auditor either using dummy data or live data for processing to manually work out the expected
result using the logic of the program
...
A satisfactory outcome gives the auditor a degree of assurance that if that
program is used continuously throughout the year, then it will perform as required
...
Live data testing has the following disadvantages
i
...
This
can sometimes be resolved by use of dummy branches or separate codes to report the
programs effects on the test data
...
Side effects can occur
...
Client’s files and totals are corrupted although this may be immaterial
...
This can be difficult to organize
...
Difficulties will be encountered in simulating the whole system or part of it
...
A more detailed knowledge of the system is required than with use of live files
...
There is often uncertainty as to whether operational programs are really being used for
the test
...
The time span problem is still difficult but more capable of resolution than live testing
...
They are also used to carry out audit work on the contents of
the files
...
They can be
written by an audit firm or they can be bought from software houses
...
Computerised Information Systems
165
Real time and on-line systems
Traditional batch processing has the advantage that the data can be subjected to checks for
validity, accuracy and completeness before it is processed
...
This has led to the
development of on-line and real time systems and the number is growing particularly in airline
offices, banks and other financial institutions
...
The key features of these systems are that they are based on the use of a remote terminal which
is just a VDU and a keyboard
...
The problem for the auditor arises from the fact that
master files held in the central computer store may be read and updated by the remote terminals
without an adequate audit trail
...
The security
techniques include;
With real systems however, action at the terminal causes an immediate response in the central
processor where the terminal is on-line
...
In view of these control problems, most
real time systems incorporate additional controls over the scrutiny of the master file
...
g
...
•• The allocation of identification numbers to authorized terminal operators
...
•• Using operator characteristics such as voice, fingerprints and hand geometry (finger
length ratios) as a means of identification by the mainframe computer
...
•• In top security systems, the authority to allocate authorities such as determination of
passwords and nominating selected terminals should be restricted to senior personnel
other than intended users
...
This log will be printed out on regular basis or on request by personnel with
appropriate authority
...
This
enables input from the remote terminals to be checked by a special scanning program before
processing commences
...
This is because computerized information systems have unique features compared to manual
systems and require inbuilt adequate controls to ensure that the accounting system can be relied
upon for complete and accurate accounting records
...
Computerized information systems will process
transactions consistently
...
On the other hand, if
there are any programming errors, the transactions will be consistently processed
inaccurately
...
In a computerized information system, few
people are involved in processing of financial information
...
This increases risk of manipulation of operating
programs and data
...
Computerized information systems are designed to limit paperwork
...
Ease of access of data and computer programs
...
Use of programmed controls
...
g
...
Use of programmed controls implies that the auditor must adopt
an audit approach to test effectiveness of those controls
...
Many systems are capable of generating transactions
automatically without manual intervention e
...
calculation of interest from customer’s
accounts may be done and charged to income automatically
...
Data and programs are stored in portable magnetic disks and tapes which are vulnerable
to theft and intentional or accidental alteration
...
These controls are mainly classified
into general controls and application controls
...
General controls
...
g
...
Computerised Information Systems
167
The objective of the general controls is to ensure the proper development and implementation
of applications and the integrity of program files and information
...
Computer operations and other controls
...
System development controls
...
The controls that can be exercised during systems development can
be discussed in the following groupings
...
The organization should set up a steering committee composed of senior management and high
level representatives of system users who should the development and implementation of the
new system
...
T E X T
Controls over program changes
...
Before the new system is commissioned for use, appropriate testing
should be carried out to ensure that both the hardware and the application programs are operating
effectively
...
Program changes refer to modifications made to existing programs
...
g
...
Once changes have been made, appropriate testing should be carried out to ensure that the
modified system is reliable
...
User training should also be carried out as appropriate
...
This involves putting together information that supports and explains computer applications
...
System documentation is important in conducting user training and also enables the management
to effectively review the system by considering whether appropriate controls have been put in
place during system development
...
Before switching to the new system, the whole system should be tested by running it alongside the
old system for a specified period
...
168
A U D I T IN G AN D A S S U RAN C E
b
...
The success of computerized information systems is largely dependent on the accuracy, validity
and credibility of the data processed by the system
...
Access controls provide assurance that only authorized individuals use the system and that the
usage is for authorized purposes only
...
This can be
achieved using both physical and programmed controls
...
g
...
Controls over computers stored in the user department could be improved by making sure
that vital data on programs are not left running when the computer is left unattended
...
Passwords should be changed regularly and access to password data held in a computer
system should be subject to stringent controls
...
In granting user rights within the system, there should be appropriate segregation of
duties to ensure that rights granted are not excessive
...
g
...
When designing the user rights, sensitive data and programs should only be accessible
to few individuals
...
Programs and data that do not need to be online should be stored in secure locations
...
This would record name of user, data accessed or entered, time of log in and mode of
access
...
There should be automatic log off i
...
the disconnection of active data terminal to prevent
viewing of sensitive data on unattended terminals
...
Computer operations and other controls
...
The recovery plan should create back up or duplicate copies of important data files and programs
which should be stored off site
...
Other
issues that should be addressed include:
••
••
Undertaking protection measures against natural disasters such as setting up computer
rooms in areas protected from floods and fitted with smoke or fire detectors
...
Computerised Information Systems
••
169
There should be adequate virus detection
...
- Establishing a formal security policy which requires only clean and certified copies
of software are installed and checking data introduced from external sources for
viruses
...
- Clean back up should be maintained and there should be adequate segregation
of duties such that people with powers and knowledge in making amendments
to the application programs should not have the responsibility for initiation and
processing transactions and even making amendments to existing data
...
Application controls
The objective of application controls which may be manual or programmed is to ensure
completeness and accuracy of accounting records and the validity of transactions processed
...
Most errors in data processed by computerized information systems can be traced to errors
made when the data was being input into the system
...
Completeness of input
...
Accuracy
...
Validity
...
It also ensures credibility and reliability of recorded transactions
...
These controls check that all data fields required to process the transactions have
been filled with correct information
...
Valid character checks
...
E
...
that amounts column is filled with numerical variables
...
S T U D Y
1
...
2
...
3
...
Controls over master files and standby data
However, some of the controls management implement would cut across the four categories
mentioned above
...
g
...
T E X T
Application controls are therefore important in providing assurance that all transaction are
recorded on timely basis and that only valid transactions are captured by the system
...
These verify that data falls within predetermined reasonable
limits
...
g
...
These controls ensure
accuracy and validity of the input data
...
These verify that the codes used in processing transactions match with those
from master files
...
g
...
These controls ensure that data is processed against correct master file
...
This agrees number of input records if what is expected as per batch control
...
Sign checks
...
E
...
a
positive sign for debit entry and a negative sign for credit entry
...
Zero balance checks
...
This control ensures
accuracy of input data
...
Measures to ensure that the reasons behind rejected transactions are investigated and corrective
action taken
...
Processing controls
...
They also seek to ensure that data is not lost, duplicated or altered
during processing and that errors are identified ad corrected
...
In addition to those, processing controls include;
Physical file identification procedures
...
Sequence tests over pre-numbered documents
...
Comparing the contents in files before and after processing a transaction to ensure that the
expected processing results have been achieved
...
An audit trail should be created through use of input and output control logs and maintenance of
transaction listing
...
Computerised Information Systems
171
Output controls
...
•• Results of processing are accurate
...
Controls over output include;
••
••
••
Matching and agreeing output information to the input data e
...
for input data related to
journal processed to create an additional provision for bad and doubtful debts, one may
want to compare or match the balance appearing in the ledger after the transaction is
processed as a way of verifying that output matches the input
...
Error listing or exception reports should be generated on a daily basis and reviewed by
an independent person to ensure that the transactions summarized in these reports are
investigated and where appropriate resubmitted for processing
...
These controls include;
••
Restrictive access to standing data and ensuring that only few individuals have the user
rights within the system to make adjustments to the standing data
...
E
...
before any changes are made on selling prices in the master file,
appropriate authorization should be obtained from the responsible officials
...
•• Where necessary, the organization should print out all the standing data and an
independent check be carried out to verify that this data is accurate and complete
...
Testing the internal controls in a computerized environment
The auditor tests the internal controls when he wishes to place reliance on the controls to
determine whether the accounting records are reliable
...
The manual controls are tested in exactly the same way as in a manual
system
...
But there is no assurance
that the items on the exception reports were the only exceptions or that they actually
met the parameters set by the management
...
Use of CAATs (computer assisted audit techniques)
...
S T U D Y
Standing data refers to the data that is required during processing of the transactions but which
does not vary or change with every transaction
...
g
...
T E X T
Controls over master files and standby data
...
The extent depends on the
degree of reliance the auditor has placed on the internal controls
...
Manual testing techniques
...
The auditor attempts to confirm these with other data
...
g
...
•• Totaling
...
•• Re-performance
...
E
...
for depreciation and interest expense
...
These will include reconciliations for computer listings with creditor’s
statements, bank statements, actual stock and personnel records
...
Computer audit programs sometimes generalized audit software
...
Computer audit programs are computer programs used by the
auditor to;
S T U D Y
T E X T
••
••
••
Read magnetic files and to extract specified information from the files
...
Uses of computer audit programs
...
The scrutiny of files and selection of exceptional items for testing
...
g
...
1000 or all stock items worth more than Shs
...
Comparison of two files and printing out the difference
...
g
...
Preparing exception reports
...
g
...
Stratification of data such as stock items or debtors with a view to examine only the
material items
...
Verifying data such as stock or fixed assets at the interim stage and then comparing
the examined file with the end file so that only changed items need to be examined at
the final audit
...
This is no surprise, of course, since the ultimate constraining
factor in the system is the computers own capability and all users are competitors for its time
...
Computerised Information Systems
173
The following should be included in the control file;
••
••
••
••
••
••
••
Chapter Summary
••
••
••
••
••
Internal controls over computer processing include both manual procedures and
procedures built into the computer programs
...
The objectives of application controls which may be manual or programmed are to
ensure the completeness and accuracy of the accounting records and the validity of the
entries made therein resulting from both manual and programmed processing
...
These are a use of test data and the use of computer audit programs
...
The extent depends
on the degree of reliance the auditor has placed on the internal controls
Quiz
1
...
2
...
Details of physical controls over source documents as well as of the nature of any
control totals of numbers, quantities or values including the names of persons keeping
these controls
...
A detailed account of the clerical, procedural and systems development controls
contained in the system
...
g
...
The arrangements for retaining source documents and input media for suitable periods
...
A detailed flow diagram of what takes place during each routine processing run
...
Copies of all the forms which output documents might take and details of their sorting
and checking
...
S T U D Y
••
174
A U D I T IN G AN D A S S U RAN C E
Answers to the Quiz
1
...
••
••
••
Output controls
Input controls
Controls over master files and standing data
...
These consist of computer programs used by an auditor to read magnetic files and to extract
specified information from the files
...
State and explain the factors which you will take into
account when planning the first audit under the new system
...
Security is the means by which losses are controlled and
therefore involves the identification of risks and the institution of measures to either prevent such
risks entirely or to reduce their impact
...
State four areas of risk which may arise in relation to a computer system and in each
case explain one factor which could lead to the system being exposed to such risk
...
Describe the different forms of control which should be instituted to safeguard against
computer security risks
...
Required:
List and briefly explain four advantages of CAATs
...
The company purchases equipment from a
variety of different suppliers and then resells this using the Internet as the only selling media
...
Customers place their orders directly on the Internet site
...
The ordering/sales software automatically verifies the order details, customer
address and credit card information prior to orders being verified and goods being dispatched
...
You are the audit manager working for the external auditors of Nagaya, and you have just
started planning the audit of the sales system of the company
...
This will involve entering dummy
orders into the Nagaya’s system from an online terminal
...
The company
owns 25 shops
...
Employees work a standard eight hour day
...
When the employee leaves work at the end of the day the process is reversed showing that the
employee has left work
...
Overtime is calculated as any excess over the standard hours worked
...
If necessary, the accountant overrides overtime payments if the hours worked are
incorrect
...
The only other manual check is the financial accountant
authorizing the net pay from Walsh’s bank account, having reviewed the list of wages to be
paid
...
Using examples from Walsh Co, explain the benefits of using Computer-Assisted Audit
Techniques to help the auditor to obtain sufficient appropriate audit evidence to be able
to draw reasonable conclusions on which to base the audit opinion
...
List SIX examples of audit tests on Walsh Co’s wages system using audit software
...
Explain how using test data should help in the audit of Walsh Co’s wages system,
noting any problems with this audit technique
...
List and briefly explain some of the difficulties of using audit software
...
S T U D Y
T E X T
176
A U D I T IN G AN D A S S U RAN C E
Auditors’ Report (ISA 700)
177
S
S TT SU
U TD
DUY
YD TY
TE
E TX
X ETT X T
CHAPTER TEN
ONE
AUDITORS’REPORT (ISA 700)
S T U D Y
T E X T
178
A U D I T IN G AN D A S S U RAN C E
Auditors’ Report (ISA 700)
179
CHAPTER 10
AUDITORS’ REPORT (ISA 700)
Chapter Objectives
By the end of this the reader should have covered
...
Auditors report to shareholders
...
Audit opinions
...
Going Concern- this concept states that the transactions and the financial statements have
to be recognized and prepared in such a way that the entity shall continue with operations for
the foreseeable future period and shall not cease to be in existence, stop or curtail is present
production either currently or in the near future
...
Students are expected to be aware of the contents of
the audit report as they may be required to state the contents or write an audit report in the exam
...
Industry context
The main purpose of any audit is to form an opinion on the financial statements, this opinion is
expressed in a report
...
S T U D Y
The Companies Act cap 486 requires that the auditor of a limited liability company to report to
the members whether the financial statements laid before the AGM show true and fair view of
the state of affairs of the company and comply with the requirements of the companies act
...
The report is addressed to
shareholders
...
This report is referred to as the auditors report
...
The
wording and the format of the report is guided by law
...
These are;
••
••
••
••
••
••
S T U D Y
T E X T
••
Whether the auditor has obtained all the information and explanation which to the best
of his knowledge and belief were necessary for audit proposes
...
Whether the company’s balanced sheet and profit and loss accounts dealt by the report
are in agreement with the books of the accounts and returns
...
In the case of the balance sheet, of the state of affairs of the company as at the end of
the accounting period
...
In the case of a holding company submitting group financial statements whether in his
opinion, the group financial statements have been prepared in accordance with the
provisions of the Companies Act so as to give a true and fair view of the state of affairs
and profit or loss of the company
...
The auditing
standards seek to ensure that the auditor’s report is clear and unambiguous
...
It does this by giving the basic elements of the
auditor’s report
...
Appropriate report title
Auditing standards require that the report be titled and that the title includes the word ‘independent’
e
...
independent auditors report’
...
ii
...
For
practical reasons, it limits the users of auditor’s report
...
Introductory paragraph
The first paragraph has three purposes, fist, it makes a statement that the practice did an audit
...
The wording
of the financial statements in the report should be identical to those used by management on
the financial statements
...
Auditors’ Report (ISA 700)
181
iv
...
This paragraph
states how the audit was planned and performed in accordance with ISAs and states that the
audit is designed to obtain reasonable assurance whether the financial statements are free of
material misstatements
...
Opinion paragraph
This final paragraph states the auditors conclusions based on the results of the audit
...
The opinion paragraph is stated as an opinion rather than a statement of absolute fact or a
guarantee
...
Audit report date
The appropriate date for the report is the one on which the auditor has completed the most
important audit procedures in the field
...
Types of audit opinions
a
...
b
...
Qualified opinion
d
...
This is issued when the auditor is satisfied in all material aspects that enable him express the
required opinion on financial statements without any reservation
...
It is expressed when the auditor concludes that the financial statements give a true
and fair view in accordance with the relevant financial reporting standards
...
In such
circumstances, the auditor should express an unqualified opinion including an extra paragraph
called ‘emphasis of the matter paragraph’ to draw attention of the reader to the unusual matter
...
T E X T
vii
...
To avoid this being
understood as a qualification, the emphasis of the matter paragraph should contain the phrase
‘without qualifying our opinion’
...
ii
...
Unusual events could also
include changes in the legislation that could have a material impact on the entity’s
business operations subsequent to the balance sheet date
...
ii
...
iv
...
S T U D Y
T E X T
i
...
These
financial statements are the responsibility of the Company’s management
...
AUDITOR
Date
Address’
Footnotes:
1
...
Indicate IASs or relevant national standards
3
...
)
T E X T
We conducted our audit in accordance with International Standards on Auditing (or refer to
relevant national standards or practices)
...
An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements
...
We believe that our audit provides a
reasonable basis for our opinion
...
The auditor’s reservation
could arise out of the following;
••
••
••
Limitation on the scope of his work
...
Significant uncertainty affecting financial statements, the resolution of which is dependent
upon future events
...
This is expressed when auditor concludes that unqualified opinion cannot be expressed but that
the effect of any disagreement with management or limitation in scope is not so material and
pervasive as to require an adverse opinion or disclaimed opinion
...
S T U D Y
T E X T
c) Disclaimer of opinion
...
A disclaimer of opinion
implies that the auditor is unable to form an opinion because sufficient audit evidence could not
be obtained
...
This is expressed when the effects of a disagreement is so material and pervasive to the financial
statements that the auditor concludes that a qualification of the report is not adequate to disclose
the misleading and incomplete nature of the financial statements
...
Limitation of scope
If for any reason the auditor is unable to receive all the information and explanations he deems
necessary for the purposes of his audit, then there is a limitation in scope of his work
...
This could arise due to the following reasons;
••
••
••
••
Refusals by management to allow the auditor examine certain documents or records
...
Destruction of accounting records or documents through fire of other disaster meaning
that such documents or records are not available for examination by the auditor
...
Auditors’ Report (ISA 700)
185
Effects of limitation in scope on the auditor’s opinion
If the possible effect of limitation in scope of an audit is material but not fundamental to the
financial statements, the auditor issues a qualified opinion
...
)
If the possible effect of limitation in scope of an audit is of fundamental importance that the auditor
is unable to express an opinion on the financial statements, the auditor issues a disclaimer of
opinion as mentioned above
...
Examples of modified reports
(a) Limitation on scope
(i) Limitation on scope – qualified person
We did not observe the counting of the physical inventories as of December 31, 20x1, since
that date was prior to the time we were initially engaged as auditors fir the company
...
In our opinion, except for the effects of such adjustments, if any, as might have been determined
to be necessary had we been able to satisfy ourselves as to physical inventory quantities, the
financial statements give a true and (remaining words are the same as illustrated in the opinion
paragraph of the unqualified report above)
...
These financial statements are the responsibility of the Company’s management
...
(The paragraph discussing the scope of the audit would either be omitted or amended according
to the circumstances
...
Because of the significance of the matters discussed in the preceding paragraph we do not
express an opinion on the financial statements
...
(remaining words are the same as illustrated in the scope paragraph of the unqualified
report above)
...
186
A U D I T IN G AN D A S S U RAN C E
Inherent uncertainties
Inherent uncertainties result from circumstances in which it is impossible for the auditor to reach
any objective conclusion as to the outcome of a situation due to the circumstances themselves
rather than a limitation of scope of the audit
...
g
...
However, time is a great constraint
and financial statements must be prepared within the required time
...
This will involve
consideration of:
The appropriateness of any accounting policies adopted by the management in treating
the effect of such uncertainties
...
•• The adequacy of disclosure of the uncertainties
...
These are uncertainties where the degree of
uncertainty and its potential impact on the view given by the financial statements may very great
...
•• The range of possible outcomes
...
Inherent uncertainties are considered fundamental when they involve a significant level of concern
about the validity of the going concern assumption or other matters whose potential effect on the
financial statements is usually great
...
But his
conclusion is at variance with the position adopted by the management or the view given by the
financial statements
...
Some facts or amounts included in the financial statements e
...
the auditor may feel
that the amount provided for as a contingent loss arising from a lawsuit against the
company is too low
...
•• Manner, mode or extent of disclosure of facts or amounts in the financial statements
...
The implications of such factors on the financial statements
...
Auditors’ Report (ISA 700)
187
Examples
(i) Disagreement on Accounting Policies- Inappropriate Accounting method – Qualified
Opinion
‘We have audited …
...
)
We conducted our audit in accordance with … (remaining words are the same as illustrated in
the scope paragraph of the unqualified report above)
...
The provision for the year ended December 31, 20x1 should be based
on the straight line method of depreciation using annual rates of 5% for the building and 20%
for the equipment
...
‘We have audited … (remaining words are the same as illustrated in the introductory paragraph
of the unqualified report above)
...
(remaining words are the same as illustrated in
the scope paragraph of the unqualified report above
...
The debenture agreement restricts the payment of future cash
dividends to earnings after December 31, 20x1
...
(Insert reference to statutory or regulatory requirement)
...
(iii) Disagreement on Accounting Policies – inadequate disclosure – adverse opinion
We have audited … (remaining words are the same as illustrated in the introductory paragraph
of the unqualified report above)
...
(Remaining words are the same as illustrated in
the scope paragraph of the unqualified report above
...
And do not comply with …… (Insert relevant statutes or law)
...
(remaining words are the
same as illustrated in the opinion paragraph of the unqualified report above)
...
If the nature of the disagreement is material but not fundamental, the auditor should issue a
qualified opinion indicating that all other aspects of the financial statements are okay except for
the matter giving rise to the disagreement
...
Material but not pervasive means that the reservation the auditor has is material in the context of
a segment of the financial statements but not to the financial statements taken as a whole
...
A limitation of scope becomes pervasive when it makes the
financial statements misleading for decision making purposes or of little value for decision making
purposes
...
Qualification matrix
Nature of circumstance
Material but not significant
Fundamental
Limitation of scope or
uncertainty
Qualified opinion (except for opinion)
Disclaimer of
opinion
Disagreement
Qualified opinion (except for opinion)
Adverse opinion
Going Concern (ISA 570)
The going concern concept is a fundamental concept of IAS 1 (disclosure of accounting policies)
which governs the preparation and presentation of financial statements
...
The auditor when reporting on the financial statements is categorically concerned of the going
concern concept because;
••
••
••
It affects true and fair view of the financial statements
It facilitates qualification of audit reports
...
•• The auditor’s main interest will be that all material matters affecting the financial
statements have been disclosed
...
Auditors’ Report (ISA 700)
189
Appropriateness of going concern assumption
The auditor should consider the risk that the going concern assumption may no longer be
appropriate
...
Examples of such indications
are as follows:
a
...
••
Changes of the financial position of the company drastically within a short period of time
especially from bad to worse
...
•• Changes of credit policies especially from credit to cash on delivery
...
•• Increased financial borrowing
...
Non financial indicators
...
This is sometimes called a clean
opinion
...
b) Qualified audit opinion (except for opinion)
This is expressed when the auditor concludes that an unqualified opinion cannot be expressed
but that the effect of any disagreement with management or limitation on scope is not so material
and pervasive as to require an adverse opinion or disclaimer of opinion
...
S T U D Y
High staff turnover in key accounting and managerial officials and finance personnel
especially without replacement
...
•• Circumstances of labour disputes e
...
strikes by employees leading to demonstrations
ad protests
...
•• Pending legal proceedings against the entity that may, if successful, result in judgements
that could not be met
...
The significance of such indications can often be mitigated by other factors
...
Similarly, the loss of a
principal supplier may be mitigated by the availability of a suitable alternative source of supply
...
A disclaimer of opinion
implies that the auditor is unable to form an opinion because sufficient audit evidence could not
be obtained
...
The auditor states that due to
the nature of the disagreement in his opinion the financial statements do not show a true and fair
view
...
It means that the auditor is unable to conclude objectively
...
List the different types of Audit opinions
...
List the basic elements of the audit report
...
List the factors that lead to the qualification of an audit Report
...
a) Unqualified opinion
b) Qualified opinion
c) Disclaimer of opinion
d) Adverse opinion
2
...
An Appropriate title
Exam questions
QUESTION ONE
Going concern concept is a fundamental assumption underlying the preparation of the financial
statements
...
QUESTION TWO
a) In respect of the going concern concept:
i
...
ii
...
b) List the audit procedures that should be carried out to determine whether or not the going
concern basis is appropriate for Green Co
...
T E X T
b
...
The Introductory paragraph
d
...
An Opinion Paragraph
f
...
A Signature in the name of the audit firm and location of the auditor i
...
This occurs when;
192
A U D I T IN G AN D A S S U RAN C E
QUESTION THREE
The Companies Act (Cap
...
Required:
a
...
b
...
c
...
An audit includes examination,
on a test basis, of evidence relevant to the amounts and disclosures in the financial statements
...
‘We planned and performed our audit so as to obtain as much information and explanation as
possible given the time available for the audit
...
The directors
however are wholly responsible for the accuracy of the financial statements and no liability for
errors can be accepted by the auditor
...
’
Required:
Identify and explain the errors in the above extract
...
The need for an audit
...
•• To prove the true and fair view of the companies state of affairs as at a given date
...
•• To write a report to be used by stakeholders
...
•• Detection of errors and frauds
...
Procedures for the appointment of an auditor
•• Upon registration of a company (30 days after) the Board of Directors or the Registrar
of Companies appoints an auditor
...
If this approach is used the outgoing auditor
must be given a 28 days notice
...
This occurs if there is no resolution to remove the existing
auditor, if the existing auditor has not given in writing a notice to resign and if he has not
committed an act to disqualify automatic re-appointment
...
c
...
•• Delivering to the government agency, court or stock exchange a copy of the company’s
auditor financial statements within the specified period after year-end
...
•• Prepare the financial statements on a going concern basis unless it is appropriate to
presume that the company will continue operations
...
d
...
It must contain statements as to matters mentioned in the 7th
schedule
...
•• Whether in their opinion proper books of account have been kept and proper returns
adequate for the purpose of the audit have been received from branches not visited
...
T E X T
QUESTION ONE
198
A U D I T IN G AN D A S S U RAN C E
••
••
Whether in their opinion and to the best of their knowledge and according to explanations
given to them financial statements give information required by companies act in the
manner so required and give the true and fair view
...
In the profit and
loss account, the profit or loss for the year
...
This might cover planning, risk assessment, tests of controls and
substantive testing
...
In relation to the cyclical audit of internal controls, it may be possible to rely on the work of
internal audit in relation to all of the areas noted, but only if the internal controls audited affect
the financial statements
...
In relation to the four-year review of internal controls – the extent of reliance will depend
on how long ago the last review was conducted
...
In relation to risk management – the relevance of internal audit work depends on the extent
to which risks in relation to reporting in general and the financial statements in particular,
have been addressed separately by management
...
(b) Information required
(i) The information required to determine the extent of external audit reliance on internal
audit’s cyclical audit will be:
Internal audit’s systems documentation (the work on information systems and
finance may include documentation of the company’s accounting and internal control
systems);
Internal audit’s planning documentation which may cover a risk analysis, tests of controls
and substantive procedures;
The results of tests of control and substantive procedures;
Documentation on the four-year review of internal controls, particularly in relation to the
finance and information services functions
...
(iii) Other documentation requested will include internal audit’s operating procedures
manuals and documentation relating to the recruitment, training and development of
internal audit staff, and management responses to internal audit recommendations
...
(c) Circumstances in which it would not be possible to rely on the work of internal audit
(i) It may not be possible to rely on the work of internal auditors if they:
• Are not competent (this relates to experience as well as qualifications)
...
(ii) It will also not be possible to rely on internal audit if internal audit is insufficiently
independent within the organization, i
...
where internal auditors have insufficient
operational freedom, where they are reporting to those who control the functions that
they work on, or where they are reporting on their own work
...
For immaterial areas in which
internal audit work can be shown by testing and review to be adequate, it may be possible
to rely on the work of internal audit without performing any other work
...
Leases may be complex and the auditors will wish to ensure that
accounting policies are appropriate and that they have been properly applied
...
This is an area that is easy
to manipulate and external auditors will wish to ensure that this has not happened
...
(a) Six financial statement assertions
i
...
Cut off: transactions and events have been recorded in the correct accounting period;
iii
...
Accuracy and valuation: financial and other information is disclosed fairly and at
appropriate amounts;
v
...
Classification: transactions and events have been recorded in the proper accounts
...
Those who own assets wish to ensure that
those to whom they have entrusted control are using those assets wisely
...
The requirement for an independent audit helps to ensure that financial statements are
free of bias and manipulation for the benefit of users of financial information
...
S T U D Y
QUESTION THREE
T E X T
•
•
200
A U D I T IN G AN D A S S U RAN C E
••
••
S T U D Y
T E X T
••
The requirement for a statutory audit is a public interest issue: the public is invited to
invest in enterprises, it is in the interests of the capital markets (and society as a whole)
that those investing do so in the knowledge that they will be provided with ‘true and fair’
information about the enterprise
...
The requirement for an audit can help prevent investors from being defrauded, although
there is no guarantee of this because the external audit has inherent limitations
...
The purpose of the external audit under International Standards on Auditing is for the
auditor to obtain sufficient appropriate audit evidence on which to base the audit opinion
...
This opinion is prepared for the benefit of shareholders
...
Why the letter of engagement is sent before any new audit appointment is accepted
...
It provides a written confirmation of the auditor’s acceptance-of the appointment, the scope
of the audit, form of his report and scope of non audit services
...
b
...
Definition and scope of audit: it should be made dear that an audit involves the examination
of and expression of opinion on the financial statements of an enterprise by an appointed
auditor in pursuance of that appointment and in the case of a statutory audit, that the matters
to be reported upon are laid down in Companies Act 1962 or any relevant legislation
...
Accounting, Taxation and other services:-the letter should delineate clearly the accountant’s
and the client a responsibilities in relation to these services and the day to day book-keeping,
the maintenance of all accounting records and the preparation of financial statements
...
c
...
The accounts kept are in agreement with the accounting records and returns
...
d
...
Where there is a change in circumstances which will lead to change in duties of the auditor
e
...
an extra assignment
...
This typically happens when the firm is small, but the client is large
...
This applies regardless of whether
the fee income is audit fee income or income for other work
...
Where a large client is involved, the firm’s professional indemnity insurance
may not cover the claim
...
If the client performs well, the value of the
shares may rise
...
This is important for
the reasons noted above
...
There is also a financial interest where partners, staff or the firm make loans to, or guarantee
the borrowings of the client or vice versa
...
Family or other close personal or business relationships
Where there is family or other close personal or business relationships between client and
audit firm, the individuals concerned may try to influence the firm in its dealings with the
client in order to protect the family or personal relationship, or the mutual business interest
...
This is important in any case but more so where the effect of a qualified (or modified) audit
report is likely to result in, say, withdrawal or non-renewal of banking facilities which might
result in the business ceasing to be a going concern
...
If there are close business relationships between client and auditor, both parties have an
interest in each other’s performance and there is therefore a double pressure to present the
results in the best possible light and not to issue a qualified audit report
...
It is very
common for auditors to provide their very small audit clients with accountancy services, for
example
...
Some firms not only provide consulting advice, but also perform IT and
other functions for some of their clients
...
Firstly, the firm may
find that it is reporting on a system that the firm itself has set up or advised on, or reporting
on information that the firm itself has prepared
...
Secondly, the fee income
from other services may well exceed the fee income from the audit and the client may
pressure the firm to give an unqualified audit report by threatening to take the other services
to another firm if a qualified report is given
...
(i) Undue dependence
A firm should put in place additional safeguards where the recurring fee income from
one client or group exceeds 15% of the gross practice income (10% for clients listed
on a stock exchange or where the public interest is involved)
...
There are exceptions where a practice is being set up or run down
...
A review mechanism should be triggered within the firm where the gross fee income
exceeds 10% (5%) of gross practice income
...
Firms are also required to keep up with changes in independence requirements as a
condition of being permitted to practice
...
There are exceptions where collective investments are held by third parties, where the
individual concerned has no control over the composition of investments
...
Where shares are held by the auditor
because the company’s constitution requires it, the minimum level should be held and
the votes attaching to the shares should not be exercised
...
Firms, their partners and staff should not make loans to, or guarantee the borrowings
of, any audit client, or vice versa
...
Problems can also arise if an officer or senior employee of an audit client is closely
connected with a partner or senior staff member responsible for the conduct of the audit
(or anyone closely connected with them)
...
In this case,
adult children and their spouses, siblings, and any other relative to whom regular
financial assistance is given (or who is otherwise indebted to the partner or employee)
are also included
...
(iv) Other services
A firm should not participate in the preparation of the accounting records of a company listed
on a stock exchange or a public interest company except in relation to the finalization of the
statutory accounts (assistance of a mechanical nature) or in an emergency situation
...
A firm may advertise for and interview prospective staff for a client and produce a short list
and recommendations, but the client must make the final decision
...
Where a firm provides other services to audit clients, it is important that the audit team should
be entirely independent of the team providing the other service
...
QUESTION THREE
(a) Internal matters and other procedures before appointment
Before accepting appointment the firm should ensure that:
••
••
••
••
It has the necessary staff with appropriate competencies to complete the audit (this
seems likely given that the firm has other clients in this sector)
The staff are available at what is a busy time of year for the firm (it may be possible that
all of the staff with the necessary competencies are otherwise occupied)
The firm is independent of client
...
There are no conflicts of interest that cannot be properly managed
...
Other procedures
The firm should:
••
••
••
Seek the directors’ permission to communicate with the company accountant about the
nature of the ‘disagreement’ and the directors should authorize the accountant to cooperate with the firm
...
If permission
is refused, the appointment should not be accepted
...
•• Indicate a likely fee (or the basis on which fees are calculated) to client, ensure that this
is acceptable and that the client is able to pay
...
(b) Starting the audit
It is inappropriate to start the audit before the procedures referred to above have been
completed because:
Without the staff with appropriate competencies, the firm will be in breach of the rules (and
may be found negligent if things were to go wrong)
...
Without performing appropriate procedures the firm will be unable to form an opinion on the
integrity of the client
...
Without agreeing a fee it is almost inevitable that misunderstandings or disagreements will
arise
...
(c) Engagement letter
The engagement letter is of benefit to both the client and auditor and helps prevent
misunderstandings
...
(ii) Summarizes the respective responsibilities of directors and auditors
...
• The responsibilities of auditors and the scope of the audit (their duty to conduct
an audit in accordance with auditing standards, to review accounting policies and
disclosures, to perform tests and to form an opinion on the financial statements)
...
• Other services to be provided
...
• Applicable legislation
...
The
internal audit department will have good knowledge of the operations of the company as well as
access to accounting information
...
T E X T
The board needs to maintain a sound system of internal control
...
S T U D Y
Internal controls
Application of ISAs and IASs
...
Internal audit will
certainly be aware of new auditing standards and will have the technical expertise (especially
where internal auditors are professionally qualified) to identify changes required by accounting
standards
...
Communication with external auditors
Under corporate governance regulations, communications with external auditors will normally be
via the audit committee, although the board must maintain an appropriate relationship with the
external auditors
...
The board will therefore receive reports
from both sets of auditors which will be accurate because they have been properly checked
...
ISA 260 provides a list of matters which should be communicated to the
board and the internal auditor can work with the external auditor to ensure that this information
is provided
...
This will be particularly important for ZX if listing arrangements go ahead
...
Financial reporting
It supports the directors in fulfilling their financial reporting obligations
...
The committee can assist by checking the
financial statements to ensure that they comply with appropriate reporting requirements
...
Communication
It enhances the role of ZX’s external auditors by providing an appropriate channel of
communication
...
‘Friend’ of the Board
The audit committee may also act as a ‘critical friend’ to the board by monitoring the work of
the board and providing helpful guidance, where corporate governance requirements do not
appear to be being met
...
c) The disadvantages of an audit committee include:
Lack of understanding of function
As the directors in ZX do not have much knowledge of corporate governance, they may see
the additional involvement of the audit committee as a threat to their authority or taking away
some of their responsibilities
...
Role of non-executive directors
As the audit committee will be made up mainly from non-executive directors, the board
may see this as a means of decreasing their power and possibly letting other people run
the company
...
It will utilize the special knowledge of account production and internal controls
from the external auditor and business non-executives to provide appropriate review of
information being given to the board
...
While this
cannot be avoided, the benefits of the committee in terms of providing assistance to the
board and raising the profile of ZX ready for possible listing must not be forgotten
...
However, client information may be disclosed where:
– Consent has been obtained from the client
– There is a public duty to disclose or
– There is a legal or professional right or duty to disclose
...
Grace has been the audit partner of Ancients for eight years
...
In other words, he may
be too friendly with the directors of Ancients
...
Rotating the audit partner would remove this threat
...
The
non-payment of fees can be a threat to objectivity similar to that of an unpaid loan
...
The audit partner in McKay may not
wish to issue a modified report for fear that the client leaves and the ‘loan’ is not repaid
...
McKay may wish to delay starting the audit work for this year until the fee is paid
to remove the potential independence problem
...
Fee income
No details are provided regarding fee income obtained from Ancients
...
As a limited liability
company, McKay should ensure that no more than 10% of its recurring practice income
(including auditing, accountancy and other work combined) is derived from this client
...
If the 10% limit is close, McKay may have to limit other
services provided so that independence is not impaired
...
Allyson Grace
Allyson Grace is not deemed to be connected to Mr
...
If she was still a minor, then there would be a connection and it would be
inappropriate for Mr
...
However, there may still appear to be an independence problem as Mr
...
He may not wish to annoy his daughter by
having to qualify the financial statements
...
Meal
The offer of a meal by Allyson may appear to be a threat to independence; having received
an expensive meal, the audit staff may be favorably disposed towards Ancients and be less
inclined to investigate potential errors
...
To
ensure no independence issues it would appear that the invitation should be declined
...
Grace and Allyson to pay personally as a purely social event
even though this may be unlikely
...
T E X T
209
S T U D Y
SUGGESTED SOLUTIONS TO EXAM QUESTIONS
210
A U D I T IN G AN D A S S U RAN C E
CHAPTER 3: IT PLANNING, CONTROL &
RECORDING (ISA 300)
QUESTION ONE
a) Planning for an audit of a new client
In planning the audit of a new client the auditor should carry out the following procedures:
S T U D Y
T E X T
••
Carry out a preliminary review of the client
...
•• Hold discussion with management to obtain an understanding of the management
structure and a general feel of the current trading circumstances of the client and any
factors that affect the client accounting and internal control system
...
This would include any issues that arose from
the previous audits that could have a continuing effect on the audit of this client
...
This will assist in determining whether the auditor could rely on
the internal control system
...
•• The audit senior should check the nature and timing of reports and other communications
with the client so that the audit plan accommodates such timings e
...
he should consider
the dates of the animal general meeting, stock taking, dates when management reports
are available
...
•• Prepare an audit planning memorandum that summarizes the scope of the work under
the engagement and the strategy to be followed to meet the client’s needs
...
The plan lays
out the strategy to be followed to ensure that the audit objectives as set out in the letter
of engagement arc met
...
A good plan assists in the proper
utilization of assistants and in the coordination of work done by other auditors and
specialists
...
The planning
process identifies potential problematic areas
...
g
...
•• It helps to ensure that audit work is completed especially through more efficient use of
time and proper allocation of work to audit staff
...
SUGGESTED SOLUTIONS TO EXAM QUESTIONS
QUESTION TWO
(a) Information and procedures: understanding the entity and its environment and risk
assessment for Rock
(i) Understanding the entity and risk assessment is likely to involve a review of prior year
risk assessments as a starting point and the identification of changes during the year
from the information gathered that may alter that assessment
...
Members of the engagements team should
discuss the susceptibility of the financial statements to material misstatements
...
This may involve:
A review of prior year working papers noting any particular issues that arose warranting
attention in the current year
...
T E X T
••
S T U D Y
The audit plan takes into consideration times when information needed for audit purposes
is available and when the client is not very busy
...
c
...
Direction and supervision
Direction involves giving audit assistants to whom work is delegated appropriate instructions/
directions
...
This also involves informing them of matters such as the
nature of the entity’s business and possible accounting and auditing problems that may affect
the nature, liming and extent of audit procedures to be performed
...
Establish whether assistants understand audit instructions
...
To identify and address any significant accounting and auditing questions raised during the
audit
...
ii
...
This involves a review of audit work performed by each staff member by a person of equal
or higher competence to consider whether
The audit work has been performed in accordance with the audit program
...
All significant audit matters have been resolved or reflected in audit conclusions
...
The conclusions expressed are consistent with the results of the work performed and support
the audit opinion
...
Quality controls
Quality controls refer to the various policies and procedures put in place by the auditor to ensure
that all audits conducted by the firm meet the quality standards set by the accounting profession
and firm’s own quality standards
...
A review of any third party information on the client such as press reports
...
A review of any changes in stock exchange requirements
...
(iv) Auditors should obtain an understanding of the control environment, the entity’s process
for identifying and dealing with business risk, information systems, control activities and
monitoring of controls
...
(vi) Analytical procedures are often used to highlight areas warranting particular audit
attention
...
(vii) Risk assessment will facilitate the determination of materiality and tolerable error
(calculations are normally based on sales, profit and assets) that will be used in
determining the sample sizes and in the evaluation of errors
...
Audit planning documentation should include the risk assessment which should be cross
referenced to the audit program, and the audit program should be cross referenced to
the audit working papers and vice versa
...
Each section of the audit file should have a lead schedule which should be cross
referenced back to the relevant working papers
...
The financial statements should be cross referenced to the trial balance
...
Schedules of review points should all be ‘cleared’ to show that all outstanding matters
have been dealt with
...
Specifically, planning is required for the following reasons:
•• To develop a general strategy and detailed approach for the specific nature, timing
and extent of the audit work
...
•• So that attention is devoted to the important areas of the audit
...
S T U D Y
(a) The purposes of audit working papers include:
•• To assist with the planning and performance of the audit
...
(b) The audit working paper does not meet the standards normally expected in a working paper
because:
•• The page reference is unclear making it very difficult to either file the working paper in
the audit file or locate the working paper should there be queries on it
...
The working paper
could easily be filed in the wrong year’s audit file
...
This means it is
unclear who to address queries to regarding the preparation or contents of the working
paper
...
However, given that the reviewer did not
query the lack of preparer’s signature or other omissions noted below, the effectiveness
of the review must be put in question
...
•• The test objective is also stated as an audit assertion
...
•• It is not clear how the number for testing was determined
...
•• Stating that details of testing can be found on another working paper is insufficient –
time will be wasted finding the working paper, if it has, in fact, been included in the audit
working paper file
...
The preparer appears to have used personal
judgment which is not appropriate as the opinion should be based on the facts available,
not speculation
...
Five errors were found therefore it is likely that there are some systems weaknesses
...
To provide a document as a reference for an initial discussion of the approach to the
audit with the company’s audit committee
...
g
...
To act as a basis for the production of the audit program
...
e
...
A responsible official should be charged with the duty of overseeing purchase of raw
materials in the company and should report to the managing director or other appropriate
senior level of management
...
When the re-order level is reached a purchase requisition should be
raised and must be authorized by the factory managers
...
Upon receipt of the purchase requisition, it should be checked to confirm that the
transaction is authorized
...
Upon delivery an official from stores department must inspect the goods for quality and
quantity
...
g
...
The goods received note and the suppliers invoice should be taken to the accounts
department where an independent person should post the entries to the purchases
ledger
...
S T U D Y
••
T E X T
Internal control procedures for purchasing system
216
A U D I T IN G AN D A S S U RAN C E
QUESTION TWO
Report to audit committee
Inventory control and Sales System
Seed division
12 June 2007
The internal audit of the inventory and sales system identified the following weaknesses:
Weakness
Potential
weakness
Recording of orders
...
The computer systems should
be amended so that order
details are transferred directly
between the two systems
...
Packing lists can be lost
resulting either in goods
not being dispatched to the
customer or the customer’s
credit card not being
charged
...
At end of each
day, gaps in the sequence of
packing lists are investigated
...
Given
that customers are unlikely
to return seeds, Rhapsody
will automatically incur bad
debts
...
Entire
orders
may
be
overlooked
and
consequently sales and
profit understated
...
S T U D Y
T E X T
Orders placed on the internet
site are transferred manually to
the inventory and sales system
...
E
...
order quantities
may be incorrect or the wrong
product code recorded
...
Each order/packing list is given
a random alphabetical code
...
Obtaining payment
The customer’s credit card is
charged after dispatch of goods
to the customer, meaning that
goods are already sent to the
customer before payment is
authorized
...
The computer system correctly
ensures that order details are
available for all charges to
customer credit cards
...
effect
of
Recommendation
SUGGESTED SOLUTIONS TO EXAM QUESTIONS
217
Summary
We look forward to arranging a meeting to discuss these weaknesses with you in more detail
...
The audit committee will assist the internal auditor by ensuring that recommendations in
internal audit reports are actioned
...
The committee helps the directors fulfill any obligations under corporate governance to
implement and maintain an appropriate system of internal control within Rhapsody
...
Strengthens the independence of Rhapsody’s external auditor by providing a clear reporting
structure and separate appointment mechanism from the board of Rhapsody
...
•• Safeguard assets – this would include the physical safeguarding of cash and safeguarding
money held in bank accounts by means of other controls
...
•• Achieve accuracy and completeness of the accounting records and timely preparation
of reliable financial information; this would include making correct payments and
deductions from the payroll, correct payments for tax and social insurance, and making
payments for work performed only (not to dummy employees, for example), in order
that quarterly or half-yearly accounts can be prepared (possibly), but in any case in
order that annual accounts can be prepared within the time limits for small companies
...
The existence of organizational controls such as review of the payroll by an independent
person such as the managing director, and the rotation of payroll duties amongst staff
responsible for processing it – this helps achieve all of the objectives set out above
...
T E X T
QUESTION THREE
218
A U D I T IN G AN D A S S U RAN C E
Internal control procedures include:
••
Limiting direct physical access to the cash, such as the use of a security firm to deliver
cash, locking doors to areas where cash is held, keeping cash in a fire-proof safe and
the protection of the computer by password controls – this will help safeguard assets
and ensure the completeness and accuracy of the records and financial statements
...
•• Approval and control of documents, such as the authorization of the payroll itself, and
authorization for the bank to make transfers and to deliver cash
...
Objectives
Existence: of assets and liabilities
such as cash on hand and in the bank,
and of the liability to pay staff and the
associated tax and social insurance
liabilities
...
Completeness: there are no unrecorded
assets or liabilities such as those noted
under ‘existence’ above or undisclosed
items such as payroll liabilities
...
Performing cash counts, with reconciliations to the records
and observing cash payments to staff, ensuring that
appropriate signatures are obtained and that unclaimed
cash is immediately re-banked
...
Performing starters and leavers tests to ensure that staff
are not paid before they join the company or after they
leave
...
Manually checking the accuracy of payroll calculations
to ensure that correct payments and deductions are
being made in accordance with approved pay rates and
approved deduction rates
...
Measurement: transactions such as As fro completeness, above, and checking to ensure that
payroll payments are recorded at the the payroll has been properly authorized and reviewed
...
Checking entries relating to hours or time worked in the
payroll to source documentation
...
have been met
...
SUGGESTED SOLUTIONS TO EXAM QUESTIONS
219
S T U D Y
(a) Risks and implications for audit risk
Inherent and control risks
Charities can be viewed as inherently risky because they are often managed by nonprofessionals and are susceptible to fraud, although many charities and the volunteers that
run them are people of the highest integrity who take a great deal of care over their work
...
Charities are also at risk of being in violation of their constitutions which is important where
funds are raised from public or private donors who may well object strongly if funds are not
applied in the manner expected
...
Again, the auditors will assess the level of risk
...
Most small charities have a high level of control risk because formal internal controls
are expensive and are not often in place
...
Charities rely on the trustworthiness of volunteers
...
Detection risk
Detection risk comprises sampling risk and non-sampling risk
...
Non-sampling risk is the risk that auditors will draw incorrect conclusions because, for
example, mistakes are made, or errors of judgment are made in interpreting results, or
because the auditors are unfamiliar with the client, as is the case here
...
This risk can be managed
by decreasing detection risk by altering the nature, timing and extent of audit procedures
applied
...
(b) Audit tests– fund raising events
Attend fund raising events and observe the procedures employed in collecting, counting,
banking and recording the cash
...
Sealed boxes or tins that are opened in the
presence of two volunteers are often used for these purposes
...
Examine bank paying in slips, bank statements and bank reconciliations and ensure that
these agree with records made at events
...
Examine the records of expenditure for fund raising events (hire of equipment, entertainers,
purchase of refreshments
...
) and ensure that these have been properly authorized
(where appropriate) and that receipts have been obtained for all expenditure
...
Review the income and expenditure of fund raising events against any budgets that have
been prepared and investigate any significant discrepancies
...
Obtain representations from the trustees to the effect that there are no outstanding unrecorded
liabilities for such events– again for completeness of expenditure and liabilities
...
The company has been expanding into the Internet, and plans to introduce other product lines
for sale in this division
...
In this situation suppliers may go unpaid and at the extreme the business will be forced into
liquidation
...
S T U D Y
T E X T
Internet trading
The decision to expand the Internet business may cause other problems for Parker
...
Selling toys may fall into a similar category, but garden furniture
and clothes are different
...
Specific risks with
this decision therefore relate to:
The overall ability of management to run the business given their apparent lack of knowledge of
Internet trading
...
The need to allow for a much larger volume of returns
...
Control environment
...
There
are errors in the systems, the extent of which is not known, and the directors and the accountant
do not appear to be inclined to attempt to remedy the situation
...
Other errors may also have occurred which have not
been detected
...
Bank loan
The directors require additional finance to expand the business
...
The auditor may need to write to the bank to
disclaim reliance on the audit report for the purposes of making a bank loan
...
SUGGESTED SOLUTIONS TO EXAM QUESTIONS
221
There is also a risk to Parker that the loan is not obtained and the company goes into liquidation
...
First year of audit
S T U D Y
T E X T
The audit is also risky for the audit firm because it is the first year of an audit and the client has
expectations about the type of auditor’s report to be produced
...
The audit firm must ensure
that sufficient time and resources are allocated to the audit to ensure that the audit opinion can
be supported
...
222
A U D I T IN G AN D A S S U RAN C E
CHAPTER 5: FRAUD & ERROR (ISA 240)
QUESTION ONE
(a) Internal audit function: risk of fraud and error
S T U D Y
T E X T
The internal audit function in any entity is part of the overall corporate governance
function of an entity
...
Corporate governance objectives also include the overarching need
for the management of an entity to exercise a stewardship function over the entity’s
assets
...
Controls over the business as
a whole, and in relation to specific areas, include the effective operation of an internal
audit function
...
iv
...
Routine internal controls (such as the controls over computer systems and the
production of routine financial information) and non-routine controls (such as controls
over year-end adjustments to the financial statements) are relevant
...
It should be recognized however that many significant frauds bypass normal internal
control systems and that in the case of management fraud in particular, much higher
level controls (those relating to the high level governance of the entity) need to be
reviewed by internal audit in order to establish the nature of the risks, and to manage
them effectively
...
If programmed controls do not operate properly, for example, the information produced may
be incomplete or incorrect
...
SUGGESTED SOLUTIONS TO EXAM QUESTIONS
223
All networked systems are also subject to the risk of error because of the possibility of the
loss or corruption of data in transit
...
All entities that employ staff who handle company assets (such as receipts from customers)
are subject to the risk that staff may make mistakes (error) or that they may misappropriate
those assets (fraud) and then seek to hide the error or fraud by falsifying the records
...
Whilst credit card companies may be liable
for such frauds, attempts to use stolen cards can cause considerable inconvenience
...
There is a risk that staff may seek to maximize the commission they are paid by entering
false transactions into the computer system that are then reversed after the commission has
been paid
...
Their audit procedures will then be based on a risk
assessment
...
Members of the engagement team should discuss the
susceptibility of the entity’s financial statements to material misstatements due to fraud
...
They should enquire of those charged with governance about
the oversight process
...
Auditors should consider fraud risk factors, unusual or unexpected relationships, and assess
the risk of misstatements due to fraud, identifying any significant risks
...
Auditors should determine an overall response to the assessed risk of material misstatements
due to fraud and develop appropriate audit procedures, including testing certain journal
entries, reviewing estimates for bias, and obtaining an understanding of the business
rationale of significant transactions outside the normal course of business
...
Auditors are only concerned with risks that might cause material error in the financial
statements
...
It is accepted that because of the hidden nature of fraud, an audit properly conducted in
accordance with ISAs might not detect a material misstatement in the financial statements
arising from fraud
...
They should also consider the need to report to management and those charged with
governance
...
Many entities in the financial services sector are subject to this type of regulatory reporting
and many countries have legislation relating to the reporting of money laundering activities,
for example
...
A matter is material if its inclusion or omission will affect the decision reached
by the user of the account and if they affect the view of the account
...
There may
be critical points ‘when materiality can be important, for example in turning a small profit into
a small loss or just making a company’s assets exceed its liabilities or reversing a trend
...
The guide to professional ethics states that information acquired in
the course of professional work should not be disclosed except consent has been acquired
from client or where there is public duty to disclose or where there is a legal or professional
duty or right to disclose
...
Professional indemnity insurance
...
The auditor seeks to pay some premiums to an
insurance firm so that in case of any suit flied against him the insurer can pay
...
Peer review may be described as an independent review of a firm’s accounting and auditing
practices
...
The work of the review is limited to:• Professional aspects of the practice
...
Quality control;
...
The auditor should ensure that audits are carried out
...
In conformity with statutory and contractual requirements
...
In agreement with any professional standards set out by the firm and by other professional
bodies
...
SUGGESTED SOLUTIONS TO EXAM QUESTIONS
225
QUESTION FOUR
Preparation of financial statements
The directors are normally required to prepare the financial statements of the company using the
appropriate law of their country and in accordance with the International Accounting Standards
(IASs)
...
Fraud and error
The directors are responsible for preventing and detecting fraud and error in the financial
statements, no matter how immaterial this may be
...
Auditors are not required to detect immaterial fraud or error
...
The auditor will check that disclosure provisions have been
complied with, and where certain disclosures have not been made (e
...
ISA 550 regarding related
party transactions) provide this information in the audit report
...
The auditor will check the accuracy of the directors’ workings and
assumptions and if these are considered incorrect or inappropriate, then the audit report may be
modified or qualified to bring the situation to the attention of the members of the company
...
226
A U D I T IN G AN D A S S U RAN C E
CHAPTER 6: AUDIT EVIDENCE (ISA 500)
QUESTION ONE
S T U D Y
T E X T
a) Audit evidence consists of any information used by the auditor to enable him to arrive
at conclusion necessary for his opinion
...
b)
Relevant audit evidence
It depends on whether it assists the auditor to form an opinion on some
aspect of the financial statements
...
Reliable audit evidence
Reliability of audit evidence can be assessed to some extent on the following
presumptions:
•• Documentary evidence is more reliable than oral evidence
...
•• Evidence originated by auditor by such means as analyzing and physical inspection is
more reliable than evidence obtained from others
...
The
cumulative effect of several evidential sources which give a consistent view is greater
than that from a single source
...
c
...
Evidence from the
enterprise is more reliable than that secured solely from within the enterprise
...
Work in progress stocks identified during annual physical stock count
...
The
auditor however needs to refer to other materials and statements so as to collect sufficient
evidence
...
It is more reliable evidence than evidence
from management
...
SUGGESTED SOLUTIONS TO EXAM QUESTIONS
227
QUESTION TWO
QUESTION THREE
(a) Headings: accounts payable and accrued expenditure
Whilst there are a great number of possible headings for accounts payable and accrued
expenditure, the seven headings below seem likely:
Food and beverages;
Payroll;
Cleaning;
Maintenance of properties;
Waste disposal;
Light, heat, water and other utilities;
Business and other local taxes
...
There are likely to be
direct relationships that do not vary such as gross margins, and income and expenditure
...
Understanding the business is important because it is the firm’s first year as auditor and
because it enables the auditor to properly plan tests, and evaluate the results thereof
...
S T U D Y
Main audit procedures and processes: interim and final audit
The interim audit generally involves risk assessment, the testing of internal controls, and
certain analytical and other substantive procedures
...
Risk assessment involves gathering information about the business, inquiries, analytical
procedures and determining the response to assessed risk
...
Risk assessment also involves evaluating the design of internal controls and determining
whether they have been implemented
Final audit procedures also involve a review of the financial statements as a whole to ensure
that they are internally consistent, and in accordance with the relevant financial reporting
framework and the auditor’s knowledge of the business
...
Arriving at the final conclusions often involves the performance of further
analytical procedures on the financial statements as a whole
...
Auditors are also required to communicate with those charged with governance
...
T E X T
S T U D Y
T E X T
228
A U D I T IN G AN D A S S U RAN C E
Analytical procedures would be applied to each heading, both for the company as a whole,
for regions and for individual restaurants if necessary
...
Any unusual items would be
investigated and explanations sought and substantiated
...
Food, payroll, cleaning, maintenance of properties
In all cases, substantive procedures would involve tracing source documentation created by
the company (such as purchase orders for food, contracts with the cleaning and maintenance
agencies and clock cards or timesheets) through the system (via goods received notes, signed
documentation indicating that services had been performed, etc
...
This type of
test helps provide audit comfort that accounts payable and accruals are complete, correctly
calculated, properly authorized and recorded in the correct accounting period
...
Substantive procedures may also involve direct confirmation of accounts payable, although
if suppliers send regular statements this may not be necessary
...
After-date payment of both accounts payable and accruals also provides evidence of the
existence and accuracy of accounts payable and accrued expenditure
...
For many such items, there may be accrued expenditure
...
Waste disposal, light, heat, water and other utilities and business and other local taxes
These items are less likely to have source documentation created by the company than
those noted above
...
Accrued expenditure is an accounting estimate based on previous experience
...
The firm should establish the basis on which accrued expenditure is calculated to ensure
that it appears reasonable and consistent with prior periods, and check the actual calculation
of the expenditure (possibly on a sample basis)
...
(c) Difficulties and decisions: direct confirmation of accounts payable
Many of the difficulties faced by auditors conducting direct confirmations of accounts payable
are the same as those relating to direct confirmations of accounts receivable
...
SUGGESTED SOLUTIONS TO EXAM QUESTIONS
229
Auditors have to consider whether the resources required to conduct a confirmation are
likely to be warranted in terms of the audit evidence likely to be obtained, particularly where
alternative third party evidence is available in the form of supplier statements
...
Auditors have to decide whether to send a positive or negative confirmation
...
The auditor is generally most
concerned to ensure that liabilities are not understated and requests for confirmation are
therefore usually positive
...
In practice, reconciling accounts can be time consuming and inefficient, and often requires
the assistance of the client’s staff
...
Analytical procedures are a good test for the overall reasonableness of an amount
...
Analytical procedures enable the auditor to make comparisons on a continuous basis, taking
prior years into account, and providing the auditor with a better understanding of both the
business as a whole, and of individual account areas
...
This means
that significant adjustments, which are often made at a late stage, are not taken into
account
...
Auditors may also be tempted to accept ‘plausible’ explanations for changes and variations
without much further substantiation, where further investigation may actually be warranted
...
Audit sampling
Advantages
Audit sampling enables the auditor to draw conclusions about a population without testing
all of the transactions or balances in the population as a whole
...
Disadvantages
There is always a risk that the auditor’s sample is not representative of the population as a
whole (known as ‘sampling risk’)
...
Sampling relies on the use of judgment in relation to materiality, exceptions, and in drawing
conclusions, for example
...
3
...
If properly designed controls are operating as prescribed, auditors can reduce the
level of substantive testing required at the period-end
...
Disadvantages
Tests of controls are often performed on a sample basis (disadvantages noted above)
...
The very high risk areas in financial statements are often outside this
area and relate to non-routine transactions and more intangible environmental or general
controls which are not easy to test
...
Detailed testing of transactions and balances
Advantages
Detailed testing enables the auditors to form a view as to whether the figures on which he is
reporting are fairly stated and often involves third party, written confirmation which is a good
source of audit evidence
...
Disadvantages
Detailed testing of transactions and balances is often performed on a sample basis
(disadvantages noted above)
...
If too much comfort has been obtained from
tests of controls, it is likely that any error will be compounded by an inadequate level of
testing of transactions and balances
...
Computer assisted audit techniques (CAATs)
Advantages
CAATs reduce the level of human error in testing and enable a very high level of audit
evidence to be derived
...
CAATs enable the auditors to test a large volume of data, or the operation of the controls
in a system, accurately and quickly
...
Disadvantages
CAATs are expensive to set up and require the co-operation of the client
...
QUESTION FIVE
a) Management representations are a form of audit evidence
...
Representations are required for two reasons:
Firstly, so the directors can acknowledge their collective responsibility for the preparation of
the financial statements and to confirm that they have approved those statements
...
In the latter situation, other forms of audit evidence are normally unavailable because
knowledge of the facts is confined to management and the matter is one of judgment or
opinion
...
Audit evidence will still be collected and the representation will support that evidence
...
(b) Lack of representation letter
The auditor may take the following actions:
Discuss the situation with the directors to try and resolve the issue that the directors have
raised
...
Ascertain exact reasons why the directors will not sign the letter
...
T E X T
Major changes in client systems often require major changes in CAATs which is expensive
...
(b) Relationship between the methods of evidence gathering
Analytical procedures are often first used during the planning stage of the audit
...
These are in turn used in audit sampling procedures
...
The results of tests of controls determine the level of detailed testing of transactions and
balances
...
Detailed tests of transactions and balances are often performed towards the end of the audit
in conjunction with analytical procedures – analytical procedures compensate to an extent
for the weaknesses in sampling procedures both for tests of controls and detailed testing of
transactions and balances (and vice versa)
...
Where CAATs are used, sampling may not be necessary because CAATs can often be used
to test the whole population, either for tests of controls, or for detailed testing of transactions
and balances
...
The reason for the audit qualification will be uncertainty regarding the amounts and
disclosures in the financial statements
...
Even if the letter is subsequently signed, the auditor must still evaluate the reliability of
the evidence
...
SUGGESTED SOLUTIONS TO EXAM QUESTIONS
233
CHAPTER 7: AUDIT SAMPLING ISA 530
S T U D Y
a
...
b
...
Audit risk has three components: inherent
risk, control risk and detection risk
...
Detection risk is the risk that auditor’s substantive tests will not detect a misstatement that
exists in an account balance that could be material
...
c
...
•• The population must consist of items of the same nature and subject to the same level
of risk i
...
it must be homogeneous
...
•• The population must be large enough to allow statistical methods to be used to select
and evaluate a sample
...
If many errors are expected, compliance testing
should be abandoned and the auditor should extent the level of substantive testing
...
Management representations
Representations by management are a source of audit evidence normally sought from
the directors at the concluding stages of an audit to confirm various matters stated in the
accounts particularly those which concern questions of facts or judgment which difficult for
the auditor to prove objectively
...
Management makes various oral representations throughout the audit process in response
to specific enquiries
...
The auditor should obtain written representations from
management on mattes material to the financial information when other sufficient appropriate
audit evidence cannot reasonably be expected to exist
...
Factor to consider before relying on work of an expert
•• The skills and competence of the expert
...
•• Objectivity and independence of the expert
...
•• The sources of data used by the expert in arriving at his opinion
...
•• The assumptions and methods used by the expert
...
S T U D Y
T E X T
QUESTION TWO
(a) Sampling risk is the possibility that the auditor’s conclusion, based on a sample, may be
different from the conclusion reached if the entire population were subjected to the audit
procedure
...
Sampling risk is controlled by the audit firm ensuring that it is using a valid method of selecting
items from a population and/or increasing the sample size
...
Examples of non-sampling risk include the use of inappropriate procedures, misinterpretation
of evidence or the auditor simply ‘missing’ an error
...
(b) The audit manager suggests checking all invoices, effectively ignoring any statistical
sampling; in other words this is not statistical sampling
...
This approach may be appropriate for the audit of Tam because:
•• The population is relatively small and it is likely to be quicker to test all the items than
spend time constructing a sample
...
g
...
As all the transactions are material, then they all need to be
tested
...
This will mean selecting a limited
number of sales invoices from the population using probability theory ensuring a random
selection of the sample and then applying audit tests to those invoices only
...
e
...
There is the query
about how long it will take to determine and produce a sample, which may make
statistical sampling inappropriate in this situation
...
The approach therefore involves
an element of bias and is not statistical or true ‘random’ sampling
...
Human nature will tend to avoid difficult items for testing
...
If an error is found it will be difficult
extrapolating that error on to the population
...
Judgment and statistical sampling
Judgment sampling uses the auditor’s judgment to select the number of items to be tested,
which items to be tested, and to interpret the results
...
Some judgment is always used in statistical sampling in the assessment
of materiality and in the determination of what constitutes tolerable error, for example
...
Representative sample
A representative sample is one whose characteristics are the same as, or similar to, the
characteristics of the population as a whole
...
For example, a sample of invoices that have not been properly authorized in 5% of cases
will be representative of all invoices if the population as a whole also has around 5% of
invoices not authorized
...
Materiality depends on the size of the item or error judged in the particular circumstances of
its omission or misstatement
...
If the auditors do not detect a material error then their opinion
on the financial statements could be incorrect
•• There are only two owner/directors who will be the initial users of the financial statements
...
•• There are also other users of the financial statements who will include the taxation
authorities and the bank who have made a loan to the company
...
The auditors must therefore ensure that the financial statements
are free from material misstatement to avoid any legal liability to third parties if they
audit the financial statements negligently
...
Tolerable error
Tolerable error is the maximum error that the auditor is prepared to accept and still conclude
that the audit objective has been achieved
...
d
...
•• Haphazard selection may be deemed to approximate to random selection provided that
no bias is displayed
...
Monetary unit sampling is also a form of systematic selection
...
•• Block selection might involve obtaining confirmation of receivables from one region of
the country only, for example
...
Extrapolation of errors
Errors found in a sample are extrapolated across the population as a whole, in order to
enable the auditor to form a conclusion on whether the population is materially misstated
...
SUGGESTED SOLUTIONS TO EXAM QUESTIONS
237
CHAPTER 8: AUDITORS REPORT ISA 700
QUESTION TWO
a) (i) Going concern
IAS 1 Presentation of Financial Statements defines the going concern concept as the
assumption that the enterprise will continue in operational existence for the foreseeable
future
...
•• Examine all appropriate evidence
...
•• Assess the systems or other means by which the directors have identified warnings of
future risks and uncertainties
...
•• Examine management accounts and other reports of recent activities
•• Consider the sensitivity of budgets and cash flow forecasts variable factors both within
the control of the directors (e
...
capital expenditure) and outside their control (e
...
interest or debt collection)
•• Review any obligations, undertakings or guarantees arranged with other entities for the
giving or receiving of support
...
A Kenyan company may be viable in itself but
may have given guarantees to other members of the group and when, say the holding
company in Uganda fails, the company goes down with it
...
•• Appraise the key assumptions underlying the budgets, forecasts and other information
used by the directors
...
Such plans should be realistic,
capable of resolving the doubts and the directors should have firm intentions to put
them into effect
...
They should
always have all their evidence documented and their reasoning explained fully in the working
papers
...
(ii) Responsibilities
The directors’ responsibilities regarding going concern is to prepare the financial
statements of an entity ensuring that the going concern basis is reasonable
...
The auditors’ responsibility regarding going concern is to form an opinion on the
appropriateness of management’s assessment of the going concern status of the entity
and the adequacy of disclosures, if any
...
To be clear, the
auditors are not responsible for ensuring that the company is a going concern; this is a
responsibility of the directors
...
Ensure that these have been
properly prepared (for example, are arithmetically correct) and show that the firm will
continue trading
...
•• Contacting firm’s lawyers to determine the progress, if there are court cases pending
...
•• Contacting firm’s bank to ascertain whether any loan or overdraft agreements are due
for renewal and whether these will be renewed
...
QUESTION THREE
a) Four situations under which the Act requires auditors to qualify their report
...
If the auditors are unable to obtain all the information and explanations they consider
necessary for the purpose of their audit, for example, if they are unable to obtain satisfactory
evidence:
•• Of the existence of ownership of material assets or of the amounts at which they have
been stated on the basis adopted
...
2
...
•• Proper returns adequate for their audit have not been received from branches nor
visited by them
...
3
...
SUGGESTED SOLUTIONS TO EXAM QUESTIONS
239
4
...
Because in the auditor’s opinion the underlying accounting policies do no conform to accounting
principles appropriate to the circumstances and nature of the business;
QUESTION FOUR
The basis of opinion paragraph may not meet the requirements of ISA 700 for the following
reasons:
••
••
••
The use of the term Auditing Standards is not clear, because the report does not state
which auditing standards have been used
...
The assessment of estimates and judgments made by the directors normally relates to
significant amounts only, rather than all of those estimates and judgments
...
Replacing
the word all with the word significant will show that there was some limit to the audit
testing and that this was probably focused on material amounts only
...
The auditor has to plan the audit carefully and
ensure that all the information and explanations considered necessary are obtained to
form an opinion, not simply stop work when time runs out
...
b
...
Uncertainty is of two levels material and not fundamental and material and fundamental
...
He therefore disclaims opinion on only an aspect of the
accounts and not the accounts taken as a whole
...
In this situation,
the auditor is unable to form an opinion on the accounts taken as a whole and he therefore
disclaims his opinion altogether by stating he is unable to form an opinion as to when the
financial statements give a true and fair view
...
Making the statement could also leave the auditor liable to claims from members or
third parties should errors be found in the financial statements later
...
The disclaimer regarding errors appears to be useful in that it limits the auditor’s liability
...
Directors’ responsibilities are also clearly outlined in another section of the
report, and this statement also appears to extend those responsibilities making the
audit report overall less clear
...
As the auditor is not required to audit the whole of the annual report of a company, it
is inappropriate to refer to disclosure in that report when checking overall adequacy of
presentation
...
SUGGESTED SOLUTIONS TO EXAM QUESTIONS
241
CHAPTER 9: COMPUTERISED INFORMATION
SYSTEMS
QUESTION ONE
••
••
••
••
Auditors need to be involved in computerized systems at a planning, development and
implementation stages
...
Timing is more important in computerized environments than in manual environment
because of the need of the auditor to be present when data and the files are available,
more frequent visits to the client are usually required
...
Recent developments including the use of
portable micro computers to make audit working papers in diskettes and not in paper
or coupling a client’s mainframe computer to a micro computer in the auditor’s office
enabling auditors to download data files onto their own personal computers
...
Thus audit firms now use the computer
audit department on some parts of the audit and allowing general audit staff to have
some computer experience
...
These techniques
often require considerable planning in advance
...
•• Hardware
...
A system which does not incorporate physical controls will
be subject to such risk
...
If terminals are not secure it might be possible for unauthorized
users to obtain or corrupt information held on file
...
If the system does not incorporate retrieval procedures there might
be a loss of data if the system breaks down for any reason such as power failure
...
If stringent checks are not carried out on data, input files may be corrupted,
with the consequent fall in the quality of output
b) Forms of control which may be instituted to safeguard against these risks are as follows
...
All hardware and files should be kept in secure locations with access
only available to authorized personnel
...
To protect the
hardware and files from damage they should be located away from possible hazards
such as fire and flood which might arise near a canteen or washroom facilities
...
S T U D Y
••
T E X T
When planning the audit in a computerized environment the following factors should be
considered:
242
A U D I T IN G AN D A S S U RAN C E
••
Access controls
...
In addition to this, terminal keys should be issued to authorized personnel
...
The use of unique
passwords will further improve control because, in the event of a key being stolen, the
system will still be inaccessible without a valid password
QUESTION THREE
S T U D Y
T E X T
(a) The advantages of Computer-Assisted Audit Techniques (CAATs) are that they:
•• Enable the auditor to test program controls – if CAATs were not used then those controls
would not be testable
...
This will
also increase the overall confidence for the audit opinion
...
•• Are cost effective after they have been setup as long as the company does not change
its systems
...
(b) Test Data
Reason for test
Input of an order for a negative number of
tennis racquets
Ensures that only positive quantities are
accepted although the company cannot
dispatch negative quantities anyway
Input of an order for ten tennis racquets
There are reasonableness checks in the
system to identify possible input errors
...
This will also limit the number of bad
debts
...
If the code is not valid an
error message should be displayed
...
•• Audit software may not be available for the specific systems setup by the client,
especially if those systems are bespoke
...
•• The software may produce too much output either due to poor design of the software
or using inappropriate parameters on a test
...
•• Checking the client’s files in a live situation
...
The data files can be used offline, but this will mean
ensuring that the files are true copies of the live files
...
Using audit software, the auditor can check the deduction and net pay calculations of a
significant proportion of wages calculations – or all of them if necessary
...
Test actual accounting records
Using CAATs enables the auditor to test the actual accounting records (the electronic
version) rather then relying on printouts or other copies of the data
...
In the case of Walsh, the actual
wages will be tested rather than any paper copies
...
In Walsh Co, the system has just been implemented
...
(b) Examples of the use of audit software
•• Calculation checks: For example, re-calculation of net pay for a number of employees
to ensure the mathematical calculation is correct
...
Use
of the CAAT enables the auditor to meet the auditing standard requirement of obtaining
appropriate audit evidence
...
Test data can be used
to check that the overtime report is being created correctly and audit software can monitor
that only the accountant’s password can be used to override the overtime payment
...
•• Detecting unreasonable items: Reviewing the list of net wages for large or negative
payments
...
•• Conducting new analysis as part of the analytical review of wages
...
•• Completeness checks – ensuring there is an electronic record of all employees who
‘clocked in’ for a day’s work and ‘clocked out’ again
...
The data can be processed during a normal processing run (a ‘live’ testing situation) or in a
special run outside of the normal processing cycle (a ‘dead’ testing situation)
...
Knowing how many hours has been input into the wages system; the auditor can calculate
the expected net pay and then compare this to the actual net pay produced by the computer
system
...
The problems of using this audit technique include:
•• The possibility that the client’s computer system will be damaged by the testing being
undertaken by the auditor
...
•• The need to reverse or remove any transactions input by the auditor
...
•• Use of test data can be expensive – the auditor needs to ensure that the benefit gained
from the test outweighs the expense
...
SUGGESTED SOLUTIONS TO EXAM QUESTIONS
245
CHAPTER 10: AUDIT TESTS
QUESTION ONE
a) Shortcomings
•• There is no check that expenses claimed by salesmen claimed by salespersons were
actually expended
...
This is appropriate because invoices can be falsified
...
•• The deputy chief accountant could easily perpetrate fraud alone or with collusion with
the salespersons as no one verifies her work
...
Consider whether the discovery casts doubt on the effectiveness of the system hence
whether further audit tests may be required
...
QUESTION TWO
a)
1
...
•• Misappropriation of unclaimed wages
...
•• Use of the cash as petty cash and buying office items not authorized
...
S T U D Y
Each salesperson should complete a weekly log showing, mileage covered and calls
made
...
•• At intervals, a member of the accounts staff should verify that claimed mileage is
consistent with mileage shown on the car’s odometer
...
They should then cancel the presented
documents to prevent a second presentation
...
Tests of control are those tests which seek to provide audit evidence that internal control
procedures are being properly applied throughout the period under review
...
Verify that each
claim is fully supported by vouchers and the additions are correct
...
This may form part of the audit of the bank transactions
...
Receipt of cash from customers
•• Teeming and lading
...
•• Writing off bad debts for customers who have paid
...
3
...
•• Paying for expenses that are non-existent to suppliers after colluding
...
4
...
•• Overstated credit notes
...
The client is asked to reply under all
circumstances i
...
Positive circularization
...
Frequently with circularization of debtors, the percentage of debtors who reply is low
...
However, negative circularization
leads to an invalid conclusion as many debtors never reply to any circularization and some
of them will disagree with the balances
...
Where client and debtor are independent of each other, replies to circularization are quite
good evidence
...
In some cases they sign the reply that they agree with the balance without
checking the purchases ledger
...
g
...
•• Sometimes the debtor will disagree with the balance on clients sales ledger is correct
...
In most businesses, the ledger
is more reliable than the purchases ledger, as sales invoice is posted to sales ledger
at the same time as the goods are dispatched to customer and cash is posted to sales
ledger when it is received usually within a day
...
This creates
inaccuracies in customers purchase ledger
...
In this case, only the existence of debtor is confirmed
...
T E X T
••
S T U D Y
Agreement of balance by debtor does not confirm that it is recoverable e
...
the debtor
may confirm the balance but because of cash flow problems, he is unable to pay it
and becomes a bad debt
...
Nevertheless, this is a serious weakness of debtor’s
circularization
...
•• Although the great advantage over debtor’s circularization is to confirm existence of
debtor, it is time consuming to carry out and because of limitations above
...
•• It is carried out only on a small sample of debtors which could be a very small percentage
of the total valuation of debtors
...
b
...
•• Check sales invoices, dispatch notes and order confirmations generated by the company
...
•• The best evidence of the existence of the debtor which is available within the company
is correspondence from the debtor such as orders from the debtor which can be found
in sales department and in the credit control
...
Only the most recent
cheques will be available for auditor to inspect but there should be remittance advices
from customers showing invoices each cheque pays
...
This
confirms existence of the business on client’s sales ledger but does not confirm that the
business is a debtor of the client i
...
the debtor balance on the sales ledger could either
be made of fictitious sales invoices or invoices posted to wrong accounts
...
•• The debtor could be telephoned and asked if he purchased goods from the client
...
To check the recoverability of a debt at the year end, the auditor should check its aging
...
Any year end invoices cleared by cash received since year end can be considered
good as it is unusual for a debtor to request repayment
...
The auditor will discuss all old outstanding amounts because
there is likely to be a dispute between the debtor and the client over the amount
...
The valuation of
inventories is a matter requiring the exercise of judgment, which means that inventories
are sometimes used to manipulate the appearance of both the income statement and
the balance sheet
...
If closing inventories are overstated, profits will be overstated
...
These include inventory turnover, inventory days, the current ratio and working capital
ratios
...
•• Poor inventory control will be reflected in inventory figures at the period-end
...
•• Some significant cases of litigation against auditors have involved the alleged
overstatement of inventories in financial statements of companies where the auditors
have issued an unqualified audit report before the company has been taken over
...
(b) Cost and net realizable value
•• IAS 2 requires that cost comprises all costs of purchase, costs of conversion and other
costs incurred in bringing the inventories to their present location and condition
...
Trade discounts, rebates and similar items are deducted
...
They also include a systematic allocation of fixed and variable production
overheads that are incurred in converting materials to finished goods
...
The
allocation of fixed overheads is based on a normal level of production
...
The allocation of variable overheads
is based on actual levels of production
...
•• Costs not included are storage costs, unless these are necessary to the production
process prior to completion, general administrative overheads and selling costs
...
(c) Audit evidence
•• The costs of purchase for a furniture manufacturing company will include purchase
costs such as the cost of timber, metals, fabrics, fillings and adhesives
...
••
••
••
••
••
••
••
••
••
The variable production overheads will include direct labour costs (including tax and
social insurance costs), the cost of power for factory machinery, the cost of small tools
and similar items that are directly related to the level of production
...
It is likely
that the cost of power for machinery will have to be allocated, but if this is not possible
it may be necessary to include such costs in fixed overheads
...
The costs of small tools can be checked
in the same way as purchase invoices, ensuring that capital items are not included in
the revenue accounts and vice versa
...
It is important to establish that the factory is operating at a normal level of
activity
...
Depreciation can be checked to asset registers
...
Factory administration may include the wages and salaries of those administering the
factory payroll for example, and the costs of the offices in which such staff work
...
The attributable payroll and overhead costs can be checked in the
same way as for direct factory costs
...
Analytical procedures on gross margins will also provide audit comfort on costs
...
It
may also be necessary to examine provisions for goods dispatched or received but not
invoiced before the period-end
...
e
...
Auditors should review inventory counting
results and inventory records for old or slow-moving inventory and form an opinion, in
discussion with directors, as to whether any such inventories need to be reduced to net
realizable value
...
If these are not available, it is important to review the entity’s
previous experience of having to sell furniture below cost
...
QUESTION FIVE
(a) (i) Four examples of external confirmations are:
•• Accounts receivable letter
•• Solicitor letter
•• Bank report letter
•• Inventory held by third parties
...
•• The letter provides evidence on cut-off because sales or cash receipts recorded in the
incorrect accounting period will have to be reconciled to the balance provided by the
receivable
...
•• The letter does not provide evidence of the valuation of the receivables balance because
the receivable cannot be expected to list all outstanding balances and confirmation of
the debt does not mean it will be paid
...
However, the letter does not necessarily confirm the valuation of claims due to uncertainty
about the future or the completeness of any legal claims as solicitors do not normally provide
a list of all claims but they prefer to comment only on claims they are actually asked about
...
A bank letter cannot necessarily be relied on to provide complete or accurate information
...
Inventory held by third parties
A letter from the third party holding the inventory will provide evidence of the existence of
that inventory because the third party has confirmed this in writing
...
(b) (i) Procedure for obtaining a bank letter
•• The auditor should consider if a bank letter is required
...
•• The auditor will produce a confirmation letter in accordance with local audit regulations
and practices
...
•• Alternatively, the client may already have provided a standard authority for the bank
to respond to a bank letter each year
...
•• Ideally the letter should be sent before the end of the accounting period to enable the
bank to complete it on a timely basis e
...
at the year-end
...
•• Audit procedures on the bank letter include:
•• Agree the balances for each bank account to the relevant bank reconciliation and the
year end balance in the financial statements
...
SUGGESTED SOLUTIONS TO EXAM QUESTIONS
251
S T U D Y
For any details of loans, ensure repayment terms are correctly disclosed in the financial
statements between current and non-current liabilities
...
(1) Obtain a copy of the year end trial balance
...
(2) Obtain a copy of Jayne Co’s bank reconciliation
...
• Agree the bank statement balance to the year end bank statement
...
T E X T
••
S T U D Y
T E X T
252
A U D I T IN G AN D A S S U RAN C E
glossary
253
S
S TT SU
U TD
DUY
YD TY
TE
E TX
X ETT X T
GLOSSARY OF
TERMS
CHAPTER ONE
S T U D Y
T E X T
254
A U D I T IN G AN D A S S U RAN C E
glossary
255
GLOSSARY OF TERMS
Acceptance sampling is sampling to determine whether internal control compliance is greater
than or less than the tolerable deviation rate
...
It may be in computer readable form or on paper
...
Estimates are included
in historical financial statements because some amounts are uncertain pending outcome of future
events and relevant data about events that have occurred cannot be accumulated on a timely,
cost-effective basis
...
Accounts receivable Debts due from customers from sales of products and services
...
adjusting entries are accounting entries made at the end of an accounting period
to allocate items between accounting periods
...
The allowance balance is the
estimated total of uncollectible accounts included in accounts receivable
...
This allowance is also the difference
between the expected error rate and the tolerable deviation rate
...
An example is to compare actual interest expense for the year (a financial statement amount) with
an estimate of what that interest expense should be
...
If actual interest expense differs significantly from the
expectation, the auditor explains the difference in audit documentation
...
Approve To authorize
...
Arm’s length transactions are transactions between people who have no relationship other
than that of buyer and seller
...
If you buy or sell something to a close relative, you might give better terms than to an unrelated
party, so the price might not represent the true market value of the goods or services
...
For example, to ascertain
the date on which an investment was purchased by examining source documents
...
Distribution according to a plan
...
T E X T
Adverse An audit opinion that the financial statements as a whole are not in conformity with
...
256
A U D I T IN G AN D A S S U RAN C E
Assertion Management asserts financial statements are correct with regard to existence or
occurrence of assets, liabilities or transactions, completeness of information in the financial
statements, rights and obligations at a point in time, appropriate valuation or allocation,
presentation, and disclosure
...
Assurance The level of confidence one has
...
Attribute sampling The characteristic tested is a property that has only two possible values (an
error exists or it does not)
...
Audit committee A committee of the board of directors responsible for oversight of the financial
reporting process, selection of the independent auditor, and receipt of audit results
...
For example, an objective related
to the completeness assertion for inventory balances is that inventory quantities include all
products, materials, and supplies on hand
...
The documentation provides the principal support for the auditor's report
...
The nature, extent, and timing of
planning varies with size and complexity of the entity, experience with the entity, and knowledge
of the entity's business
...
Audit risk includes uncertainties due to
sampling (sampling risk) and to other factors (nonsampling risk)
...
Authorize (authorization) To give permission for
...
Backup A copy of a computer program or file stored separately from the original
...
Capitalized Recorded as an asset
...
An asset is recorded equal to the present value of the lease payments, which is also recorded as
a liability
...
The lease
asset is depreciated by the lessee as though it were legally owned by the lessee
...
Assets and liabilities are normally classified as current
or non current
...
glossary
257
Comparability Users evaluate accounting information by comparison
...
Another goal is comparison of one company's
information from one period to the next (consistency)
...
Comparative Financial statements of a prior period shown with those of the current period to aid
in comparisons between periods
...
The auditor observes similarities and differences
among similar items such as an account from one year to the next
...
A requirement by some banks that a borrower
maintain a minimum balance in a checking or savings account as a condition of a loan
...
Competence of an internal audit staff is a function of qualifications, including education,
certification, and supervision
...
Computer controls Internal controls performed by computer (software controls) as opposed to
manual controls
...
Consistency To achieve comparability of information over time, the same accounting methods
must be followed
...
Consulted Sought advice or information
...
Contingency is an existing condition involving uncertainty as to possible gain (gain contingency)
or loss (loss contingency) that will be resolved by future events
...
Eventual expiration of the asset's utility is not uncertain
...
Control accounts are general ledger accounts that report totals of details included in subsidiary
ledger accounts
...
Control A policy or procedure that is part of internal control
...
This includes integrity and ethical rules, commitment
to competence, board or audit committee participation, organizational structure, assignment of
authority and responsibility, and human resource policies and practices
S T U D Y
Compliance Following applicable rules or laws
...
For example, management asserts that all
purchases of goods and services are included in the financial statements
...
258
A U D I T IN G AN D A S S U RAN C E
Control policies and procedures Control activities are the policies and procedures that help
ensure management directives are carried out
...
Control risk The risk that material error in a balance or transaction class will not be prevented
or detected on a timely basis by internal controls
...
Cumulative effect of changing to a new accounting principle is the effect on retained earnings
at the beginning of the current period
...
Only
the direct effect (net of income tax effect) is considered
...
An auditor uses tests of cutoff to obtain evidence that
transactions for each year are included in the financial statements of the appropriate year
...
Detective control A control designed to discover an unintended event or result
...
Financial statement footnotes are one way of providing
necessary disclosures
...
Document (documentary) (documentation) Written or printed paper that bears information
that can be used to furnish decisive evidence
...
Edit check Reasonableness, validity, limit, and completeness tests that are programmed
routines designed to check input data and processing results for completeness, accuracy and
reasonableness
...
Effectiveness Producing a desired outcome
...
Efficiency The ratio of the audit evidence produced to audit resources used
...
The letter identifies the financial statements and describes the nature of
procedures to be performed
...
Error Unintentional misstatements or omissions in financial statements
...
Estimation sampling is sampling to estimate the actual value of a population characteristic
within a range of tolerable misstatement
...
Except for a qualified opinion
...
The opinion
paragraph of the qualified report is worded "In our opinion, except for
...
Existence Assertions about existence deal with whether assets or liabilities exist at a given
date
...
Flowchart A schematic representation of a sequence of operations in an accounting system or
computer program
...
General controls Policies and procedures to assure proper operation of computer systems,
including controls over data center and network operations, software acquisition and maintenance,
and access security
...
It is the final record from which financial statements are prepared
...
Generalized audit software Packaged computer programs used on a variety of computers
during audit field work to read computer files, select information, perform calculations, create
data files, and print reports in a format specified by the auditor
...
Presenting assets at
historical cost is justified by assuming productive assets will be used rather than sold
...
Gross margin percentage The gross margin from an income statement divided by net sales
revenue
...
S T U D Y
GAAP or Generally Accepted Accounting Principles According to Rule 203 of the AICPA
Code of Professional Conduct, GAAP for non government entities include (in a conflict the source
earlier in the list prevails): 1
...
2
...
3
...
4
...
5
...
T E X T
Fraud A deliberate deception to secure unfair or unlawful gain
...
Fraud includes fraudulent financial reporting
undertaken to render financial statements misleading, sometimes called management fraud, and
misappropriation of assets, sometimes called defalcations
...
Immaterial Of no importance
...
Implicitly Implied or understood even though not directly expressed
...
This means freedom from bias, which is possible even when
auditing one's own business (independence in fact)
...
Information systems consist of infrastructure (physical and hardware components), software,
people, procedures (manual and automated), and data
...
Human fallibility, collusion, and management override are examples
...
Input control Computer controls designed to provide reasonable assurance that transactions
are properly authorized before processed by the computer, accurately converted to machine
readable form and recorded in the computer, that data files and transactions are not lost, added,
duplicated or improperly changed, and that incorrect transactions are rejected, corrected and, if
necessary, resubmitted on a timely basis
...
As
part of a CPA firm's quality control system, to monitor the effectiveness of the system
...
If client management lacks integrity the auditor
must be more skeptical than usual
...
Interim financial information is financial statements of a time period less than a full year
...
An
important responsibility of internal auditors is to monitor performance of controls
...
It consists of: the control environment, risk assessment,
control activities, information and communications, and monitoring
...
The
questionnaire is a part of the documentation of the auditor's understanding of the client's internal
controls
...
A material
weakness is a reportable condition that does not reduce to a relatively low level the risk that
material errors or fraud would not be detected in a timely manner by employees in the normal
course of their duties
...
ISB Independence Standards Board
...
The journal lists all transactions and
the accounts to which they are posted
...
Debt paying ability
...
Management representation letter A letter addressed to the auditor, signed by the client's
chief executive office and chief financial officer
...
Written representations from management in the letter confirm
oral representations given to the auditor, document the continuing appropriateness of such
representations, and reduce the possibility of misunderstanding
...
Misstatement Stated wrongly or falsely
...
Mitigating Reducing in force or intensity
...
Negative assurance A statement of what the CPA does not know as opposed to what the CPA
believes (positive assurance)
...
Negative confirmation request The negative form of accounts receivable confirmation asks the
client's customer to respond only if the customer disagrees with the balance determined by the
client
...
The negative form is used when controls over receivables
are strong and accounts receivable consists of many accounts with small balances
...
Non sampling risk is audit risk not due to sampling
...
Non sampling risk includes the
possibility of selecting audit procedures that are not appropriate to achieve a specific objective
...
Non
sampling risk can be reduced to a negligible level through adequate planning and supervision
...
Objectivity The internal auditors' objectivity depends on the organizational status of the internal
audit function, whether the internal auditor has direct access and reports regularly to the board, the
audit committee, or owner-manager, and who oversees internal auditor employment decisions
...
T E X T
Material (materiality) Information important enough to change an investor's decision
...
Materiality includes the
absolute value and relationship of an amount to other information
...
For example, management asserts that amounts capitalized for leases
in the balance sheet represent the cost of the entity's rights to leased property and that the
corresponding lease liability represents an obligation of the entity
...
Occurrence Assertions about occurrence deal with whether recorded transactions have occurred
during a given period
...
Online Access to a computer for immediate processing without having to wait for a batch of
transactions to be processed at a later time
...
S T U D Y
T E X T
Opinion A CPA's conclusion held with confidence but not substantiated by positive knowledge
or proof
...
The wording of the standard, unqualified opinion paragraph is: "In our opinion, the financial
statements referred to above present fairly, in all material respects, the financial position of XYZ
Company at December 31, year A, and the results of its operations and its cash flows for the year
then ended in conformity with U
...
generally accepted accounting principles
...
A company starts the purchase process internally with a requisition, which
results in an order being transmitted to a supplier
...
Overall review The objective of the overall review stage of the audit is to assess conclusions
reached, and evaluate the overall financial statement presentation
...
Results of an overall review may indicate the need
for additional evidence
...
Password A sequence of characters required to gain access to a computer system
...
Payroll Department that determines amounts of wage or salary due to each employee
...
Permanent audit documentation includes items of continuing accounting significance, such as
the analysis of balance sheet accounts and contingencies
...
Sometimes called the continuing file
...
Persuasive Having the power to influence
...
glossary
263
Pervasive Having the ability to permeate
...
Piecemeal opinion Expression of an opinion on an item in financial statements is not permitted
as part of a disclaimer or adverse opinion on the financial statements as a whole because it
would tend to overshadow or contradict a disclaimer of opinion or an adverse opinion
...
The
nature, extent, and timing of planning vary with size and complexity of the entity, experience with
the entity, and knowledge of the business
...
Population size The number of items in the population from which a sample is drawn
...
Presentation Assertions about presentation deal with whether particular financial statement
components are properly classified and described
...
Similarly, management asserts
that extraordinary items in the income statement are properly classified and described
...
Probable A contingent loss is probable if it is uncertain but likely to happen
...
Processing control is an internal control included in computer software designed to assure that
all transactions are handled as authorized and none omitted or added
...
The
independent auditor must undergo training adequate in technical scope, including commensurate
general education
...
Program An audit program is a listing of audit procedures to be performed in completing the
audit
...
Programmed controls are built into computer software and include reasonableness tests,
control totals, and sequence checks
...
The negative form of accounts receivable confirmation asks the client's
customer to respond only if the customer disagrees with the balance determined by the client
...
The positive form is used when controls are
weak or there are fewer, but larger, accounts
...
An example is an opinion that the
financial statements are presented fairly in conformity with U
...
GAAP
...
A statement that the CPA was "not
aware of material modifications that should be made to financial statements for them to conform
with
...
264
A U D I T IN G AN D A S S U RAN C E
Pronouncements of the FASB and GASB are rules that determine the principles for external
financial reporting and disclosure
...
Prospective financial statements may cover a period that has partially expired
...
Qualified (qualify) An audit opinion that the financial statements as a whole are presented in
conformity with
...
Qualitative Relating to the quality of a trait, as opposed to quantitative, which means expressed
as a number
...
It covers personnel management, acceptance and continuance of clients, engagement
performance, and monitoring
...
T E X T
Ratio The relation between two quantities expressed as the quotient of one divided by the other
...
Financial statement ratios are used in analytical
procedures in audits
...
The questionnaire is part of the audit documentation of the auditor's understanding of the client's
internal controls
...
The audit
opinion, to be economically useful, must be formed in a reasonable time and at reasonable cost
...
Reasonable assurance (in internal control) An internal control, no matter how well designed and
operated, cannot guarantee that an entity’s objectives will be met because of inherent limitations
in all internal control systems
...
Related parties are those with whom the client has a relationship that might destroy the selfinterest of one of the parties (accounting is based on measurement of arm's length transactions)
...
Reliable (reliability) Different audit evidence provides different degrees of assurance to the
auditor
...
More effective internal controls provide more assurance about reliability of the accounting data
and financial statements
...
Remote A contingency with only a slight chance of occurring
...
glossary
265
Reperformance The repeating by the auditor of a computation made by the client to check its
accuracy
...
The letter is addressed to the independent auditor, and dated at the date
of the auditor's report
...
Requisition A formal written request for something needed
...
Review To examine again
...
A peer review is a practice monitoring program in which audit documentation of one CPA
firm is periodically reviewed by independent partners of other firms to determine that they conform
to professional standards
...
A review
of financial statements of a nonpublic company is an engagement that results in the expression
of less assurance than an audit, but more than in a compilation
...
Sample size The number of population items selected when a sample is drawn from a
population
...
This risk is sampling error
...
Sampling risk The possibility that conclusions drawn from the sample may not represent correct
conclusions for the entire population
...
The scope of an engagement might be a review, an audit, or a
compilation
...
Scope paragraph The paragraph in the audit report that explains the scope of the engagement
...
S
...
Those standards require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are free of material
misstatement
...
An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as evaluating the overall
financial statement presentation
...
"
Segregation of duties means assigning different people the responsibilities of authorizing
transactions, recording transactions, and maintaining custody of assets
...
Software Programs and languages that control computer hardware
...
S T U D Y
Risk analysis An analysis of the possibility of suffering loss
...
For example, management asserts that amounts capitalized for leases in the balance sheet
represent the cost of the entity's rights to leased property
...
Statistical Making inferences in uncertain situations using applied mathematics
...
Probability theory determines how well the sample represents the population
...
Stratified sampling is used in
auditing to select a greater percentage of accounts with high balances than of accounts with low
balances
...
" Auditors are no longer permitted to issue such opinions
...
Some such events provide additional evidence about conditions that
existed at the balance sheet date, such as the bankruptcy of a customer with a history of financial
difficulty
...
Evidence about conditions
that did not exist at the balance sheet date, such as fire that destroyed the client's plant after the
balance sheet date, may be so significant as to require disclosure
...
Sufficiency (sufficient) A measure of the quantity of audit evidence
...
Supervise Supervision is directing efforts of assistants in the audit and determining whether
objectives were accomplished
...
The appropriate extent of supervision depends on the complexity of subject
matter and qualifications of persons performing the work
...
Sometimes called vendors
...
Test data is run through a computer program to test the software
...
Test of controls (tests of the operating effectiveness of internal controls) Auditors evaluate the
design of controls, then determine if the controls are in operation
...
Tolerable error When planning a sample for a substantive test of details, the auditor considers
how much monetary misstatement may exist without causing the financial statements to be
materially misstated
...
Trace Follow a transaction through the steps of the system
...
Analytical procedures, which
compare financial statement ratios of different years, are an example of trend analysis
...
Unqualified An audit opinion that the financial statements are in conformity with GAAP
...
glossary
267
If those statements are changed, the report says they have been restated and expresses the
appropriate opinion
...
Validity check Software control over input of data to a computer system
...
g
...
Valuation An assertion made by management that each asset and liability is recorded at an
appropriate carrying value
...
The variance is the square of the
standard deviation
...
Vendors provide goods or services to an audited entity
...
Verify (verification) Prove accuracy of numbers or existence of assets
...
Write-off Cancellation of part or all of a balance
...
S T U D Y
Working papers (written audit documentation) Records kept by the auditor of procedures applied,
tests performed, information obtained, and pertinent conclusions in the engagement
...
The signature of an appropriate official on the
voucher is authorization for the treasurer to issue a check
...
10
Balance sheet ratios
...
v
Beneficial shareholding
...
115
C
Cash in bank
...
136
Client
...
16, 133
Completeness of input
...
72
Components
...
172
Computer files
...
168
Computer programs
...
112
Confidence level
...
168
Accounting and internal control system
...
63
Adjusting events
...
181, 184
Advertising
...
98
Application controls
...
9
Ascertaining
...
15
Assertions
...
39
Audit evidence
...
7
Audit planning memorandum
...
52
Audit report
...
65
Audit tests
...
67
T E X T
A
272
A U D I T IN G AN D A S S U RAN C E
Confirmation
...
71
Conflict of interest
...
9
Control Environment
...
172
Control procedures
...
65
Corporate Governance
...
98
Criminal law
...
56
Cut off
...
145
S T U D Y
T E X T
D
Debtors circularization
...
134
Detection
...
127
Disagreement
...
184
Disclosure
...
118
Documentation
...
170
E
Emphasis on matter report
...
84
Estimation sampling
...
71
Exception reports
...
v
Existence
...
85
Expected errors
...
12
F
Fees
...
169
Final audit
...
189
Financial statements
...
135
Fraud
...
153
General controls
...
16
Going Concern
...
115
J
Judgmental sampling
...
29
Liability
...
184
Limitations of internal control system
...
170
Liquidation
...
6
IFRS
...
208
Inherent limitations of an audit
...
65
Inherent uncertainties
...
98
institute of internal auditors
...
9
Internal audit
...
71
Internal control questionnaire
...
6
International Federation of accountants
...
6
Inventory
...
10
Management controls
...
73
Management representations
...
170
Material and pervasive
...
188
Materiality and judgment
...
16
Monetary unit sampling
...
71
Negative circularization
...
31, 32
Non- adjusting events
...
189
Non sampling risk
...
7
Objectives of quality control
...
72
Occurrence
...
165
Opinion paragraph
...
101
Organizational plan chart
...
171
Ownership of stock
...
167
Peer review
...
54
Pension
...
56
Physical controls
...
170
Planning
...
112
Positive circularization
...
35
Presentation and disclosure
...
9
Procedural audits
...
170
Professional ethics
...
167
Q
Qualification matrix
...
184
Quality control
...
114
Sampling
...
112
Scope of Audit Planning
...
181
Segregation of duties
...
170
Standardized working papers
...
171
Statistical
...
116
Statutory audits
...
139
Stratification
...
96
Substantive tests
...
114
Ratio analysis
...
170
Receivership
...
71
Recurring audits
...
97
Reliability
...
101
Review
...
127
Rights and obligation
...
86, 212, 227
Risk and materiality
...
65
Rotation of duties
...
68
T E X T
R
276
A U D I T IN G AN D A S S U RAN C E
Sufficiency
...
68
Systematic selection
...
167
System documentation
...
227
Tests of control
...
112
Trend analysis
...
15
U
S T U D Y
T E X T
Unqualified opinion
...
8
V
Valid character checks
...
169
Valuation
...
128
W
Working papers
...
138
Written representations
...
170
S T U D Y
T E X T
277
S T U D Y
T E X T
278
A U D I T IN G AN D A S S U RAN C E
S T U D Y T E X T
S T SU TDUYD Y
T E TX ET X T
279
REFERENCES
CHAPTER ONE
S T U D Y
T E X T
280
A U D I T IN G AN D A S S U RAN C E
281
REFRENCES
1
...
Audit and assuarance Study text from Strathmore
S T U D Y
T E X T
3
Title: AUDITING AND ASSURANCE
Description: Audit This is the independent investigation into the quality of published accounting information.
Description: Audit This is the independent investigation into the quality of published accounting information.