Professional Documents
Culture Documents
Advanced Auditing Module Guide
Advanced Auditing Module Guide
GUIDE
ACC 410
Pre –requisites
Students who take on this module should have passed the following modules:
Course assessment
Course work (Written) 30%
Examination 70%
Total 100%
Module Content
5. Other engagements
• Review engagements (ISRE 2400)
Recommended texts
1. Auditing Notes for South African Students, Jackson, R.D.C. & Stent W.J., 2018
2. Advanced Case Studies in External Auditing & Corporate Governance, Prinsloo, F.E.,2018
4. Applied Questions on Auditing, Marx, Van der Watt, Sadler, Van Staden, 6th Edition
CHAPTER 1
RECAP
1.0 Introduction
The role of external audit is often explained in relation to the economic model of agency theory.
Appoint independent
Auditor
Adds credibility
Financial Statements
Measure
Prepare
performance
Appoint
Shareholders Directors
Own Company
Manage
Independent is essential and underlies the value of auditing. There are no certainties and there are
no certifications of correctness or accuracies.
Opinion really means that another auditor could look at his set of financial statements and disagree
with the opinion of another auditor
The determination of fair presentation relates to the financial statements taken as a whole. Fair is
based on the following financial information;
- Information on the financial position – Statement of financial Position
- Information on performance – Statement of comprehensive income and statement of
changes in equity
- Information on changes in the financial position- Statement of changes in Cashflows
Systematic process: it is a logical and purposeful process based on a disciplined and structured
approach to reaching final decisions. It has a logical starting point, proceeds along established
guidelines and has a logical conclusion. It is not haphazard, unplanned or unstructured
Obtaining and evaluating evidence: evidence consists of all types of influences that ultimately
guides auditors decisions and relates to assertions made by management about economic actions
and events (that the revenue recorded on the income statement really occurred, that assets on the
balance sheet actually exists, that the liabilities recorded are complete e.t.c.) as well as assertions
that the financial statement disclosures are fairly presented.
The purpose of collecting and evaluating evidence is to ascertain the degree of correspondence
between assertions made by the information provider and the established criteria i.e. the applicable
financial reporting framework. The auditors will ultimately communicate their findings to
interested parties
The purpose of an audit is to enhance the degree of confidence that intended users can place in the
financial statements. This is achieved by the expression of an opinion by the auditor on whether
the financial statements are prepared in all material respects in accordance with an applicable
financial reporting framework. In short the purpose of assurance services is to:
• increase the confidence
Statutory audits are audits required in terms of an act, such as the Companies act Chapter 24:03.
The statutory duties and responsibilities are spelled out in the act.
Non–statutory(Voluntary) audits on the other hand are requested by clients but are not obligatory
in terms of the relevant legislation.
Reviews are based on inquiry and analytical procedures applied to financial statement amounts,
rather than the more rigorous procedures required in an audit, such as physical inspection and
confirmation with third parties.
The review culminates in a report that provides limited assurance, that is, that the CPA is not aware
of any material modifications that should be made to the accompanying financial statements in
order for them to be in conformity with generally accepted accounting principles.
Reviews are also used for quarterly financial statements of publicly held companies.
Reviews are performed for privately owned companies when the financial statement user wants
some assurance about the statements but do not require the level of assurance provided in an audit.
A review engagement has all the attributes of an audit engagement; however, there are important
differences between a review engagement and an audit i.e.
• For an audit the user will always be the company’s shareholders, whereas for review engagement,
the user could be whoever commissions the work e.g.:
• a bank wanting to know whether to maintain existing or extend further credit facilities
• limited evidence gathering work is performed which is narrower in scope than audit
The objective of a review engagement is to enable the auditor to state whether anything has come
to his/her attention which has caused him/her to believe that financial statements have not been
complied with an identified financial reporting framework in all material respects.
The profession's response was the creation of standards for attestation engagements. In an
attestation engagement, the CPA applies the tools used in audits and reviews to report on whether
the subject matter of the engagement (such as internal control or management's discussion and
analysis of operations) complies with applicable criteria for measurement and disclosure. In
addition, CPAs can apply procedures specifically designed by the expected users of the report to
financial or non-financial items. Levels of service in attestation engagements are limited to
examination and application of agreed upon procedures.
This service is neither an audit nor a review. These engagements, called agreed-upon procedures
engagements, result in a report in which the CPA describes the procedures applied and their results
but provides no overall conclusion.
These are engagements in which a practitioner is engaged to issue a report on subject matter, or an
assertion about subject matter that is the responsibility of another party.
The subject matter of an attest engagement may take many forms, including the following:
c. Historical events (for example, the price of a market basket of goods on a certain date)
f. Behavior (for example, corporate governance, compliance with laws and regulations e.g
ISO, and human resource practices)
8. Compilation: consists of preparing financial statements from a client’s book and records
without performing any evidence-gathering work. This service, provided only to
privately owned companies, is usually done in connection with helping the company
record its transactions and transform its records into financial statements. The accountant
does not do any tests of the underlying data, but helps put the data into financial statement
form and reads the statements for material misstatements. The compilation report
expresses no assurance, but if the accountant discovers material misstatements, they must
be corrected or described in the CPA's report.
The term ‘Assurance’ is sometimes used inconsistently among individual CPA firms, Assurance
Services are expanded independent professional services that improve the quality of information
or its context for decision makers.
1. Independence: Auditors want to preserve their attestation and audit reputations and
competitive advantages by preserving integrity and objectivity when performing assurance
services
The CPA should be independent in order to provide an assurance service; that is, he or she should
have no vested interest in the information reported on.
The CPA's only interest should be the accuracy of the information, not whether the information
portrays results favorable or unfavorable to either the entity that prepares the information or the
one that uses it.
2. Professional services: all work is defined as professional for as long as it involves some
element of judgment based on education and experience
3. Improving the quality of information: auditors can enhance quality by assuring users
about the reliability and relevance of information or making it easier to use and understand.
4. Or its context: context is relevant in a different light. For assurance services improving the
context of information refers to how information is used in decision-makingand how it is
presented e.g. Value Added Statements
5. For decision making: these are consumers of the information. Decision makers are the
users of the information and immediate beneficiaries of the assurance service. They might
be internal to an entity, such as the board of directors, or a trading partner, such as a creditor
or customer.
The decision maker need not be the party engaging the CPA or paying for the service.
Assurance services might involve the type of reports provided in more traditional attestation
engagements or they might provide less structured communications, such as reports without
explicit conclusions or reports that are issued only when there are problems.
Assurance services are often desired to be more customized to information needs of decision
makers in specific circumstances. To be responsive to those needs, the form of CPA
communication is expected to be more flexible.
They differ from many services historically provided by CPAs in that they represent an expansion
of the information and forms of reports provided. Indeed, they represent an evolution in the nature
of services provided by CPAs, as CPAs have begun to provide services not just on accounting
information but on many other types of information that people need in order to make decisions.
While auditing refers specifically to reporting on financial statements and attestation refers to
expressing an opinion on an expanded set of financial information beyond financial statements or
a specified element of financial statement information, assurance includes many areas of
information, including non-financial information.
• financial or non-financial,
• historical or forward-looking,
The CPA identifies and assesses the various risks facing an organization, such as the operating
environment, operating systems, or information systems. The risks might be internal, external, or
regulatory. The CPA can help prioritize the risks and assess the entity's efforts to control or
mitigate risks faced.
Many organizations use, or should use, data to run their businesses other than that emanating from
the financial reporting system. The service deals with identifying or providing explicit assurance
on the financial or nonfinancial measures used to evaluate the effectiveness or efficiency of the
organization's activities. While CPAs have historically been involved in the development of
financial statement information, their skills and knowledge can add similar value to the creation
of other information that can monitor the organization's results and its effectiveness in
implementing strategic plans.
11. Reports on social and environmental issues (e.g. to validate an employer’s claims about
being an equal opportunities employer or a company’s claims about how ‘green’ it is)
disclosure of an entity's business policies and about the controls over privacy and information
integrity in consumer purchases over the Internet.
The CPA assists the increasing population of older adults with a wide range of services such as
bill paying, providing assurance that health care providers are delivering services in conformity
with the client's criteria, and consulting on care alternatives and how to pay for them. The CPA
provides independent, objective information to protect vulnerable clients from potentially
unethical individuals and businesses as well as more traditional services (such as financial control)
for nontraditional clients.
The CPA provides assurance that a company complies with its own policies. The policies—such
as ones involving treatment of women or minorities, conflicts of interest, animal testing,
environmental matters, or customer service—might be based on internal concerns, calls for social
accountability, or laws and regulations e.g. trust funds and non-governmental organisations or
charitable organisations
The CPA provides assurance that the client's trading partners—such as suppliers, customers, or
joint venture partners—have appropriately fulfilled their responsibilities. Common situations
involve collecting rents or royalties based on sales made by another entity or agreements regarding
use of lowest prices or specific billing practices.
The CPA applies the types of services done on a client's records and practices to a potential
acquisition. He or she can, for example, provide insights into the acquisition target's business risks,
appropriateness of accounting methods, the value of its assets, or the adequacy of its systems and
controls.
The needs of decision makers are evolving. For decades their needs were generally met by periodic
cost-based financial statements
This service is neither an audit nor a review. These engagements result in a report in which the
CPA describes the procedures applied and their results but provides no overall conclusion
Thus, a significant difference between assurance and attestation engagements is that assurance
engagements do not necessarily result in a standard form of report, whereas attestation
engagements (and more familiar audits and reviews) do. Yet assurance services require adherence
to key professional qualities by practitioners.
A CPA has both the right and responsibility to be an advocate for the client in arguing tax
positions
A CPA can also provide consulting and advisory services,. But they are prohibited from
performing any client services in which the auditor may find themselves making managerial
decisions or auditing their own firms work
Since decision makers rely largely on information technology, a new need has arisen for various
forms of audit assurance. The degree of satisfaction obtained and therefore the level of assurance
that can be provided is determined the auditability of the financial information, the nature and
extent of the procedures which have been carried out and results obtained.
• The lack of precision often associated with the subject matter – e.g. financial statements are often
subject to estimation and judgment
Irregardless of the scope of an auditors work, the Framework permits only three types of assurance
engagement to be performed:
(We will look at this in detail in the chapters on audit evidence and audit procedures, but for now
let us accept that it means that the practitioner has to do enough work to be able to draw rational
conclusions)
• concludes that the subject matter conforms in all material respects with identified suitable criteria.
Information is material if its omission or misstatement could influence the economic decisions of
users taken on the basis of the financial statements.
(Materiality is another concept which we will consider in detail later. The important point for you
to understand is that the practitioner is not saying that everything is absolutely correct, but that,
broadly speaking, the information given is reliable.)
This means that the report states that in the auditor’s opinion e.g.:
• Financial statements have been prepared in accordance with applicable legislation and
accounting standards
• The company’s employment policy in respect of disabled people isin accordance with
applicable legislation or guidance
• The volume of greenhouse gasses emitting from the company’s factories is within targets set
by government.
– Identifiable
– the practitioner is not aware of any reason for believing that a conclusion expressing a
reasonable level of assurance about the subject matter based on suitable criteria cannot be
expressed.
ii. No assurance
The auditor:
• gathers sufficient appropriate evidence to be satisfied that the subject matter is plausible in the
circumstances
'Nothing has come to our attention that causes us to believe that the financial statements are not
prepared, in all material respects, in accordance with an applicable financial reporting framework'.
The level of assurance given by a reasonable assurance engagement is high, whereas a limited
assurance engagement gives a moderate level of assurance.There is no precise definition of what
is meant by high or moderate in this context.
What is clear is that the confidence inspired in the user by the report produced after a reasonable
assurance engagement is designed to be greater than the outcome of a limited assurance
engagement.
• The evidence gathered needs to be of higher qualityfor a reasonable assurance engagement and
this is reflected in the nature of the opinion given.
The contrast between the objective of the audit as a reasonable assurance engagement and the
expectation that it should lead to the discovery of all errors and fraud is a phenomenon known as
the ‘expectation gap’.
• The lack of precision often associated with the subject matter – e.g. financial statements are often
subject to estimation and judgment
Regardless of the scope of an auditors work, the Framework permits only three types of assurance
engagements to be performed:
(We will look at this in detail in the chapters on audit evidence and audit procedures, but for now
let us accept that it means that the practitioner has to do enough work to be able to draw rational
conclusions)
• concludes that the subject matter conforms in all material respects with identified suitable criteria.
Information is material if its omission or misstatement could influence the economic decisions of
users taken on the basis of the financial statements.
(Materiality is another concept which we will consider in detail later. The important point for you
to understand is that the practitioner is not saying that everything is absolutely correct, but that,
broadly speaking, the information given is reliable.)
This means that the report states that in the auditor’s opinion e.g.:
• Financial statements have been prepared in accordance with applicable legislation and
accounting standards
• The company’s employment policy in respect of disabled people isin accordance with
applicable legislation or guidance
• The volume of greenhouse gasses emitting from the company’s factories is within targets set
by government.
– Identifiable
– the practitioner is not aware of any reason for believing that a conclusion expressing a
reasonable level of assurance about the subject matter based on suitable criteria cannot be
expressed.
v. No assurance
The auditor:
• gathers sufficient appropriate evidence to be satisfied that the subject matter is plausible in the
circumstances
'Nothing has come to our attention that causes us to believe that the financial statements are not
prepared, in all material respects, in accordance with an applicable financial reporting framework'.
The level of assurance given by a reasonable assurance engagement is high, whereas a limited
assurance engagement gives a moderate level of assurance. There is no precise definition of what
is meant by high or moderate in this context.
What is clear is that the confidence inspired in the user by the report produced after a reasonable
assurance engagement is designed to be greater than the outcome of a limited assurance
engagement.
• The evidence gathered needs to be of higher quality for a reasonable assurance engagement and
this is reflected in the nature of the opinion given.
The contrast between the objective of the audit as a reasonable assurance engagement and the
expectation that it should lead to the discovery of all errors and fraud is a phenomenon known as
the ‘expectation gap’.
•Codes of ethics
•Company law.
In addition, Governments have increasingly tried to ensure that audits are conducted by people
who are suitably qualified and whose work is of satisfactory quality – a process known as Audit
Regulation.
In the light of the various corporate scandals which have occurred in the past decade – Enron,
WorldCom, Lehman brothers etc. and of late the Gupta Brothers There is a need for a basis for
this level of trust. The user needs to believe that assurance practitioners act in accordance with a
code of ethics, while the practitioner needs a code of ethics to make sure that he or she is worthy
of that level of trust.
In order to be trusted the auditor needs to be independent of their client. Independence is defined
as ‘freedom from situations and relationships which make it probable that a reasonable and
informed third party would conclude that objectivity either is impaired or could be impaired.’
IFAC has issued a code of conduct which follows a conceptual framework which identifies:
The engagement partner should consider whether members of the engagement team have complied
with ethical requirements (Part A& B of IFAC Code). The fundamental principles of professional
ethics as set out in the code are as follows:
- Integrity;
- Objectivity;
- Professional competence & due care;
- Confidentiality; and
- Professional behaviour
• Self-interest threat
• Self-review threat
• Advocacy threat
• Familiarity threat
• Intimidation threat
Safeguards that may eliminate or reduce these threats to an acceptable level fall into two broad
categories:
1004 The relationship between banking supervisors and banks’ external auditors
1005 The special considerations in the audit of small entities
1006 Audits of the financial statements of banks
1010 The consideration of environmental matters in the audit of financial statements
1012 Auditing derivative financial instruments
1013 Electronic commerce –effect on the audit of financial statements
1014 Reporting by auditors on compliance with international financial reporting
standards
PRE-ENGAGEMENT
ISA 210: Terms of audit engagement.
Question 1
The auditing firm known as Vincent and partners, where you are a manager, recently lost a senior
partner of theirs to one of their most prominent clients, the DevelopOne Limited Group.
DevelopOne Limited Group is a large property developer in Bulawayo, listed on the ZSE. Mr
Kere, the partner in question, had a very long relationship with DevelopOne Limited before joining
them as the financial director. In fact, he went to university with one of the founding members of
the company, John Phiri. He was the senior partner in charge of the audit for the last eight years
and knows their business inside out. The directors of DevelopOne Limited approached him during
the previous financial year with the offer to become the financial director, after the previous
financial director immigrated to Australia. He apparently told his partners at Vincent and Partners
that it was a very lucrative deal in terms of remuneration and that it also included performance
bonuses and share options. As part of the agreement to leave the partnership, Mr Kere promised
that he would try his utmost to ensure that Vincent & partners remained the auditors of the
DevelopOne Group. He kept this promise and the firm was reappointed as auditors. In return, he
insisted on keeping his office in the firm’s building. He intends to do consultation work, especially
in the field of Black Economic Empowerment (BEE), from this office. His new employer is fully
aware of the arrangement and does not have a problem with it.
During the planning of the first audit of DevelopOne Limited and its subsidiaries, with a new
partner in charge, it came to the attention of the audit team that DevelopOne Limited concluded a
BEE deal in order to introduce new broad-based black ownership into the company. The deal
represents an opportunity to a BEE Consortium to obtain an interest in DevelopOne Limited with
the prospect for DevelopOne Limited to grow its business and in doing so increase the value of
the Consortium’s investment. Mr Kere was instrumental in clinching and managing this deal.
• The BEE Consortium will be a 30% shareholder of a newly formed subsidiary of DevelopOne
Limited, which will be called BeeOne (Property) Limited. DevelopOne Limited is the holder of
the other 70% of the shares.
• BeeOne (Property) Limited will buy a 15% stake in DevelopOne Limited and this transaction
will be funded by a loan from DevelopOne Limited. The loan will be interest-free for a period of
three years in order to assist the BeeOne shareholders to establish themselves financially.
• The BEE Consortium consists of two politicians and a number of up-and-coming black business
people.
• BeeOne (Property) Limited appoints Vincent & partners as auditors of the company.
• The Consortium is restrained from having an interest in a substantially similar BEE transaction
in the property sector. The Consortium, through the deal, will be entitled to nominate two new
directors for appointment to the Board of DevelopOne Limited. The Consortium has put forward
their names and although they are technically competent in their respective fields, they are totally
inexperienced as directors.
Two other important transactions came to the attention of the audit team when inspecting the
minutes of directors meetings of DevelopOne Limited:
1. The company bought a piece of land situated next to one of their latest developments in Norton
from Mrs Ndlovhu, the wife of the marketing director of DevelopOne, for a significantly larger
sum compared to current market prices. Mrs Ndlovhu works as an estate agent on a part-time basis,
but bought the property a few months ago with her own money. She was tipped off by her husband
that the company would probably be interested in the property, as it is adjacent to one of their most
popular apartment developments.
2. The company also bought a large piece of land just outside Kadoma, for the purpose of
developing a golf estate. It was noted in the minutes that DevelopOne Limited paid more than the
market value of the adjacent land. While they were still considering the viability of the golf estate
project, the previous owner sold the land to another developer. As a result they had to buy it from
this developer when they eventually decided to go ahead with the project. This developer is a
private company that belongs to Mr Frank (the managing director of DevelopOne Limited) and an
old university friend, who each have a 50% share. They formed the company many years ago to
use should opportunities like these arise. Their sons are now managing the company and identify
investment opportunities on their behalf. The new partner in charge of the audit identified an
opportunity to increase the fee income received from the DevelopOne Group. She convinced
management that the firm should be part of an information technology project to update the
company’s internal controls. The project will specifically aim to ensure that all transactions
between the companies in the group are correctly valued and properly recorded.
You also stumbled upon a piece of interesting information during a social event. One of your
friends, who work at the City Council as a city-planner, told you about a contentious rezoning
application that was approved by the Council. He mentioned the name of the DevelopOne Group
during the conversation.
At the next planning meeting with the management of DevelopOne Limited you enquired about
this issue and the client informed you that they are actually planning a party to celebrate the
rezoning approval. You and the partner in charge of the DevelopOne Group audit attended this
function in order to build client relationships. At the party you overheard Mr Willow remark to Mr
Frank how relieved he was that their “little investment” in the mayor’s holiday fund paid off. It
also became evident from various conversations, that DevelopOne Group desperately needed this
rezoning, as some of their transactions put some strain on the company’s financial position. The
excesses paid for the properties in Sandton and Dullstroom depleted their cash reserves and
additional finance had to be raised.
REQUIRED
(a) Identify all the ethical issues evident from the above scenario and, where appropriate, state the
possible actions or safeguards in terms of the Code of Professional Conduct. (20 marks)
(b) Outline the responsibilities of directors for all of the above transactions in terms of the
Companies Act (5 marks)
Question 2
You are a manager in the audit firm of AlphaΩ and this is your first time you have worked
on one of the firm’s established clients, BetaPLC. The main activity of Beta PLC is providing
investment advice to individuals regardingsaving for retirement, purchase of shares and securities
and investing in tax efficient savings schemes.
You have been asked to start the audit planning for Beta PLC, by Mr Son, a partner in
Alpha&Omega. Mr Son has been theengagement partner for Beta PLC for the previous nine years
and so has excellent knowledge of the client. Mr Sonhas informed you that he would like his
daughter Zoe to be part of the audit team this year; Zoe is currently studyingfor her first set of
fundamentals papers for her CA qualification.
Mr Son also informs you that Mr Far, the audit senior, received investment advice from Beta PLC
during the year and intends to do the same next year. In an initial meeting with the finance director
of Beta PLC, you learn that;
1. The audit team will not be entertained on Beta PLC yacht this year as this could appear to
be an attempt to influence the opinion of the audit. Instead, he has arranged a balloon flight
costing less than one-tenth of the expense of using the yacht and hopes this will be
acceptable.
2. The director also states that the fee for taxation services this year should be based on a
percentage of tax saved and trusts that your firm will accept a fixed fee for representing
Beta PLC in a dispute regarding the amount of sales tax payable to the taxation authorities.
Required:
(a) (i) Explain the ethical threats which may affect the auditor of Beta PLC.(6 marks)
(ii) For each ethical threat, discuss how the effect of the threat can be mitigated. (6 marks)
Question 3
(a) Explain the situations where an auditor may disclose confidential information about a client.
(8 marks)
(b) You are an audit manager in McKay & Co, a firm of Chartered Certified Accountants. You are
preparing theengagement letter for the audit of Ancients, a public limited liability company, for
the year ending 30 June2018.Ancients has grown rapidly over the past few years, and is now one
of your firm's most important clients.Ancients has been an audit client for eight years and McKay
& Co has provided audit, taxation andmanagement consultancy advice during this time. The client
has been satisfied with the services provided,although the taxation fee for the period to 31
December 2017 remains unpaid.
Audit personnel available for this year's audit are most of the staff from last year, including Mr
Grace, anaudit partner and Mr Jones, an audit senior. Mr Grace has been the audit partner since
Ancients became anaudit client. You are aware that Allyson Grace, the daughter of Mr Grace, has
recently been appointed thefinancial director at Ancients.
To celebrate her new appointment, Allyson has suggested taking all of the audit staff out to an
expensiverestaurant prior to the start of the audit work for this year.
Required
Identify and explain the risks to independence arising in carrying out your audit of Ancients for
the yearending 30 June 2018, and suggest ways of mitigating each of the risks you identify.
(12 marks)
QUESTION 10
You are the audit manager in the audit firm of Dark & Co. One of your audit clients is NorthCee
Co, a companyspecialising in the manufacture and supply of sporting equipment. NorthCee have
been an audit client for five yearsand you have been audit manager for the past three years while
the audit partner has remained unchanged.
You are now planning the audit for the year ending 31 December 2018. Following an initial
meeting with thedirectors of NorthCee, you have obtained the following information.
(i) NorthCee is attempting to obtain a listing on a recognised stock exchange. The directors
have established an audit committee, as required by corporate governance regulations,
although no further action has been taken in this respect. Information on the listing is
not yet public knowledge.
(ii) You have been asked to continue to prepare the company's financial statements as in
previous years.
(iii) As the company's auditors, NorthCee would like you and the audit partner to attend an
evening reception in a hotel, where NorthCee will present their listing arrangements to
banks and existing major shareholders.
(iv) NorthCee has indicated that the fee for taxation services rendered in the year to 31
December 2016 will be paid as soon as the taxation authorities have agreed the
company's taxation liability.
(v) You have been advising NorthCee regarding the legality of certain items as 'allowable'
for taxation purposes and the taxation authority is disputing these items.
(vi) Finally, you have just acquired about 5% of NorthCee's share capital as an inheritance
on the death of a distant relative.
Required
a. Identify, and explain the relevance of, any factors which may threaten the independence of
Dark & Co's audit of NorthCee Co's financial statements for the year ending 31 December
2018. Briefly explain how each threat should be managed. (10 marks)
CHAPTER 2
PRE-ENGAGEMENT ACTIVITIES.
2.0 Introduction
Obtaining
engagement
Before accepting the auditor/audit firm should consider potential issues. It should evaluate
compliance with the following issues;
PRELIMINARY ACTIVITIES
However, the second most common way of obtaining new work is by submitting a successful
tender, after being invited to participate in what is frequently referred to as a ‘beauty parade’.
‘Tendering’ is the process of quoting a fee for work before the work is carried out.
In addition to the risk associated with any other new client the specific risks of being involved with
the tender include:
• setting an uncommercially low fee in order to win the contract leading to lowballing
An audit client that has integrity generally results in a problem free engagement. Conversely
despite conducting an audit in line with the generally accepted auditing standards, it is difficult for
an auditor/ audit firm to avoid appearing “guilty by association” with a client that lacks integrity.
With regard to the integrity of client, matters that a firm should consider include for example;
• The identity and the business reputation of the client’s principal owners, management,
related parties and those charged with its governance
• The nature of the clients, operations, including business practices
• Information concerning the attitude of the client’s principal owners, management, related
parties and those charged with its governance towards such matters as aggressive
interpretation of accounting standards and the internal control environment
• Indications of an appropriate limitation of scope of work
• Indications that the client might be involved in criminal activities
• The reasons for the proposed appointment of the firm and non-reappointment of the
previous firm
Information will be obtained through performance of risk assessment procedures consisting of:
• Inquires of management and others inside and outside the entity.
• Observation and inspection.
• Analytical review.
Basic information should be collected directly from the predecessor regarding issues that reflect
directly on the integrity of management. The audit client must of course grant its approval before
the communication can occur between the prospective auditor and the predecessor auditor.
In addition to client acceptance and continuance policies and procedures generally include
Obtaining and reviewing financial information about the prospective client-annual reports, interim
statements, registration statements e.t.c.
• Enquiry of client personnel (boards, audit committees and management),
• Enquiry from third parties e.g. bankers, layers, analyst, etc.
• Enquiry from other auditors with similar clients in the industry.
• Press and media coverage of the client.
• Background searches of relevant databases e.g. detailed criminal background checks for
senior managers
The Engagement partner should take responsibility for the overall quality on each audit
engagement and by this setting an example to all the other members of the engagement team
through all stages of the audit engagement (ISA 220.6-220.7).
1. Perform a client investigation:
The process activities are clearly focused on understanding and managing audit risk. Evaluate the
acceptance of new clients and continuance as auditors for the existing clients (ISA 220.14-220.18).
Consider risks and exposure involved in the process of decision-making to accept a client/not
(Legal liability, reputational damage, etc.).
Consider;
• Independence.( In fact and appearance)
• Integrity of the client.
• Changes in the entity for existing clients.
• Information obtained from communication with the predecessor auditor.
• Financial responsibility of the client.
• Legal procedures prior the engagement.
• Conflict of interest
• The entity’s business standing risk
• Ability to pay the audit fees.
Matters to consider:
i. The number of audit team members in relation to the size of the client.
ii. Firm personnel’s knowledge base of the relevant industry/subject matters.
iii. Firm personnel experience of relevant regularity/reporting requirements or the ability to gain
the necessary skills and knowledge effectively.
iv. Experience of the audit team members, especially that of management (audit seniors).
v. Does the firm have sufficient personnel with necessary skills and competencies?
vi. Use of an expert and/or other third parties, are experts are available, if needed?
ISA 610: Using the work of internal auditors (par 8-9; par A4-A5).
ISA 620: Using the work of an auditor’s expert (par 7; 9; 12-13; par A10-A13, A32-
A40)
vii. Can the audit deadline be met?
viii. ISA 600: Special considerations – Audits of group financial statements (including the work
of component auditors) (par 12-14; par A10-A21).
ix. Compliance with quality control as per SAAPS1 and ISQC1.
Once the terms of the engagement have been established they have to be confirmed through the
engagement letter. When a new client is accepted or when an existing client continues from year
to year an engagement letter is required.
The engagement letter will be sent before the audit, but for an existing auditor continuing to work
for the same client the auditor must issue a new engagement letter if the scope or context of the
assignment changes after initial appointment or there is a change in circumstances.
i. specifies the nature of the contract between the audit firm and the client.
ii. minimises the risk of any misunderstanding of the auditor’s role.
iii. should be reviewed every year to ensure that it is up to date but does not need to be reissued
every year unless there are changes to the terms of the engagement. Many firms of auditors
choose to send a new letter every year to emphasise its importance to clients.(ISA 200.10-
200.11).
It serves as a means for reducing risk of misunderstandings- the expectation gap- with the client
and as a means of avoiding legal liability for claims that the auditors did not perform the work
promised.
The engagement letter is to be sent and the terms agreed with client and signed, preferably before
the commencement of the engagement.
- audit divisions
The engagement partner should ensure that the engagement team has the appropriate capabilities,
competence and time to perform the audit engagement in accordance with professional standards
(ISA 220.19-220.20).
Question 1
You are an audit senior at Storm Incorporated a medium-sized audit firm in Zimbabwe. Storm has
offices in Gweru, Mutare and Bulawayo, and the head office is situated in Harare. Storm has a
workforce of 200 employees, including 12 partners.
In March 2017, the Board of Directors of Whatsapp (Pvt) Ltd awarded a tender to Storm for the
audit of Whatsapp. Whatsapp is one of the largest mobile communication companies providing
voice and data services in Zimbabwe. Whatsapp (Pvt) Ltd will be the largest client of Storm in
terms of fee revenue.
After completing the preliminary engagement activities, the audit partner requested one of the
trainee accountants assigned to the audit, to prepare a draft engagement letter to be issued to
Whatsapp (Pvt) Ltd. The draft engagement letter is shown below.
Storm
P.O Box 777
Harare
26 March 2017
The Accountant
Whatsapp (Pvt) Ltd
PO Box 333
Harare
Dear Sir/Madam
We will conduct our audit in accordance with International Standards on Auditing, the Code of
Professional Conduct of the Institute of Chartered Accountants of Zimbabwe (ICAZ) and the
Companies Act Chapter 24:03. The standards require that we plan and perform the audit to obtain
assurance about whether the financial statements are free of material misstatements.
The procedures selected will depend on the auditor’s judgement, including the assessment of the
risks of material misstatement of the financial statements, whether due to fraud or error. An audit
involves performing procedures to obtain audit evidence about the amounts and disclosures in the
financial statements.
An audit also includes evaluating the appropriateness of accounting policies used and the
reasonableness of accounting estimates made by management, as well as evaluating the overall
presentation of the financial statements.
In making our risk assessments, we consider internal control relevant to the entity’s preparation of
the financial statements in order to design audit procedures that are appropriate in the
circumstances.
Our statutory audit will include the expression of an opinion on the effectiveness of the entity’s
internal control. We remind you that the responsibility for the preparation of financial statements
and their fair presentation is that of the management of the company. This responsibility includes
the maintenance of adequate accounting records and internal controls that management determines
is necessary to enable the preparation of financial statements that are free from material
misstatement, whether due to fraud or error.
We confirm our agreement to accept a management representation letter signed by the financial
director as sufficient appropriate audit evidence on the revenue and inventory accounts.
We look forward to full cooperation with your staff, as the daughter of the financial director is
included in the audit team. We trust that your staff will make available to us whatever records,
documentation and other information we may request in connection with the audit.
Our audit fees, which will be billed as work progresses, It will be$25 000 (including VAT and
excluding disbursements) and will not be adjusted for a period of five years. The audit fee to be
charged is 15% lower than the fee charged by the previous auditors.
In addition to the statutory audit we will prepare calculations of current and deferred tax liabilities
(or assets) for Whatsapp Pvt Ltd. The fee for these calculations will be charged at 10% of the
resulting tax refund.
The maximum liability of Storm Incorporated for any claims resulting from any services rendered
in terms of this engagement letter shall be limited to an amount equal to twice the fees billed.
This letter will be effective for future years unless the agreement is terminated or amended with
our consent.
Yours faithfully
Required:
Critically discuss your concerns with regards to the draft engagement letter prepared by the trainee
accountant. Your answer should comprise the following:
i. The requirements in terms of ISA 210: Agreeing the terms of Engagement of audit
engagements (10 marks)
ii. The requirements in terms of the IFAC Code of Professional Conduct (10 marks)
Question 2
You are a senior audit manager at Captain and Morgan Incorporated, a firm of chartered
accountants. You joined the firm six (6) years ago, after spending two (2) years in New Zealand
at one of the big four audit firms as an audit manager. Shortly after arriving back in Zimbabwe,
Captain and Morgan head-hunted you and made you an offer you could not resist. They offered
you a favourable package and a good client profile.
Captain and Morgan recently won a tender to audit Ram (Pvt) Ltd, a dairy and free-range livestock
farm, for the year ended 31 December 2018. You are currently engaged in planning the 2018 year-
end audit for Ram Pvt (Ltd) and you obtained the audit file from the audit senior, which includes
the New client pre-acceptance questionnaire shown below.
Client Ram (Pvt) Ltd Year-end 31 Dec 2018
Prepared by Audit senior Date 11 Feb 2018
Subject New client pre-acceptance questionnaire
Services to be provided:
1. The statutory audit
2. Completion of the tax return and assisting management in preparing the financial statements
The potential client has demonstrated X The fee for statutory audit work is of little
both the willingness and the ability to consideration, since high fees will be
settle the fees for services rendered. charged for tax services and preparation
of financial statements.
There is no evidence of a history of X
litigation by the potential client
against its auditors.
The previous auditor has resigned X
or was removed in compliance with
the Companies Act.
The client is agreeable to the terms of X The client has signed the letter but has
engagement contained in the standard expressed reservations regarding the
audit engagement letter. right of access of the external audit staff
to the clients’ shareholders register.
Contact previous auditor to confirm X Done telephonically by the engagement
no professional reason not to partner.
accept the engagement.
Required:
Discuss, with reference to the New client pre-acceptance questionnaire, your concerns
regarding the acceptance of Ram (Pvt) Ltd as audit client. (25)
CHAPTER 3
3.0 Introduction
PRE-ENGAGEMENT ACTIVITIES
Perform a client
investigation: Terms and conditions
The process activities of the audit
Determine skills and Engagement
are clearly focused on competence
understanding and requirements for the Documentation of
managing audit risk. engagement procedures performed
Consideration of with regard to
Evaluating the whether the acceptance of a new
acceptance of new engagement would client/continuance with
clients and require special engagement clients.
continuance as attention or involve
auditors for the unusual risks. Issuance of an
existing clients (ISA engagement letter to
220.14-220.18). Engagement being those charged with
taken only if the audit governance
We have already discussed how before beginning to work on an audit, the auditor must complete
Consideration of risks firm has the skills,
a number of required pre-engagement activities that help to determine whether to accept a new
and exposure involved competence,
client or agree to work with an existing client.
in the process of necessary staff and
3.1 Why
decision-making plan?
to experience to provide
accept
The a client/not
auditor should plan the auditan
so thateffective and will be performed in an effective
the engagement
efficient
manner.(ISA 300: Planning an audit audit.Statements para 2)
of financial
The purpose of all this is to ensure that the risk that the financial statements may be misstated is
reduced to an acceptable level.
An audit is:
• an expensive process
• a potentially complex project which needs to be managed effectively.
Although it is tempting to assume that it is simply a question of following a tried and tested
programme and that the important thing is to ‘get busy’, the extra time spent planning the
engagement properly will repay itself by:
• Ensuring the right team is selected for the assignment.
• Ensuring that staff are employed effectively rather than simply ‘given something to do’.
• Ensure that assignment of engagement teams is done with consideration of effectiveness
and efficiency
• Ensuring the work is properly focused on material areas of risk.
• Identifying potential problem areas and resolving them on a timely basis
• Ensuring that the nature and quantity of the work done addresses the risks and problem
areas.
• Ensuring the work can be fully completed in time for the review process.
• Enabling deadlines to be met so that there is time for due consideration of the important
issues.
• Assists in co-odination, review, supervision and direction of work done by auditors
Planning is not a discrete phase of an audit, but rather a continuous and iterative process that often
begins shortly after( or in connection with) the completion of the previous audit and continues
until the completion of the current audit engagement.
Assessing risk
Assessing materiality
Everything in the planning process is about the auditor’s response to assessed risk. There are two
sources of information from which it is possible to assess risk:
Auditors should have or obtain a KOB which is sufficient to enable them to identify and understand
the events, transactions and practices that may have significant effect on financial statements or
the audit thereof
The auditors level of knowledge for an engagement normally includes;
i. General knowledge of the economy and industry within which the organisation operates
ii. Particular knowledge of how the entity operates
• Analytical procedures
Information is material if its omission or misstatement could influence the economic decisions of
users taken on the basis of the financial statements.
3.2.2.1 Scope
Determine the characteristics of the engagement that define the scope of the audit.
i. What is the financial reporting framework for the financial statements?
• National GAAP?
• International Accounting standards?
• IFRS’s
Are there other factors which influence the overall approach to the audit?
3.2.2.2 Timing
Ascertaining the reporting objectives of the engagement so to plan the timing of the audit and the
nature of the communication required such as deadlines for:
• final reporting
• any interim report
• key dates for expected communications with management and to those charged with governance.
It is always good, when managing a project (even an audit) to start with the completion date and
work backwards.
Late enough:
– to enable sufficient work to be done to ease the pressure on the final audit.
providing the results can be satisfactorily ‘rolled forward’ to the statement of financial position
date. (A roll forward reconciles the movements between the date of the count or circularisation
and the year end date.)
The final audit can then focus on:
• statement of financial position areas
• finalisation of the financial statements and the audit report.
For an interim audit to be justified the client normally needs to be of a sufficient size, although, if
reporting deadlines are very tight it may be possible to audit up to ‘Month 11’ and then ‘roll
forward’ to the statement of financial position date.
1.2.2.3 Direction
Considering the important factors that will determine the focus of the engagement teams
efforts. The ‘direction’ of the audit covers the overall approach and concerns such issues as:
• Preliminary assessment of materiality
• Preliminary identification of high risk areas
• Preliminary identification of material components and account balances.
• Evaluation of whether the auditor may plan to obtain evidence regarding the effectiveness of
internal controls
• Preliminary identification of any significant entity-specific, industry, financial reporting and
other relevant developments
Component – A division, branch, subsidiary, joint venture, associated company or other entity
whose financial information is included in financial statements audited by the principal auditor.
• Decisions about whether assurance is expected to be derived from reliance on controls or a fully
substantive approach.
• The need for site visits and other logistical issues.
• The impact of recent developments at the client, in its industry, inregulatory or financial reporting
requirements.
If their work confirms that, or is unable to conclude whether, the financial statements are materially
misstated as a result of fraud, the auditors need to consider the implications for their audit.
There is no requirement in the auditing standards for the auditor to detect any fraud or errors,
though they are required based on the risk assessment, to design audit procedures to obtain
reasonable assurance that misstatements arising from fraud and error that are material to the
financial statements taken as a whole are detected
The external auditor is responsible for identifying material misstatements in the financial
statements in order to ensure that they give a true and fair view. By definition then, the external
auditor is responsible for detecting any material fraud that may have occurred as this will lead to
a material misstatement.
However, they have no specific responsibility with regard to immaterial fraud. As with
immaterial errors, if they identify them they will be reported to those charged with governance,
but there is no duty to identify them.
The auditor cannot guarantee that the financial statements are free of all fraud and error because
of the inherent limitations of the audit, for example the use of sampling.
The risks in respect of fraud are higher than those for error because of the possibility of
concealment and collusion between staff.
In order to have a chance of detecting fraud the auditor must maintain an attitude of professional
skepticism when performing their work which involves keeping an open mind to the possibility
of fraud occurring.
POSSIBLE
STRATEGIES
The nature of the client’s business and structure will have a huge impact on the appropriate strategy
• Clients with multiple sites, such as retail chains or manufacturers with a number of factories, will
require the planning of a programme of site visits, perhaps on a rotational basis.
• Finance companies where the confirmation of a bewildering number of bank balances is crucial
to the audit.
• The need to use experts, e.g.
– specialist inventory checkers in the restaurant and pub trade or for livestock
– surveyors and valuers for property companies
– actuaries for pension schemes.
There is no point:
• Recommending a receivables circularisation for a client with cashsales.
• Suggesting an inventory count for a software company whose work in progress consists of the
unamortised costs of developing its products.
Analytical
review
Assess materiality
Design procedures to
get it
The relationship between the audit strategy and the audit plan
Whilst the strategy sets the overall approach to the audit, the plan fills in the operational details of
how the strategy is to be achieved.
STRATEGY
PLAN
PRECEDURES
In order to demonstrate that it has taken place and that the standard has been complied with, there
will need to be evidence, usually in the form of minutes of the discussion meeting.
Analytical procedures are usually carried out at three stages of the audit process. They are
mandatory at the planning and final review stages. At the substantive testing stage, they are one of
several methods for obtaining evidence, so may not be appropriate in some circumstances.
comparison of financial information with prior periods, budgets and forecasts and similar
industries.
At the planning stage, analytical procedures are used for two main reasons:
• To help understand the client’s financial statements
• To help spot possible errors.
If errors look possible, the audit work will be directed towards those errors.
3.3 Materiality
We have already seen the definition of materiality; ‘Information is material if its omission or
misstatement could influence the economic decisions of users taken on the basis of the financial
statements (ISA 320 para 3: Audit Materiality).
What are the implications for the work the auditors do?
Auditors will:
• Need to examine all items in the financial statements which are material
BUT
• they will also need to design tests to give assurance that material amounts have not been omitted
from the financial statements
AND
• they will need to allow for the fact that a number of immaterial errors could together add up to a
material misstatement.
but these are up to the judgment of the auditor. As a result, different firms use different measures.
Any calculation done is very flexible, and may have to be reassessed during the audit (if for
example many large errors are found).
Tolerable error is considered during the planning stage, and for substantive procedures, is related
to the auditor's judgement about materiality.
Most firms will use ‘audit packs’ – pre-printed or computerised documents and checklists to ensure
that the requirements of ISAs have been followed.
Amongst matters required to be considered by the auditor when planning the audit in accordance
with the requirements of ISA 300: Planning an Audit of Financial Statements are those of
‘materiality’ and the ‘direction, supervision and review’ of the audit.
Question 1
a) State the objective of the statutory audit and explain how carrying out the audit in
accordance with ISAs helps the auditor to achieve that objective. (4 marks)
b) ISA 315:Identifying and assessing the risks of material misstatement through
understanding the entity and its environment sets out matters that should be
documented during the planning stage of an audit.
Required
List six matters that should be documented during audit planning. (3 marks)
c) ISA 230: Audit documentation provides guidance to auditors in respect of audit working
papers.
Required
List six factors which affect the form and content of audit working papers. (3 marks)
Question 2
During the planning process, the auditor will develop an audit strategy and also produce a detailed
audit plan. They will also make an assessment of the level of materiality to be used during the
audit.
Required
a) State the purpose of the 'audit strategy' and describe two areas that would be covered by the
audit strategy. (3 marks)
b) Explain what an 'audit plan' is and give two examples of items that would ordinarily be
included in the audit plan. (3 marks)
c) Define the term 'performance materiality' and explain how it is determined. (4 marks)
(Total = 10 marks)
Question 3
Auditors are required to plan and perform an audit with professional scepticism, to exercise
professional judgement and to comply with ethical standards.
Required
(a) Explain what is meant by 'professional scepticism' and why it is so important that the auditor
maintains professional scepticism throughout the audit. (3 marks)
(b) Define 'professional judgement' and describe two areas where professional judgement is
applied when planning an audit of financial statements. (3 marks)
(c) Discuss the importance of assessing risks at the planning stage of an audit. (4 marks)
(Total = 10 marks)
Question 4
Your firm, ABC & Co, has been appointed as the auditor of Visual Reflections PLC, a large
company. The company sells televisions, DVD players and Blu-ray Disc players to electrical
retailers.
You are planning the audit for the year ended 31 January 2018. The audit for the year ended 31
January 2017 wascarried out by another firm of auditors.
Question 5
Tshuma & Co, a firm of Chartered Certified Accountants, has recently obtained a new audit client,
Tenda Brothers Pvt Ltd whose year end is 31 December. Tenda Brothers Pvt Ltd requires its audit
to be completed by the end of February; however, this is a very busy time for Tshuma & Co. and
so it intends to use more junior staff as they are available. Additionally, in order to save time and
cost, Tshuma & Co. has not contacted Tenda Brothers Pvt Ltd previous auditors.
Required
(a) Describe the steps that Tshuma & Co should take in relation to Tenda Brothers Pvt Ltd:
(i) Prior to accepting the audit (5 marks)
(ii) To confirm whether the preconditions for the audit are in place (3 marks)
(b) State four matters that should be included within an audit engagement letter. (2 marks)
(Total = 10 marks)
CHAPTER 4
RISK
AUDIT APPROACH
PRE-DETERMINED
TESTS AUDIT PRECEDURES
ADAPTED TO CLIENTS’
CIRCUMSTANCES
When doing an audit, auditors can take one of two basic approaches:
• Procedural
The auditor carries out a set of standard procedures and tests regardless of the particular nature of
the client.
• Risk-based.
The auditor plans the audit around the risks that the client’s financial statements may contain
misstatements, whether as a result of fraud or error.
As such, each audit will involve different priorities, different tests, and will take different lengths
of time.
Traditionally, auditors have followed a risk-based approach, as this should minimise the chance of
them giving the wrong opinion. It also helps to ensure that audit work is carried out as efficiently
as possible, as assurance is obtained using the most effective tests.
A potential conflict of interests always exists between the auditors and the management of the
enterprise under the audit. Management wants to present the company in the best possible light,
while auditors must ensure that the information about the company’s financial condition is
presented fairly.
If the auditor needs to conduct the audit with an attitude of professional scepticism, he or she needs
to ask the question, ‘So what could go wrong?’
Although the key to risk assessment is to do it as part of the planning process, it is important to
understand that:
• Risk can be uncovered at any stage of the audit.
• In the light of the work done the level of risk may be reappraised.
• The review and completion phase of the audit has to confirm that the risk of material misstatement
has been reduced to an acceptable level.
4.3 The impact of ISA 315 : Identifying and assessing the risk of
material misstatement through obtaining an understanding the
entity and its environment
Audits conducted under ISAs must follow the risk-based approach. It affects:
• how audits are planned
• the sources of assurance
• the nature of audit evidence gathered by the auditor
• the nature of the procedures carried out by the auditor
ISA 315: Identifying and assessing the risk of material misstatement through obtaining an
understanding the entity and its environment
Put simply, it says when you do an audit you have to:
• Assess the risk.
• Address the risk.
• Review the results to make sure that the risk of material misstatement has been reduced to an
acceptable level.
As well as considering the entity as a whole, the auditor needs to assess whether individual
headings in the financial statements or assertions about those items, carry increased levels of
inherent risk.
Management makes a number of assertions about items in the financial statements – whether they
exist, their value, whether all are included, whether they are recognised in the correct accounting
period etc. which we will consider in detail in the chapter on audit evidence.
The client therefore needs to make a judgement about whether the benefits of the control outweigh
the costs of implementing it.
• the installation of new equipment
• the employment of extra staff
• the time taken by additional administrative procedures.
• How much ‘shrinkage’ would there need to be to make it worthwhile employing a store detective
or installing electronic tags and detectors?
In other words it is the risk that the sample may not be representative. On the other hand any other
risks that the auditor may come to the wrong conclusion are referred to as non-sampling risk e.g.:
• by misinterpreting the results of a test
• by using inappropriate procedures
• by failing to investigate a particular balance or transaction
• because a member of the client’s staff misleads the auditors.
Non-sampling risk is defined as arising from factors that cause the auditor to reach an erroneous
conclusion for any reason not related to the size of the sample.
This involves the various risks being assessed (often using a checklist of relevant questions) and
being issued a ‘score’, a process that may be carried out using software.
Inherent risk and control risk cannot be directly influenced by the auditor, as they relate to the
nature of the entity and its systems. Together these two risks are known as the Entity risk. The
only risk that the auditor can change is detection risk.
Therefore, once inherent and control risk have been assessed, and with a maximum overall audit
risk ‘score’ in mind, detection risk can be manipulated to make the audit risk an acceptable level.
Detection risk will be a major variable in determining the extent of audit procedures, e.g. sample
sizes for audit tests. If control risk and inherent risk are deemed low because the entity is not
particularly risky and the its controls are effective, the auditor will place reliance on these factors.
Detection risk can be allowed to be higher and still give an acceptably low level of audit risk. If
detection risk needs to be low because the client is inherently risky or controls are not effective,
the auditor will increase the sample size and/or use more experienced staff.
Lack of physical Employees are more Physical checks of the Control risk
controls likely to steal assets assets required to
• Valuable assets not from the company or determine
being locked away. not look after them; completeness and
• No restricted access therefore they get value.
to sensitive areas. damaged and become
• No CCTV or other impaired. Analytical review to
security measures for see any unusual
access to premises. Incorrect statement of trends.
Financial statements
valuer to value
inventory
Consider using a
Substantive approach
Check opening
balances are correct
Tight audit Staff working quickly Increase substantive Detection risk
to a tight deadline are Testing
Question 1
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 2018.
Rock is a company listed on a stock exchange. 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.You have worked on the audit of this client for
several years as an audit junior.
Required:
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
2018. (10 marks)
Question 2
(a) Explain the purposes of planning an audit. (4 marks)
(b) You are the audit supervisor of Bluebird & Co and are currently planning the audit of
your existing client, Bridgford Products Co, a listed company. During a recent visit to
the company you obtained the following information:
The management accounts for the first 10 months of the year show a significant
increase in revenue and profit compared to the prior year. This was achieved by
attracting new customers by offering extended credit. The new credit arrangements
allow customers three months credit before their debt becomes overdue, rather than
the one month credit period allowed previously. As a result of this change, receivables
days have increased from 55 to 123 days.
Unfortunately there have been some recent reliability problems with the company’s
products, which have resulted in legal claims being brought against the company by
customers, and customers refusing to pay for the products. Partly as a result of this the
chief financial officer and purchasing manager were dismissed on 15 August. A
replacement purchasing manager has been appointed but it is not expected that a new
chief financial officer will be appointed before the year-end of 31 January 2019. The
accounts supervisor will be responsible for preparing the financial statements for audit.
The company installed a new computerised inventory control system which has
operated from 1 June 2018. As the system records inventory movements and current
inventory quantities the company is proposing to use the inventory quantities on the
computer as a basis for the year-end inventory figure rather than carrying out a full
year-end count as has happened in previous years. Test counts have been carried out
on a monthly basis.
Required:
Explain FIVE audit risks, and explain the auditor’s response to each risk, in
planning the audit of Bridgford Products Co. (10 marks)
Question 3
Your firm has been invited to tender for the audit of Phones Anywhere for the year ended
31 December 2013. Phones Anywhere was established two years ago, and it provides a
mobile phone service for individuals and businesses. All the shares are owned by three non-
executive directors who do not plan to make any further investment in the company.
Currently the local relay stations cover one large city with a population of about 1,000,000.
The cost of the relay stations and central computer are capitalised and depreciated over six
years.
Within the next year the directors hope that the system will cover all cities with a population
of over 250,000 in the country. By 2018, the system will cover all motorways and cities with
a population of over 100,000. Establishing the network of relay stations and subscribers will
result in the company making losses for at least three years. Extending the coverage of the
system will involve considerable capital expenditure on new relay stations and require
additional borrowings. Current borrowings are about 20% of shareholders’ funds. To obtain
additional finance the owners plan to list the company on a Stock Exchange in 2016. The
listing will involve issuing new shares to the general public to provide funds for the
company, and the three non-executive directors selling some of their shares.
You are aware that Phones Anywhere has a number of very large competitors, each of which
has a large number of users and comprehensive coverage (over 90% of the population are
within range of a relay station).
Required:
(a) Explain FIVE audit risks, and explain the auditor’s response to each risk relevant
to Phones Anywhere. (10 marks)
(b) Describe the substantive procedures the auditor should perform to obtain
sufficient and appropriate evidence in relation to:
(i) Capital expenditure (5 marks)
(ii) Borrowings (3 marks)
(iii) Share capital (2 marks)
(Total: 20 marks)
Question 4
(a) Explain why it is important to plan an audit. (5 marks)
(b) You are the audit manager in charge of the audit of Tempest, a limited liability
company. The company’s year-end is 31 December, and Tempest has been a client for
seven years. The company purchases and resells fittings for ships including anchors,
compasses, rudders, sails etc. Clients vary in size from small businesses making yachts
to large companies maintaining large luxury cruise ships. No manufacturing takes
place in Tempest.
Information on the company’s financial performance is available as follows:
Other information
The industry that Tempest trades in has seen moderate growth of 7% over the last year.
• Non-current assets mainly relate to company premises for storing inventory. Ten
delivery vehicles are owned with a carrying value of $300,000.
• One of the directors purchased a yacht during the year.
• Inventory is stored in ten different locations across the country, with your firm
having offices close to seven of those locations.
• A computerised inventory control system was introduced in August 2019.
Inventory balances are now obtainable directly from the computer system. The
client does not intend to count inventory at the year-end but rely instead on the
computerised inventory control system.
Required:
Using the information provided above, prepare the audit strategy for Tempest
for the year ending 31 December 2019. (15 marks)
(Total: 20 marks)
CHAPTER 5
If the auditor is able to rely on the system it will be because it contains some of the components of
internal control as set out in ISA 315. A company’s management has a number of obligations:
• To manage the business effectively.
• To produce timely, and accurate financial statements and management information (both for
management and statutory purposes).
• To safeguard the business’ assets.
• To prevent and detect fraud.
Logically, the more reliable a system is the more accurate its output will be as more reliable
information will lead to better decision making.
It follows, therefore, that to form a view about the extent to which internal control can be relied
upon, the auditor will need to:
– understand how the system works
– understand the controls within the system
– test whether or not the controls are effective.
ISA 315 states that there are five components of internal control:
C R I M E
ISA 315 states:'The auditor should obtain an understanding of the information system, including
the related business processes, relevant to financial reporting.' ISA 315 assumes that the vast
majority of systems are IT based – see below about application controls and general controls in IT
systems.
5.6.1Application controls
Application controls are controls that are built into the system, e.g.
• Arithmetic checks
• Range checks
• Validation checks
• Quickbooks, the small business accounting package, for example, willnot let you enter a sale
until you have set up an ‘item’, which means youhave to allocate the sale to a revenue account, set
up the customer as areceivable, decide on VAT treatment, etc.
• Some systems will not let you reverse or delete entries so that all errors have to be corrected
through the use of journals. This may be seen as a strength, because all entries must leave an ‘audit
trail’, although the system can be so cumbersome to operate and correcting journals become so
difficult to follow, that the operational difficulties created outweigh the benefits of the control.
If the systems produce the financial statements then we can test the systems because that is
ultimately testing the financial statements. If the internal controls are strong then we can have the
confidence the financial statements are accurate. From an audit point of view the systems can be
tested and if the tests confirm the system is being complied with, then the auditor can assume the
financial statements are accurate.
The size of the transaction is irrelevant.This is known as a test of control or compliance testing.
For example, if, when auditing the ‘bank and cash’ figure, an auditor is toldthat the client performs
bank reconciliations at the end of every month and the auditor looks for evidence that this
reconciliation is indeed taking place every month, and is done properly, a test of control has been
performed.
This is one possible source of assurance that the financial statements are not materially misstated.
It is also compulsory as stated in ISA 315:‘The auditor should obtain an understanding of the
information systems, including the related business processes, relevant to financial reporting.’ISA
315 para 81
Nevertheless ISA 315 insists that for material areas some substantivetesting needs to be carried
out.The reason for this is that there are limitations to the reliance that can beplaced on internal
control because of:
• human error in the use of judgement
• simple processing errors and mistakes
• collusion of staff in circumventing controls
• responsible people abusing that responsibility to override controls.
The chart below shows the decisions to be taken which depend on theeffectiveness of controls and
the impact on the audit plan if they are foundnot to be effective.
• It may be more efficient and cost effective not to rely on controls at all asa source of assurance
(but we need sufficient assurance from othersources).
• It is possible that, even though the controls are not as effective as wewould like, and the risk of
misstatement may be increased, it may stillbe at an acceptable level.
• If we do need to amend the plan, it is not simply a matter of increasingthe number of items we
test.
YES
NO
NO ALTERNATIVE
EVIDENCE
AMMEND
PLAN
INCREASE BUT
MUST BE
If we need to change the plan as you can see from the diagram, there are two possibilities:
TESTING
EFFECTIVE
• Find an alternative source of assurance.
• Increase the extent of testing.
Possibilities are:
Alternative sources
• external confirmation
• analytical procedures
• management representations (be careful with this one – you cannotsimply rely on what the client
tells you, because your opinion has to beindependent – but representations may add to the sum
total ofevidence).
• If the risk increases you would normally increase the extent of your auditprocedures.
BUT
• The evidence you gather must always be relevant to reducing the risk(simply looking at more
incorrect invoices will not achieve anything).
• The increase in sample size may need to be substantial. (The originalstatistical studies –
admittedly carried out when manual systems werethe norm – indicated that sample sizes needed
to be tripled tocompensate for poor internal control.)
In particular, the auditor ordinarily increases the extent of auditprocedures as the risk of material
misstatement increases. However,increasing the extent of an audit procedure is effective only if
theaudit procedure itself is relevant to the specific risk; therefore, thenature of the audit procedure
is the most important consideration.’ISA 330 Para 18
This is a summary of the sales cycle, showing the possible problems andthe related controls:
When GDN is
raisedcheck it matches
with the
customer order
(stapletogether and file)
Use sequentially
numbered GDNs, file
acopy numerically and
check that they are
allthere
Credit notes to be
allocated to invoice
itrelates
Authorised by
managersequence check
done ona regular basis
Computer controls
Double check back
toinvoice
Perform receivables
ledger control account
reconciliation
Customerstatements
sent out (customers
letyou know if error)
Refer receivable to
solicitor
Class discusssion
Rhapsody Co supplies a wide range of garden and agricultural productsto trade and domestic
customers. The company has 11 divisions, witheach division specialising in the sale of specific
products, for example,seeds, garden furniture, agricultural fertilizers. The company has aninternal
audit department which provides audit reports to the auditcommittee on each division on a
rotational basis.
Products in the seed division are offered for sale to domestic customersvia an Internet site.
Customers review the product list on the Internet andplace orders for packets of seeds using
specific product codes, alongwith their credit card details, onto Rhapsody Co's secure server.
Orderquantities are normally between one and three packets for each type ofseed. Order details are
transferred manually onto the company's internalinventory control and sales system and a two part
packing list is printedin the seed warehouse. Each order and packing list is given in a
randomalphabetical code based on the name of the employee inputting theorder, the date and the
products being ordered.
In the seed warehouse, the packets of seeds for each order are takenfrom specific bins and
despatched to the customer with one copy of thepacking list. The second copy of the packing list
is sent to the accountsdepartment where the inventory and sales computer is updated to showthat
the order has been despatched. The customer's credit card is thencharged by the inventory control
and sales computer. Bad debts inRhapsody are currently 3% of the total sales.
Finally, the computer system checks that for each charge made to acustomer's credit card account,
the order details are on file to prove thatthe charge was made correctly. The order file is marked
as completedconfirming that the order has been despatched and payment obtained.
Required:
In respect of sales in the seeds division of Rhapsody Co, prepare areport to be sent to the audit
committee of Rhapsody Co which:
(i) identifies and explains FOUR weaknesses in that sales system;
(ii) explains the possible effect of each weakness; and
(iii) provides a recommendation to alleviate each weakness. (14 marks)
SOLUTION
Report to audit committee
Seed Division
12 June 2007
The internal audit of the inventory and sales system identified the following weaknesses:
Control over orders and Packing lists can be lost Orders/packing lists are
packing lists resulting either in goods not controlled with a numeric
Each order / packing list is being despatched to the sequence. At the end of each
given a random alphabetical customer (if the list is day, gaps in the sequence of
code. While this is useful, lost prior to goods being packing lists
using this type of code makes despatched) or the customer's returned to accounts are
it difficult to check credit card not being charged investigated.
completeness of orders at any
We look forward to arranging a meeting to discuss these weaknesses with you in more detail.
This is a summary of the purchases cycle, showing the possible problemsand the related controls:
The table shows the various stages of the purchases ‘cycle’, together with:
• the risks (what could go wrong)
• control procedures (so that things don’t go wrong!).
Check inventory
levelsfirst
Check quoted
priceagainst supplier
price list
(discounts to contract)
Check
invoicecalculations
Supplier statement
reconciliation
One suggested way to design tests of control for a particularsituation is to list the documents in a
transaction cycle and generateappropriate tests of control for each document.
• Obtain the ledger recording purchase orders; ensure each page hasbeen signed by a responsible
official to confirm all orders have beenrecorded and there are no gaps in the sequence of orders.
• Obtain a sample of purchase invoices; ensure each invoice has beensigned by a responsible
official to confirm checks on the invoice havebeen completed and the invoice is passed for
payment.
• Obtain a sample of credit notes; ensure each credit note is signed by aresponsible official to
confirm credit note details (goods descriptionand quantity) have been agreed to the relevant goods
returned note.
• Review the purchase order for the relevant signature for approval.
• Review purchase invoice for evidence that the invoice has beenreviewed and checked.
• Review purchase invoice for initialling of the grid stamp.
• Review/observe the supplier reconciliation note to ensure the controlhas been complied with.
Class discussion
You are carrying out the audit of the purchases system of SpondonFurniture. The company has a
turnover of about $10 million and all theshares are owned by Mr and Mrs Fisher, who are non-
executivedirectors and are not involved in the daytodayrunning of the company.
The bookkeeper maintains all the accounting records and prepares theannual financial
statements.The company uses a standard computerised accounting package.You have determined
that the purchases system operates as follows:
• When materials are required for production, the production managersends a handwritten note to
the buying manager. For orders of otheritems, the department manager or managing director
sendshandwritten notes to the buying manager. The buying manager findsa suitable supplier and
raises a purchase order. The purchase orderis signed by the managing director. Purchase orders are
not issuedfor all goods and services received by the company.
• Materials for production are received by the goods receiveddepartment, who issue a goods
received note (GRN), and send acopy to the bookkeeper. There is no system for recording receipt
ofother goods and services.
• The bookkeeper receives the purchase invoice and matches it withthe goods received note and
purchase order (if available). Themanaging director authorises the invoice for posting to the
purchaseledger.
• The bookkeeper analyses the invoice into relevant nominal ledgeraccount codes and then posts
it.
• At the end of each month, the bookkeeper prepares a list ofpayables to be paid. This is approved
by the managing director.
• The bookkeeper prepares the cheques and remittances and poststhe cheques to the purchase
ledger and cashbook.
• The managing director signs the cheques and the bookkeepersends the cheques and remittances
to the payables.
Mr and Mrs Fisher are aware that there may be weaknesses in the above system and have asked
for advice. Identify the weaknesses in controls in Spondon’s purchases system, explain what the
impact is and suggest improvements.(12 marks)
SOLUTION
Therefore overspending or
potentialshock outs due
toorders not being
processed.
It doesn't statethat the GRN Goods received thatare of Agree GRN back to the
arechecked toanything. poor quality orincorrect purchase order.
amounts.
5.10.3 Payroll
Objectives of controls
The objectives of controls for the payroll cycle are to ensure that thecompany will:
• pay the right people
• at the right rate
• for valid work done
And
• deal correctly with taxes and other deductions.
This is a summary of the payrolls cycle, showing the possible problems andthe related controls:
The table shows the various stages of the payroll ‘cycle’, together with:
• The risks (what could go wrong).
• Control procedures (so that things don’t go wrong!).
Stage Risks Control Control procedures
objectives
Clockcards input Cards may not To ensure allclock Batch total or hash
Intocomputer be cardsentered totalchecks
recordedaccurately
To ensure details Range checks inputtersigns
input correctly clock card to say
double checked details to
To ensure inputter screen
doesn't input data Programme only allowsinput
twice/input bogus for each persononce, can only
employees input for
employees held
withinstanding data
Hierarchicalpasswordcontrol
to payroll system
Inputter to signjoiner/leaver
form /wagerise form to say
checkedto input
Sample of deductions(PAYE,
NIC) recalculated
manually print out signed as
checked
Senior management
review wages expensesfor
reasonableness
Staff paid Staff may not be To ensure all staff Have two people
Paid are presentwhere cash wages are
paid(employees paid. (See controls
Bogus staff could will above over standingdata)
be paid complain if
not!!!) Responsible individualshould
review any BACS
To ensure payroll summary prior
nobogusemployee topaying staff – sign to
s arepaid confirm reviewed
• Test a sample of timesheets, clock cards or other records, for approvalby a responsible official.
Pay particular attention to the approval ofovertime there relevant.
• Observe wages distribution for adherence to procedures ensuringemployees sign for wages, that
unclaimed wages are rebanked, etc.
• Test authorisation for payroll amendments by reference to personnelrecords.
• Test controls over payroll amendments by reviewing changes andseeing whether they have been
authorised. You could print off anexception report highlighting changes and follow those through.
Youcould also do a dummy transaction to see how the system handleschange.
• Obtain the payment sheet for casual labour payments and ensure thishas been signed by the chief
accountant to authorise the paymentsmade.
• Obtain the weekly payroll and ensure this have been signed by aresponsible official to approval
those payments.
• Examine evidence of independent checks of payrolls (e.g. by internalaudit).
• Inspect payroll reconciliations done regularly, clearing wage controlaccount, tying the PAYE
liability up to the Inland Revenue records.Review the client working papers or observe the
reconciliation processhappening.
• Examine explanations for payroll expense variances.
• Test authorisation for payroll deductions by reviewing the employeesrecords, looking at who is
authorised to place through amendments,and observe the process.
• Test controls over unclaimed wages. You could do a dummy transactionto see how the system
works, what happens to the wages unclaimed,are they place in a safe, if so tick the clients working
to the amount inthe safe.
Class Discussion
Bassoon Ltd runs a chain of shops selling electrical goods all of whichare located within the same
country.It has a head office that deals with purchasing, distribution andadministration. The payroll
for the whole company is administered athead office.
There are 20 staff at head office and 200 staff in the company’s 20shops located in high streets
and shopping malls all over the country.Head office staff (including directors) are all salaried and
paid by directtransfer to their bank accounts.The majority of the staff at the company’s shops are
also paid throughthe central salary system, monthly in arrears. However, some studentsand part
time staff are paid cash out of the till.
Recruitment of head office staff is initiated by the department needingthe staff who generally
conduct interviews and agree terms andconditions of employment. Bassoon has an HR manager
who liaiseswith recruitment agencies, places job adverts and maintains staff fileswith contracts of
employment, etc.
Shop managers recruit their own staff.Shop staff receive a basic salary based on the hours worked
andcommission based on sales made.
The company has a fairly sophisticated EPOS (electronic point of sale)till system at all shops that
communicates directly with the head officeaccounting system.All staff when making a sale have
to log on with a swipe card whichidentifies them to the system, and means that the sales for which
theyare responsible are analysed by the system and commissionscalculated.
Store managers have a few ‘guest cards’ for temporary and part timestaff, who generally do not
receive commissions.Store managers and regional supervisors are paid commissions basedon the
performance of their store or region.
Directors and other headoffice staff usually receive a bonus at Christmas, depending on
thecompany’s performance. This is decided on by the board in consultationwith departmental
managers and put through the system by the payrollmanager.
The payroll manager is responsible for adding joiners to the payroll and deleting leavers as well as
for implementing changes in pay rates, taxcoding and other deductions and for making sure that
the list of monthlytransfers is communicated to the bank.
The computerised payroll system is a standard proprietary system whichis sophisticated enough to
incorporate the commission calculationsmentioned above which are fed in directly from the EPOS
system.The company employs an IT manager who is responsible for themaintenance of all IT
systems and installing new hardware and software.
Comment on the strengths and weaknesses of the payroll systemat Bassoon Ltd and recommend
any changes which you thinkare appropriate.(10 marks)
SOLUTION
5.10.4 Inventory
Objectives of controls
The objectives of controls in the inventory cycle are to ensure that:
• inventory levels are in keeping with the needs of:
– production (raw materials and bought in components)
– customer demand (finished goods)
• inventory levels are not:
– excessive
– too low (‘stockouts’)
• value for money is achieved
• goods/services delivered are what was ordered
• quality of goods/services delivered is satisfactory
• liabilities are recorded completely and accurately
• only valid liabilities are paid
• liabilities are paid in a sensible, commercial timescale.
The table shows the various stages of the inventory ‘cycle’, together with:
• the risks (what could go wrong)
• control procedures (so that things don’t go wrong!).
Inventory is stored until Poor storage conditions Storage areas fitted with
it is needed lead to damagedinventory. sprinklers, fire
alarms,temperature monitors.
Inventory items not used
before their useful life Inventory ‘rotated’ toensure
ends. FIFO usagewhere relevant.
Goods leave becausethey are Returned goods actually See purchase returns.
being returnedto suppliers being stolen.
by management.
• Capital expenditure is often for substantial amounts. As such, mostcompanies would require such
items to be included in an annual budgetand authorised by very senior level management.
• Regular revenue expense items may be monitored by simple varianceanalysis (i.e. actual versus
budget) on a monthly basis.
• Capital items are likely to be stored on an asset register, which recordsdetails of supplier, price,
insurance details, current location, responsibleemployee, etc.
• Just as inventories are counted, assets are likely to be checked againstthe register on a regular
basis.
• When assets are sold secondhand,the items will be checked againstsimilar items or price guides
to ensure the company receives fair value.
• Ownership documents (title deeds, vehicle registration documents) willbe safely stored.
Possible controls
Night safes.
Imprest system.
Cash receipts:
• observe that mail is opened by two staff to minimise the possibility offraud (cash being stolen on
receipt)
• test independent check of cash receipts to bank lodgements
• test for evidence of a sequence check on any prenumberedreceiptsfor cash
Cash payments:
• inspect current cheque books for:
– sequential use of cheques
– controlled custody of unused cheques
– any signatures on blank cheques
• test (to avoid double payment) to ensure that paid invoices are marked“paid”
• test for evidence of arithmetical checks on cash payments records,including cashbook
• obtain the file of direct debit payments – ensure each payment isauthorised.
Bank reconciliations:
• examine evidence of regular bank reconciliations, at least once permonth, but in larger
organisations this should be done daily or weekly
• examine evidence of independent checks of bank reconciliations (e.g.a signature)
• examine evidence of follow up of outstanding items on the bankreconciliation. Pay particular
attention to old outstanding reconcilingitems that should be written back such as old, unpresented
cheques.
Petty cash:
• Test petty cash vouchers for appropriate authorisation.
• Test cancellation of paid petty cash vouchers.
• Test for evidence of arithmetical checks on petty cash records.
• Test for evidence of independent checks on the petty cash balance.
• Perform a surprise petty cash count and reconcile to petty cashrecords.
The form, timing and addressees of this communication should be agreed at the start of the audit,
as part of the terms of the engagement.
This report has traditionally been known as a letter of weakness or report to management and
is usually sent at the end of the audit process.
Recent revision of audit standards has added other matters that should becommunicated.
• For listed companies, a report on audit independence.
• A report at the planning stage, identifying key audit risks and the workto be performed.
• At the end of the audit, a report covering:
– expected audit report
– unadjusted errors and misstatements
– comments on accounting practices and policies in use by the
– company any
– other relevant matters.
However, this section of the Notes will concentrate on internal control issues.
• the report is not a comprehensive list of weaknesses, but only those thathave come to light during
normal audit procedures
• the report is for the sole use of the company
• no disclosure should be made to a third party the without writtenagreement of the auditor
• no responsibility is assumed to any other parties.
The usual structure of the report is an appendix, noting the weaknesses, consequences,
andrecommendations (often with a space left for management to respondwith their planned action).
In the exam, an internal control question may require you to analysecontrols and report
weaknesses in the form of a management letter. If so, it is the appendix (see below) that you
need to produce. A covering letter would be specifically requested by your examiner.
Illustration
(A table format is the best format, it keeps you structured and the markersfind it easier to
mark.)
Question 1
You are the senior in charge of the audit of Dean Manufacturing. To assist you in your audit
planning, one of the audit team has provided the following description of the purchasing
system. No other controls exist apart from those described.
The company has no buying department so employees place orders in their own area of
responsibility. A three part order form is used; copy 1 is retained by the originator, copy 2 is
sent to the goods inward department and copy 3 is sent to the supplier.
Goods are received, but not checked, by the goods inwards clerk. Once received, the
supplier’s delivery note and the purchase order for those goods are sent to the purchase ledger
clerk.
When the supplier’s invoice is received the purchase ledger clerk checks the calculations on
it, initials it and staples the delivery note and purchase order to it. She enters the invoice on
to the purchase ledger.
The invoice is then sent to the manager responsible for the employee who ordered the goods.
The manager codes the invoice and returns it to the purchase ledger clerk. Coded purchase
invoices are entered onto an analysis sheet and posted to the nominal ledger monthly by
journal entry.
The cashier pays suppliers monthly on instructions from the purchase ledger clerk. The
purchase ledger control account is reconciled monthly by the purchase ledger clerk who also
reconciles suppliers’ statements.
Required:
CHAPTER 6
AUDIT EVIDENCE
AUDIT OPINION IS
BASED ON
EVIDENCE UPON
TRANSACTIONS
BALANCES
DISCLOSURES
Management is responsible for the preparation of financial statements thatgive a true and fair view,
but what does this really mean?
• The payroll expense was for the company’s genuine employeesworking on the company’s
business.
The table below provides a list of all management assertions and some of the key questions that
the audit team must address.
1. OCCURANCE 1. OCCURANCE,RIGHTS
1. EXISTANCE
2. COMPLETENESS AND OBLIGATIONS
2. RIGHTS AND
3. ACCURACY 2. COMPLETENESS
OBLIGATIONS
4. CUTOFF 3. CLASSIFICATION AND
3. COMPLETENESS
5. CLASSIFICATION UNDERSTANDABILITY
4. VALUATION AND
4. ACCURACY AND
ALLOCATION
VALUATION
The auditors therefore need evidence that these assertions are valid.
Completeness– are all transactions or balances that should be included inthe financial statements,
actually included?
Rights and obligations– does the client own or have other rights over theassetsand have a genuine
obligation to pay liabilities?
The assertions are important because they have an impact on how theauditor gathers evidence.
There are 13 different types of assertion across the three headings althoughsome of them repeat
each other and this may seem to be rather daunting toremember.
Remember that the audit evidence required depends on both:
• the nature of the item being tested
• the assertion being tested
and it can all be simplified down to four key questions that the auditor needs
to answer.
Reperform
Note.The completeness assertion tends to be the most difficult assertion totest. It is usually easier
to verify items we know about than to think aboutwhat should be there, but is not.
ISA 500 identifies eight types of procedures that the auditor can adopt toobtain audit evidence:
In the forthcoming chapters ‘Audit procedures’ we will look in detail at how theseprocedures are
applied in specific circumstances as well as at some of themore detailed requirements of ISAs.
ISA 500 identifies eight procedures that the auditor can adopt to obtainaudit evidence:
6.5.3 Observation
• Involves looking at a process or procedure.
• May well provide evidence that a control is being operated, e.g. doublestaffing or a cheque
signatory examining supporting documentation.
6.5.4 Enquiry
• Enquiry is a major source of audit evidence, however the results ofenquiries will usually need to
be corroborated in some way throughnother audit procedures.
• The answers to enquiries may themselves be corroborative evidence.
Management representations
Management representations are a subsetof Enquiry.
The auditor obtains written representations from management toconfirm oral enquiries where:
6.5.5 Confirmation
• A specific form of enquiry
• Examples of use:
– circularisation of receivables
– confirmation of bank balances
– confirmation from legal advisers of actual or contingent liabilities
– arising from legal proceedings
– confirmation of inventories held by third parties
– confirmation of investment portfolios by investment managers.
6.5.6 Recalculation
• Checking the arithmetical accuracy of the client’s calculations.
6.5.7 Reperformance
• May be something relatively simple, e.g. test checking inventory counts.
• May be more sophisticated, e.g. using IT tools to check a receivablesageing.
WHICH ASSERTION(S)
We have seen that the types of audit procedure the auditor can carry out:
• are quite limited – inspection, observation, enquiry, etc.
• are driven by the nature of the transaction or balance being audited andthe assertion being tested.
These three factors – risk, purpose and quality – have a complexrelationship, as we shall see.
Although risk is the most important factor, aseverything the auditor does on an audit is in response
to the assessed levelof risk, we will consider it after we have dealt with the quality and thepurpose
of audit evidence.
EVIDENCE
PERSUASIVE
NOT CONCLUSIVE
SUFFICIENT APPROPRIATE
RELIABLE
RELIABLE
• appropriate?
Sufficient
Example 1
For the client’s bank balance, one confirmation letter from the bank (if theclient has only one bank
account) will be enough, and indeed is all there isavailable.
The bank letter will not, however, give the auditor all the informationrequired. There will need to
be consideration of the bank reconciliation aswell.
Example 2
To test purchases for a manufacturing client where there are literallythousands of transactions a
year, the auditor may well decide to extract astatistical sample of purchase transactions to test to
purchase orders,invoices, delivery notes, etc. But how many items should there be in thesample?
Statistical sampling theory will give some help here – see below –but ultimately it is a question
for the auditor’s professional judgement.
Reliable
Reliable is deemed credible, trustworthy and dependable evidencetherefore the following is
deemed more or less reliable.
Documentary. Oral.
Broadly speaking, the more reliable the evidence the less of it the auditorwill need.
If the evidence is found to be unreliable, looking at a greater quantity of suchevidence will never
be sufficient.
Relevant
As we have seen above the nature of the evidence the auditor wantsdepends on:
And
• the assertion being tested.
Persuasive not conclusive
Consider:
• The auditor gives an opinion about the financial statements not acertificate that the financial
statements are correct.
• The audit report gives reasonable not absolute assurance about thefinancial statements.
• Audit procedures are designed to reduce the risk that the financialstatements contain material
misstatements not to eliminate allpossibility of error.
The reason for all this lack of absolute, definitive certainty is the nature ofaudit evidence which is
gathered by human beings in real live organisations.
• The auditor gathers evidence on a test basis (the sample may or maynot be representative).
• People make mistakes (both client and auditor).
• Documents could be forged (increasingly easy with digital technology).
• The client’s personnel may not always tell the truth.
As a result, we have to say that audit evidence is persuasive rather thanconclusive in nature.
This also means that the auditor will need to gather evidence from a varietyof sources.
6.8 Sampling
The audit evidence gathered, therefore, will be on atest basis – hence the need for the auditor to
understand the implications and effective use of sampling.
• 100% testing may be appropriate in certain circumstances –particularly where there is a small
population of high-valueitems
• the use of analytical procedures – see section 7 above and the moredetailed coverage in chapter
10 – and a variation on analyticalprocedures ‘proof in total’, may be a more effective and
efficientmethod of gathering audit evidence
• because analytical procedures are a requirement of ISA 520 at theplanning and overall review
stages of the audit, it is sensible to makebest use of the work done.
6.9 Definition
The definition of sampling set out in ISA 530 Audit sampling and othermeans of testing is:
‘Audit sampling’ (sampling) involves the application of audit procedures toless than 100% of items
within a class of transactions or account balancesuch that all sampling units have a chance of
selection. This will enable theauditor to obtain and evaluate audit evidence about some
characteristic ofthe items selected in order to form or assist in forming a conclusionconcerning the
population from which the sample is drawn. Audit samplingcan use either a statistical or a non-
statisticalapproach. ISA 530
Statistical or non-statisticalsampling
‘Statistical sampling’ means any approach to sampling that has thefollowing characteristics:
• random selection of a sample, and
• use of probability theory to evaluate sample results, includingmeasurement of sampling risk.
A sampling approach that does not have both these characteristics isconsidered non-
statisticalsampling.ISA 530
• Evaluation of results using probability theory, e.g. if a sample with atotal value of $100,000
contains errors of $1,000, it may be possible toextrapolate and say that there may be an error of
1% in the populationas a whole, i.e $30,000 in a population of $3m or $100,000 in apopulation of
$10m.Clearly this will depend on how representative the sample is and themargin of error
according to probability theory.
– usually at least 30 items – and the larger the sample size, the greaterthe precision it will give.
If the results of the sample reveal potential errors which might bematerial, the auditor has to resolve
the problem:
– by considering whether there were special circumstancessurrounding the errors, e.g. the absence
of a key member of theclient’s staff and carrying out additional testing on items or theperiod likely
to be affected
– by deciding whether, because the risk of misstatement has clearlyincreased, which will lead to
an increase in the level of materiality,the new level of materiality is too high. If it is, it will be
necessary toincrease the level of testing.
However, care needs to be taken overthis – see the section on risk revisited below.
(2) List two reasons why audit evidence is likely to bepersuasive rather than conclusive.(2 marks)
(3) List two examples where it would be appropriate to usestatistical sampling.(2 marks)
• Relevant.
• Reliable.
(2) List tworeasonswhy auditevidence islikely The auditor gathers evidence on atest basis
to bepersuasiverather than (the sample may or may notbe representative).
conclusive. • People make mistakes (bothclient and
auditor).
• Documents could be forged(increasingly
easy with digitaltechnology).
• The client’s personnel may notalways tell the
truth.
WORKING PAPRES
SUBJECT
CROSS REFERENCE
Principles
There are two major principles
• If it’s not recorded, it didn’t happen.
If there is nothing on file, there is no evidence that the necessaryprocedures were completed, so
there can be no basis for the auditopinion.
Completeness – If the working papers are easy to understand it will bemore obvious if anything
has been omitted.
Efficiency – Working papers need to be reviewed for quality controlpurposes and to ensure that
the audit opinion is justified. The reviewermay be at a senior level in the firm and therefore time
will be charged atan expensive rate. Clear working papers will keep the time spent andtherefore
the costs to a minimum.
The file
There are two broad areas to the file.
• The control part consisting of:
– the planning section
– the completion and review section.
–
• The main working papers are divided into the relevant sections of thefinancial statements, e.g.
non-currentassets, inventories, receivables,etc.
• Access to the working papers is controlled by the auditor, not the client, which is an element in
preserving the auditor’s independence.
• In some circumstances care may need to be taken when copies ofclient generated schedules are
incorporated into the file.
Security
Retention
ISA 230 states that audit documentation should be retained for five yearsfrom completion of the
audit. Many firms keep working papers for longerthan this because information may still be
required for tax purposes.
Evidence implications
• The normal rules concerning the relationship between risk and thequality and quantity of
evidence apply irrespective of the size of theentity.
• The quantity of evidence may well be less than for a larger organisation.
• It may be more efficient to carry out 100% testing in a smallerorganisation.
Small not for profit organisations have all the attributes of other smallentities. Arguably, however,
the position is more difficult for the auditorbecause:
• While most small businesses are under the direct management of theowner, small not-for-
profitorganisations tend to be staffed by volunteersand the culture is more likely to be one of trust
rather than accountability.
Problems
• Management override – Smaller entities will have a key director orowner who will have the
authority to do what they want. Therefore couldoverride the systems with ease.
• No segregation of duties – Smaller entities tend to only have oneaccounts clerk that processes all
information, therefore having a lack ofsegregation of duties. To overcome this issue the director
shouldauthorise and review the accounts clerk work.
• Less formal approach – Smaller entities tend to have simple systemsand very few controls due
to the lack of complexity and trust, therefore itwould be difficult to test the reliability of the
systems, thereforesubstantive testing, tends to be used more.
Question 1
(a) Identify and describe five of the procedures for obtaining audit evidence.
(5 marks)
(b) For each of the procedures, describe an audit test using that procedure to obtain
evidence over the balance of plant and equipment. (5 marks)
Your client Powerfest Co utilises large quantities of coal in order to produce their output.
The coal is stored in large piles and is transported to the factory by means of a conveyor
system. Perpetual inventory records are maintained showing the amount of coal on hand,
receipts and withdrawals of coal. No annual physical inventory count is performed on coal
as the company intends to rely on the perpetual inventory records when determining closing
inventory.
Required:
(c) Describe the substantive audit procedures, other than those relating to cut-off,
One method of determining the inventory value at the year-end is to use standard costs.
Required:
(d) Describe THREE audit procedures that should be carried out when auditing
standard costs. (3 marks)
Question 2
The FireFly Tennis Club owns 12 tennis courts. The club uses ‘all weather’ tarmac tennis
courts, which have floodlights for night-time use. The club’s year-end is 30 September.
Members pay an annual fee to use the courts and participate in club championships. The club
had 430 members as at 1 October 2017.
Income is derived from two main sources:
(1) Membership fees: Each member pays a fee of $200 per annum. Fees for the new
financial year are payable within one month of the club year-end. Approximately 10%
of members do not renew their membership. New members joining during the year
pay 50% of the full year fees. During 2018, 50 new members joined the club. No
members pay their fees before they are due.
(2) Court hire fees: Non-members pay $5 per hour to hire a court. Non-members have to
sign a list in the club house showing courts hired. Money is placed in a cash box in the
club house for collection by the club secretary.
All fees (membership and court hire) are paid in cash. They are collected by the club
secretary and banked on a regular basis. The paying-in slip shows the analysis between
membership fees and court hire income. The secretary provides the treasurer with a list of
bankings showing member’s names (for membership fees) and the amount banked. Details
of all bankings are entered into the cash book by the treasurer.
Main items of expenditure are:
(1) Court maintenance including repainting lines on a regular basis.
(2) Power costs for floodlights.
(3) Tennis balls for club championships. Each match in the championship uses 12 tennis
balls.
The treasurer pays for all expenditure using the club’s debit card. Receipts are obtained for
all expenses and these are maintained in date order in an expenses file. The treasurer also
prepares the annual financial statements.
Under the rules of the club, the annual accounts must be audited by an independent auditor.
The date is now 13 December 2018 and the treasurer has just prepared the financial
statements for audit.
Required:
(a) Describe the audit work that should be performed to confirm the income figure
for the FireFly Tennis Club. (10 marks)
(b) Describe the audit procedures that should be performed to confirm the
completeness and accuracy of expenditure for the FireFly Tennis Club. (5
marks)
(c) Discuss why internal control testing has limited value when auditing not-for-
profit entities such as the FireFly Tennis Club. (5 marks)
(Total: 20 marks)
CHAPTER 7:
AUDIT PROCEDURES
• Discuss and provide relevant examples of the use of test dataand audit software for the transaction
cycles and Statement of Financial Position items
• Discuss the use of computers in relation to the administration ofthe audit
• Discuss and provide examples of how analytical procedures areused as substantive procedures
• Compute and interpret key ratios used in analytical procedures
• Discuss the problems associated with the audit of accountingestimates
• Discuss the extent to which auditors are able to rely on the workof experts and internal audit
• Discuss the audit considerations relating to entities using serviceorganizations
• Discuss why auditors rely on the work of others
• Explain the extent to which reference to the work of others can bemade in audit reports
• Apply audit techniques to small not for profit organisations
• Explain how the audit of a small not for profit organisation differsfrom the audit of for profit
organisations.
In the sections that follow, we will examine a number of specific audit areasand deal with how
these are usually tested. You may be tempted to learnthese by heart. Whatever you do,DO NOT
DO THIS!!!!
The examiner is not stupid. He or she knows that auditing is a matter ofprofessional skill and
judgement. If you can answer an exam question simplyby learning a few pages of a book, it is not
a very good test of whether youare a competent auditor.
So the questions may not ask about standard situations and you will have toapply your knowledge
to the demands of the question.
• Management representations are required for some items by ISA 580and by a number of other
ISAs.
• If there are high volumes of transactions, consider using computerassisted audit techniques
(CAATs).
• PLANNING-RISK ASSESMENT-COMPULSORY (
ISA 520)
• SUBSTANTIVE-NOT COMPULSORY,BUT
WHY? USUALLY AN EFFECTIVE AND EFFICIENT
MENAS OF GATHERING EVIDENCE
• REVIEW- FINAL CHECK THE FIGURES MAKE
SENSE COMPULSORY (ISA 520)
• EFFICIENT
• EFFECTIVE
Why do them?
Analytical Procedures as substantive evidence
ISA 520 states that analytical procedures must be used at the planningstage to identify risks, and
at the completion stage of the audit as a finalreview of the FS.
They may also be used at the substantive stage when the auditor is auditing the draft financial
statements.
Analytical procedures are not just the comparison of one year with another.AP’s can be used in
the following ways:
• Ratio analysis
• Trend analysis
• Proof in total
• Create your own expectation of what you think the figure should be
• Compare your expectation to the actual figure
Calculating the ratios is just the start. Analytical procedures are auditproceduresin their own right,
designed to enable the auditor to reduce therisk of coming to the wrong opinion about the financial
statements.
This means that the auditor needs to use analytical procedures to identifyanomalies in the figures,
which may indicate problems.
To do this, the auditor will make comparisons:
• between the current year and previous year(s)
• between actual figures and budgets, forecasts or client’s expectations
• with similar companies
ISA 520 states that the auditor may use analytical procedures assubstantive procedures.
Some examples.
(1) Suitability
– Analytical procedures are clearly unsuitable for testing the –existence of inventories – to do this
you need to go and count theitems on the shelves in the warehouse.
– Analytical procedures may well be suitable for testing the value–oflabour carried forward in
inventory – by comparing direct labourcosts for the year with value in inventory, in the context of
the costsof raw materials and overheads in inventory.
(2) Reliability
– If controls over sales order processing are weak, it will –probablybe necessary to rely on tests of
details rather than analyticalprocedures.
(3) Precision
– There is likely to be greater consistency in gross margins over –time than in discretionary
expenditure like advertising or R&D.
(6) Acceptable variation
– Variations in sales revenue, which may have a minor impact–on theresults for the year, will be
regarded differently from receivables,which, if uncollectible will have a proportionately greater
impact.
Key assertions
Assertions – receivables
Audit procedures
(PREPAYMENTS)
(CIRCULARSATION)
FOR CUTOFF
Receivables circularisation – procedures
• Obtain a list of receivables balances, cast this and agree it to thereceivables control account total
at the end of the year. Ageing ofreceivables may also be verified at this time.
Purpose:
– Transactions and events have been recorded in the correctaccounting period.
Advantages:
• Independent evidence.
• External evidence.
• Relatively efficient (if successful).
Disadvantage
• Those circularised may not reply.
Method
• Select sample of receivables to be circularised.
• Inform client of intended list of those to be circularised.
• Consider implications if client objects to any of the accounts selectedbeing circularised.
• Record names and amounts circularised.
• Record replies received and consider implications of any accounts notagreed.
• For non-repliesperform alternative procedures (other evidence inrelation to accounts receivable).
Analytical review
• Calculate the trade receivables collection period and compare to lastyear to assess reasonableness
Cutoff
• Select a sample of GDN’s immediately prior to the yearendandimmediately after the year end
and and ensure that they have beenrecorded in the correct period.
• For prepayments review relevant invoices to check calculation ofprepayment and ensure that
payment has actually been made byagreeing it to the bank statements.
Income statement entries related to accounts receivable
Ensure doubtful receivables and recoveries identified from other audit workare properly reflected
in the income statement.
INVENTORIES
KEY QUESTIONS
The audit of inventories is usually regarded as one of the higher risk areasof the audit:
• It is usually crucial to assurance about an entity’s profit.
• It may be complex.
• It is usually subject to a degree of estimation.
7.3.1 InventoryProcedures
Consider need for experts Not cut off details Conclude on reliability of
quantities used as a basis for
computing inventory
Role of internal audit
Extract representative sample Valuation review lower of
cost or net realizable value
• The inventory count is a ‘one off’. It is a single opportunity to establishwhat is and what is not
in inventory
• Because of the crucial impact of inventory levels on the results for theyear, it must be tested both
for existence and completeness. (Formost other areas the emphasis is likely to be on one or other
of theseassertions rather than both)
• Inventory can consist of almost anything with different properties (seethe list above). It can
therefore be quite complex and so needs to bewell organised by the client. The auditor needs to be
equally wellorganised to ensure that sufficient, appropriate evidence is gathered
• It is the client’s responsibility to establish the correct value of theinventory. The auditor’s job is
to form an opinion as to whether thatvalue is materially correct or not. It is therefore not the
auditor’sresponsibility to count the inventory, only to check that it has been donecorrectly.
Procedures
Before the count
• Conduct test counts on a suitably random basis whilst gearing the tests towards material
items:
– Existence – it will be necessary to check from the client’s inventory records to your test
data, so you need to ensure that you record sufficient details of the location and the items
to be able to trace them later.
– Completeness– you will need to be able to trace the items from your counts, into the client’s
inventory records and will therefore need to record sufficient details to enable you to do
this.
Note. These aspects of the count are crucial – the auditor needs toknow in advance:
– the details of the inventory
– how the inventory will be recorded in the client’s system.
• Check that the figures disclosed in the financial statements agree to the
audited figures and that inventories have been correctly analysed
between finished goods, raw materials and work in progress.
Valuation
• Trace some items of inventory in the inventory sheets back to originalpurchase invoices to agree
the cost
• Trace the same items of inventory to post-yearendsales to determinethe net realisable value of
inventory
• For items that have not yet been sold trace to the provision for slow-movinginventory or discuss
with management why these have not beenprovided for
• Ensure that inventory is stated in the accounts at the lower of cost andnet realisable value by
reviewing the relevant purchase invoices andafter year end sales invoices.
Analytical review
• Calculate inventory turnover and compare to last year to assessreasonableness
Cutoff
• Select a sample of GRN’s from immediately prior to the year end andincluded in
yearendpayables, and ensure that the goods are includedin yearendinventories.
• Select a sample of GDN’s from immediately prior to the year end andincluded in
yearendreceivables, and ensure that the goods are notincluded in yearend
Advantages
• The auditor is less time constrained and can pick and choose particularlocations and inventory
lines at any time to ensure the system is workingproperly.
• Slow moving and damaged inventory should be identified and adjustedfor in the clients' records
on a continuous basis therefore the inventoryvaluation should be more reliable.
Disadvantages
• The auditor will need to gain sufficient evidence that the systemoperates correctly at all times,
not just at the time of the count.
• Additional procedures will need to be devised to ensure that the yearend inventory figure is
reliable, even though it may not have beencounted at that date.
• As with confirmations from receivables, the auditor requests detailsfrom the party holding the
inventory on behalf of the client to confirm itsexistence.
• The confirmation request will be sent by the client to those partiesidentified by the auditor.
• The reply should be sent directly to the auditor to prevent it beingtampered with by the client.
• Problems can occur if the third party uses a different description to thatof the client and as always,
a response is not guaranteed.
•Testing for existence, valuation, etc. is still important, but the majorconsideration, is for the
auditor to gain assurance that all liabilitieswhich should be included, are included.
You therefore have to think of the best indicators that additional liabilitiesmay exist. If as a result
of this, none are revealed, the testing of the values,rights and obligations of the payables we know
about is relativelystraightforward.
Existence
• Circularise a sample of trade payables to confirm the balance at theend of the year [this is not a
usual audit test, and is more or less thesame format as for receivables confirmations except that
negativeconfirmations are more acceptable]
• Reconcile supplier statement balances to the payables ledger
Completeness
• Investigate any supplier names that were shown on last year's payableslisting but do not have a
balance showing in this year's list of balances
• Review after date invoices and payments and ensure they have beenprovided for at the year-
endas appropriate
• Perform analytical procedures on the list of payables. Determinereasons for any unusual changes
in the total balance of individualpayables in the list
• Calculate the trade payables payment period and compare to last yearto assess reasonableness
• Obtain a list of the individual balances from the payables ledger, checkthe cast and agree the total
to the trade payables figure in the draftfinancial statements
• Obtain a list of debit balances in the payables ledger and obtainexplanations from management
• Agree brought forward figures to last year's audit file
Cutoff
• Select a sample of GRN's immediately prior to the year end and to testthat they are in
yearendpayables, and ensure that the goods are inyearendinventories, also test GRN's post year
end to test that they arenot in inventory at the year end
Accruals
• Review relevant invoices when received after the statement of financialposition date. If none are
received, compare with previous periods
• Obtain the list of accruals from the client, cast it to confirm arithmeticalaccuracy
• Agree the figure per the schedule to the general ledger and financialstatements
• Agree the calculation of the accrual by reference to supportingdocumentation e.g. previous period
invoice
Tax balances
• Corporation/Profits taxes – agree computations.
• Payroll taxes – agree to payroll records.
ASSERSIONS PROCEDURES
EXISTANCE
BANK LETTER
RIGHTS & OBLIGATIONS
COMPILED BY MAJORY TINOTENDA NYAZEMA CASH COUNT Page 173
BANK CONFIRMATION
ADVANCED AUDITING (ACC 410) MODULE GUIDE
VALUATION
COMPLETENESS
agreed to the disclosurein the statement of financial position to ensure it is correctly classifiedinto
the current and non current elements.
• Note. It is vital for an auditor conducting a cash count to do so in thepresence of a member of the
client’s staff and to obtain a signature forthe amounts handed back into the client’s custody
• Where there are multiple cash balances – a number of tills in adepartment store, etc. – it is
important to ensure amounts cannot bemoved between tills and that proper cutoffprocedures are
in place.
Completeness
• Select a sample of assets from the non-currentasset register andphysically inspect them.
• Examine the repairs and maintenance accounts in the general ledgerfor large and unusual items
that may be capital in nature.
Valuation
• Reperform depreciation calculations by:
– selecting a sample of assets from the register and recalculating the charge for the year
– recasting the list of individual asset depreciation charges
– agreeing the total charge to the financial statement.
• Alternatively, agree this year’s charge as reasonable by taking lastyear’s charge and amending it
for additions, disposals, revaluations,changes in method or policy, etc. Compare the predicted
charge for theyear with the actual charge, and seek explanations for any materialdifferences.
• Assess depreciation policies for reasonableness by:
– comparing methods used with prior year
– comparing methods used with similar companies
– analysing the recent trend of profits and losses on asset disposals.
• If any assets have been revalued during the year:
– agree new valuation to valuer’s report
– verify that all similar assets have also been revalued
– reperform depreciation calculation to verify that charge is based on new carrying value.
• For a sample of assets, agree cost to purchase invoice (or otherrelevant documentation) ensuring
all relevant costs have been included.
• If any assets have been constructed by the company, obtain analysis ofcosts incurred and agree
to supporting documentation (timesheets,materials invoices, etc.).
• When physically inspecting assets, take note of their condition andusage in case of impairment.
Disclosure
• Agree opening balances with prior year financial statements.
• Compare depreciation rates in use with those disclosed.
• For revalued assets, ensure appropriate disclosures made (e.g. nameof valuer, revaluation policy).
• Agree breakdown of assets between classes with the general ledgeraccount totals.
NON-CURRENT ASSETS
ASSERSIONS PROCEDURES
RECALCULATE DEPRECIATION
CHARGE
CONSIDER IMPAIRMENT
NON-CURRENT LIABILITIES
ASSERTIONS PROCEDURES
EXISTANCE
BANK LETTER
RIGHTS AND OBLIGATIONS LENDER STATEMENTS
VALUATION
COMPLETENESS
BACK TO BACK WITH RELATED
ASSETS
REVIEW PAYMENTS TO
POSSIBLE LENDERS
Loan payables
• Agree loan balance to the loan statement confirms rights and obligationand valuation.
• Agree interest payments to the loan agreement and the bankstatements, to confirm rights and
obligations.
• Analyse relevant disclosures of interest rates, amounts due (e.g.between current and
noncurrentpayables) to ensure complete andaccurate.
• Recalculate the interest accrual to ensure arithmetical accuracy.
Where the likelihood of payment is only possible, rather than probable, noamounts will be entered
in the accounts. However, the matter (contingentliability) must be adequately disclosed.
• Discuss the matter giving rise to the provision with the client to verifywhether an obligation
exists.
• Obtain confirmation from the clients lawyers as to the possible outcomeand probability of having
to make a payment.
• Review subsequent events. By the time the final audit is taking placethe matter may have been
settled.
• Obtain a letter of representation from the client as the matter is one ofjudgement and uncertainty.
• specialist inventory – livestock, food and drink in the restaurant trade,technically complex
inventory
• actuarial valuations for pension schemes.
• internal audit
• confirmation from external holders of the client’s inventory
• another firm of auditors for assurance on an overseas branch orsubsidiary
• service organisations
In making this assessment the external auditor must assess the expert’s:
For example, the auditor might inspect a valuation report to provideevidence of a revaluation of
land and buildings. However, this report mightbe have been produced by a qualified valuer who is
a close friend or relativeof one of the directors.
The auditor cannot devolve responsibility for the audit opinion onto theinternal audit department.
“ISA 610: Considering the Work of Internal Audit” states that before relying onthe work of
internal audit, the external auditor must first assess the internalaudit function with regard to:
• the objectivity and technical competence of the internal audit staff
• whether the internal audit function is carried out with due professionalcare
• the effect of any constraints or restrictions placed on the internalfunction by management or those
charged with governance.
If the function is assessed and is found not to be sufficiently independent ofthe management
structure or the staff are not suitably qualified and trained,there is no point in the external auditor
going to the trouble of assessing thework that has been performed by the function during the year
as it will not beconsidered reliable enough for external audit purposes.
However, if the internal audit function has been assessed as reliable, thespecific work should be
evaluated to ascertain its adequacy.
If the auditor assesses both the function and the specific work to be reliableand adequate, the work
will be relied on and reduced levels of testing will beperformed.
• payroll
• receivables collection
• the entire finance function
• internal audit.
Disadvantages
• May not obtain information readily
• Difficulties in assessing the reliability of the outsource company
• Lack of sufficient appropriate evidence.
Other considerations
• The auditor will need to be confident of the reliability and theindependence of the service
organisation.
• If the audit firm provides some of these services itself – e.g.bookkeeping or payroll services – it
will need to ensure that it canmaintain its own independence and objectivity as auditor.
Therefore, no reference should be made in the audit report to the use ofothers during the audit.
If the auditors cannot satisfy themselves that the work of others is sufficientlyreliable then the
auditor must find another means of obtaining the requiredlevel of comfort.
are the easy way for them to do this. The auditor must take care whenauditing estimates to ensure
this has not been the case.
An accrual can be compared with the actual invoice if the invoice hasbeen received by the client
by the time of the audit.
With so many accounting systems now held on computer, the assuranceprovider may wish to make
use of CAAT’s. There are two types of CAAT’s
(1) Audit software
(2) Test data- live
- dead
It is used to process the client’s data in order to checkthat the figures themselves are correct. It can
therefore carry out a wholerange of substantive procedure, across all sorts of different data.
It maybe processed during a normal production run -‘live’ test data orduring a special run at a
point in time outside the normal cycle -‘dead’ testdata, either with real data or dummy data.
Through test data. This is data generated by the auditor in order to test thesystems, processing
logic, calculations and controls, to ensure that thecontrols within the system are operating properly.
An auditor would take a transaction through a system, testing the systemslimits. So you would
have ‘normal’ transactions and invalid transactions totest that the system work. If the results are
positive that means the auditorcan rely on the system and have more confidence that the output
isaccurate.
CAAT’s force the auditor to rely on Credit limits within a system canonly be
programmed controls during the audit. changed by theaccountant. A computerassisted
Sometimes it may be the only way to test check will test that thisis the case.
controls within a computer system, therefore
enables the auditor to test program controls
Using CAAT’s enables the auditors to
comply with ISA of obtaining appropriateaudit
evidence increasing the overallconfidence for
the audit opinion
After initial set up costs, using CAAT’sare Examples of use or audit tests
likely to be cost effective, as thesame audit (1) Calculation checks
software can be used eachyear as long as the (2) Reviewing lists of old oroutstanding items
system doesn’tchanged andinvesting those specifically
(3) Detecting for unreasonableitems
(6) Detecting violation of thesystem rules
(5) New analysis
(6) Completeness checks
(7) Selects samples
(8) Identifying exceptionreporting facilities
Allow the results from using using CAATsto If the two sources of evidenceagree then this
be compared with ‘traditional’ testing, too will increasethe overall audit confidence
What are the weaknesses, or problems with CAAT’s, and how canthey be resolved?
CAAT’s will be limited depending onhow well Ensure you understand the system
the computer system isintegrated. The more to assess whether audit software
integrated thebetter the use of CAAT’s. For will be relevant for the company.
examplethe invoices should be Need to assess whether there is a
Lack of software documentationIf the Shouldn’t use audit software untilthese have
company you are auditing can notconfirm all been identified. Holduntil this point.
system documentation isavailable, then the
auditors will beunable to do the tests
effectively due to
lack of understanding.
Lack of direction and uselessresults The audit manager needs to beclear exactly
Audit tests may be done just becausethe what audit assertionsare being tested, and what
auditors have the facility to dothem, therefore theexpected outputs are.
the output of results willeither be inconclusive
or not required.
Therefore having an inefficient andcostly
audit.
Revenue
Input an order into the clientssystem that The order should not be accepted, orshould
would cause acustomer to exceed theircredit raise a query whether you are sureyou wish to
limit proceed. If this happens thenthe auditors will
have confidence the systemis working
properly
Input a negative number ofitems on an order Ensures only positive quantities areaccepted
Input incomplete customerdetails The system should not process the orderunless
all information is completed
Input an excessive amount There are reasonable checks in the systemto
identify possible input errors. A
warningshould appear on the screen
confirming thenumber
Input and invalid inventorycode Ensures that the computer detects the
invalid code and presents an errormessage
rather than taking the nearest
Input of invalid details Ensures that no errors are made for sippingand
payment
Purchases
Raise an order from asupplier not on the A query should be raised as to whether
preferredsupplier list youwant to proceed with this transaction
Process an order with anunauthorised staff ID The system should reject the processaltogether
or send the request through to anappropriate
person for authorisation
Try and make changes to thesupplier standing The system should reject the processaltogether
data usingthe ID of someone who is or send the request through to anappropriate
notauthorised to do so person for authorisation
Payroll
Try and set up a newemployee up on the The system should reject the processaltogether
payrollsystem using an unauthorized ID or send the request through to anappropriate
person for authorisation
Try and make employeechanges of detail using The system should reject the processaltogether
anunauthorised or send the request through to anappropriate
ID person for authorisation
Make an excess change forexample increase The system should have parameters inplace to
someone’ssalary by $1,000,000 bysomeone question this amount, and maybereject it due to
authorised it being outside the normalrange
Cast the receivables ledgerto ensure it agrees To ensure the completeness and accuracyof the
with thetotal on the receivables items on the receivables controlaccount
control account
Compare the balances to thecredit limits to To check or violation of the system rules
ensure theyhaven’t been exceeded
Review the balances toensure they don’t To check for unreasonable items in the
exceed thetotal sales to that customer ledger
Solution
Orders
• In not for profit organisations the transactions tend to be less formal, sothere maybe no receipt
for expenses or receipts of money. Whereas aprofit organisation will document all communication
and transactions.
• Revenue is unpredictable in non profit organisations, so if difficult toforecast, unlike profit
organisations who tend to hold contracts andorders, so difficult to test the going concern basis.
Question 1
During the final audit of Powerfast, the following points arose in the audit manager’s review of
the audit of inventories for the year ending 31 May 2019.
(a) No audit work had been conducted in order to ascertain whether any inventory items should be
written down to net realisable value. (12 marks)
(b) The client utilises large quantities of coal in order to produce their output. The coal is stored in
large piles and is transported to the factory units by means of a conveyor system. Perpetual
inventory records are maintained showing the amount of coal on hand, and receipts and
withdrawals of coal. No audit work has been carried out in this area, the perpetual inventory
records having been accepted for financial statement purposes. (8 marks)
Required:
Describe the audit procedures which would be carried out at this late stage of the audit in
order to satisfy the audit manager’s review points and ensure that inventories are accurately
stated in the financial statements.
(c) Another client of your firm is Camry Products. You are reviewing the plans for a physical
inventory count at the company's warehouse on 31 May 2019. The company assembles domestic
appliances, and inventory of finished appliances, unassembled parts and sundry inventories are
stored in the warehouse which is adjacent to the company's assembly plant. The plant will continue
to produce goods during the inventory count until 5 pm on 31 May 2019. On 30 May 2019, the
warehouse staff will deliver the estimated quantities of unassembled parts and sundry inventories
which will be required for production for 31 May 2019; however, emergency requisitions by the
factory will be filled on 31 May. During the inventory count, the warehouse staff will continue to
receive parts and sundry inventories, and to despatch finished appliances. Appliances which are
completed on 31 May 2019 will remain in the assembly plant until after the physical inventory
Question 2
ISA 500 requires that ‘The auditor should obtain sufficient appropriate audit evidence to be able
to draw reasonable conclusions on which to base the audit opinion.’ The explanatory material
contained within ISA 500 identifies a number of procedures for obtaining audit evidence. ISA 500
also offers guidance as to assessing the reliability of audit evidence.
Required:
(a) Identify and describe five of the procedures for obtaining audit evidence. (5 marks)
(b) For each of the procedures, describe an audit test using that procedure to obtain evidence
as to the balance of plant and equipment including the related balances of accumulated
depreciation and charges to income. (5 marks)
(c) For each of the procedures, discuss considerations affecting your judgement as to
the reliability of the evidence with particular reference to the test described in your
Question 3
ISA 500 Audit Evidence requires auditors to obtain evidence that supports the relevant financial
statement assertions. One of these assertions is that of valuation. Evidence is therefore required to
ensure that assets or liabilities are recorded at an appropriate carrying value. Many audit failures
are associated with difficulties experienced by auditors in verifying this assertion in the face of
attempts by management to engage in creative accounting. In verifying valuation auditors need to
determine that the basis of valuation is consistent with accepted accounting practice usually aided
by reference to financial reporting standards. Additionally auditors need to obtain sufficient
evidence as to the values themselves. Valuation problems likely to be encountered by auditors
include those associated with determining:
(i) the appropriate amount of overhead carried forward as part of the cost of closing inventory.
(ii) the carrying amount of property, plant and equipment having a limited useful economic life.
(iii) development costs deferred in the year and recognised as an intangible asset.
Required:
(b) state and explain the audit approach and procedures to be performed in verifying
the appropriateness of the basis of valuation and the correctness of the actual
Note: You are only required to consider audit procedures relevant to the valuation assertion.
(Total: 20 marks)
CHAPTER 8
8.1 Introduction
This chapter deals with some of the procedures which happen at the completion stage of the audit.It
deals with:
• the significance of the partner’s file review
• what to do about errors
• subsequent events (events after the reporting period)
• going concern
• management representations.
It does not deal with the technicalities of how to carry out a file review or some of the other issues
which tend to arise at the completion stage. You will come across these later in your studies.
• Errors identified through sampling need to be extrapolated so that the potential error in the
population as a whole can be estimated. If such errors reveal a potentially material adjustment, the
audit team should have carried out additional work to determine whether or not the error actually
is material, before the assignment reaches the review stage.
• ISA 260 Communication of audit matters with those charged with governance states that the
auditors would normally report:
– material audit adjustments whether or not recorded by the entity and
– aggregate uncorrected misstatements
– Consideration of errors identified in the course of the audit will often provide useful input to the
planning process for the following year’s audit.
Audit procedures undertaken in performing a subsequent events review might include any of the
following:
• Enquiring into management procedures/systems for the identification of subsequent events.
• Reading minutes of members’ and directors’ meetings, and of audit and executive committee
meetings, and enquiring about matters not yet minuted.
• Reviewing accounting records including budgets, forecasts and interim information.
• Making enquiries of directors to ask if they are aware of any subsequent events, adjusting or non-
adjusting,that have not yet been included or disclosed in the financial statements.
• ‘Normal’ post reporting period work performed in order to verify year end balances:
– checking after date receipts from receivables
– verifying the value of accrued expenses by checking invoices when received
– checking inventory valuations are at lower cost and net realizable value by testing to
eventual selling prices.
• Obtaining, from management, a letter of representation.
Illustration
A few days after signing an audit report, but before the client’s financialstatements have been
approved by the shareholders at the AGM, theauditors receive a phone call from a director
indicating a material errorin the financial statements.
• Client produces a revised set of financial statements.
In such circumstances, a number of things may happen.Where this happens, the auditor needs to
produce a new audit report, asthe audit report must always be dated on or after the date that
thefinancial statements are signed by the directors. The auditor willtherefore need to extend ‘active
duties’ on all other matters from theoriginal date of the audit report to the new date.
Now the financial statements are materially wrong, but the initial auditreport said they were true
and fair. The auditor should ask for the auditreport back, so that a new qualified report can be
issued. However, theclient may refuse this as well.
In such circumstances, the auditor should obtain legal advice, considerresignation, and speak at
the AGM to notify shareholders.
Required:
(a)For each of the two events above:
(i) Explain whether the events are adjusting or non-adjustingaccording to IAS 10Events After the
Reporting Period.(6 marks)
(ii)Explain the auditors' responsibility and the auditprocedures and actions that should be carried
outaccording to ISA 560 (Redrafted) Subsequent Events.(12 marks)
(a) Assume that the date is now 15 September 2017, the financialstatements and the audit report
have just been signed, and theannual general meeting is to take place on 10 October 2009.
TheEnvironmental Agency has issued a report stating that Brand Co isin breach of
environmental legislation and a fine of $800,000 willnow be levied on the company. The
amount is material to thefinancial statements.
Required:
Explain the additional audit work the auditor should carry outin respect of this fine.(6 marks)
Solution
(a) Event 1
(i) The problem with the light bulb inventory providesadditional evidence of conditions existing
at the endof the reporting period as the inventory was inexistence and the faulty filiments were
included inthe inventory at this time.1 mark
The value of the inventory is overstated and shouldbe reduced to the lower of cost and net
realizable value in accordance with IAS 2 Inventories.1 mark
An adjustment for this decrease in value must bemade in the financial statements.1 mark
The inventory should therefore be valued at$125,000 being the net realisable value.1 mark
(ii) The decrease in value of inventory took place afterthe end of the reporting period but before
thefinancial statements and the audit report weresigned.
1 mark
The auditor is therefore still responsible foridentifying material events that affect the
financialstatements.1 mark
Audit procedures are therefore required todetermine the net book value of the inventory andcheck
that the $125,000 is the sales value of thelight bulbs.1 mark
Event 2
(i) The release of oil occurred after the end of thereporting period, so this is indicative of
conditionsexisting after the end of the reporting period – theevent could not be foreseen at the end
of thereporting period.1 mark
However, the investigation by the EnvironmentalAgency could result in legal claim against
thecompany for illegal pollution so as a material event itwill need disclosure in the financial
statements.1 mark
(ii) As with event 1, the event takes place before thesigning of the audit report, therefore the
auditorshave a duty to identify material events affecting thefinancial statements.1 mark
Audit procedures will include:
– Obtain any documentation on the event, forexample board minutes, copies of
environmental legislation and possibly interimreports from the Environmental Agency
todetermine the extent of the damage.1 mark
– Inquire of the directors whether they will disclosethe event in the financial statements.1 mark
– If the directors plan to make disclosure of theevent, ensure that disclosure appearsappropriate.1
mark
– If the directors do not plan to make anydisclosure, consider whether disclosure isnecessary and
inform the directors accordingly.1 mark
– Where disclosure is not made and the auditorconsiders disclosure is necessary, modify theaudit
opinion on the grounds of disagreementand explain the reason for the qualification inthe report.
This will be for lack of disclosure (notprovision) even though the amount cannot yetbe
determined.1 mark
– Alternatively, if the auditor considers that therelease of oil and subsequent fine will affectBrand's
ability to continue as a going concern,draw the members' attention to this in anemphasis of matter
paragraph.1 mark
(b) The notification of a fine has taken place after the audit report hasbeen signed.
– Discuss the matter with the directors to determinetheir course of action.
– Where the directors decide to amend the disclosurefinancial statements, audit the amendment
and thenredraftand redatethe audit report as appropriate.
– Where the directors decide not to amend thefinancial statements as the disclosure the auditor
can consider other methods of contacting themembers. For example the auditor can speak in
theupcoming general meeting to inform the members ofthe event.
– Other options such as resignation seeminappropriate due to the proximity fo the annualgeneral
meeting (AGM). Resignation would allowthe auditor to ask the directors to convene
anextraordinary general meeting, but this could nottake place before the AGM so the auditor
shouldspeak at the AGM instead.
The procedures that the auditors undertake for their going concern review will depend on the risk
that the company may not be a going concern.
• In a company where profits are high, cash flows are positive, finance is in place, and there is no
obvious exposure to large losses, goingconcern procedures are likely to be minimal.
• Where any doubts regarding going concern exist, procedures are more extensive.
• When companies go out of business, it is more likely to be due to a lack of cash than a lack of
profits. However, in the long term, profits are ofcourse essential for survival.
• The auditor should remain alert for evidence of events or conditions which may cast significant
doubt on the entity’s ability to continue as agoing concern, both in the planning stage and
throughout the audit.
This is not an exhaustive list and you may identify other factors from the scenario given to you in
the exam.
Where the directors have been unable to assess going concern in the usual way (e.g. for less than
one year beyond the date on which they sign the financial statements), this fact should be disclosed.
Where the financial statements are prepared on a basis other than thegoing concern basis, the basis
used should be disclosed.
The annual audit is nearly complete. As audit senior you have reportedto the engagement partner
that Smithson is having some financialdifficulties. Income has fallen due to the adverse effect of
two high-profilecourt cases, where Smithson's services to assist the prosecution werefound to be
in error. Not only did this provide adverse publicity forSmithson, but a number of clients withdrew
their contracts. A senioremployee then left Smithson, stating lack of investment in new
analysismachines was increasing the risk of incorrect information beingprovided by the company.
A cash flow forecast prepared internally shows Smithson requiringsignificant additional cash
within the next 12 months to maintain even thecurrent level of services.
Required:
(a)Define 'going concern' and discuss the auditor's anddirectors responsibilities in respect of going
concern.(5 marks)
(b)State the audit procedures that may be carried out to try todetermine whether or not Smithson
Co is a going concern.(10 marks)
(c)Explain the audit procedures the auditor may take where theauditor has decided that Smithson
Co is unlikely to be agoing concern.(5 marks)
As part of the completion process the auditors will write to the client’s management stating the
issues about which they are seeking representations.
However, there are three good reasons why management representations are necessary:
(1) Precisely because it is management’s responsibility to produce financial statements that show
a true and fair view, the most obvious first source of audit evidence is to ask them whether or not
they have done so.
(2) There may be circumstances where no other sufficient, appropriate audit evidence may
reasonably be expected to exist – the issues concerning estimation and judgement mentioned above
are the most obvious examples.
(3) ISA 580 Management representationsand the requirements of a number of other ISAs make
it compulsory for the auditors to obtain management representations on a number of specific
issues.
• its source (independent, external or auditor generated evidence is better than evidence generated
internally by the client)
• how it is obtained (evidence obtained directly by the auditor is better than evidence obtained
indirectly by inference)
• its medium (documentary, particularly original rather than copied,evidence is better than oral
evidence).
Clearly written management representations are documentary evidence obtained directly by the
auditor which is the good news.
The bad news is that management representations are not independent.The auditor will therefore
have to make judgements about:
• management’s competence to make the representations
• management’s integrity
• whether circumstances are such that management’s behaviour may be expected to be different
from how it has been in the past.
If, for example the client was:
• under increased financial pressure because of difficult trading conditions
• subject to being taken over, where the value of managements’shareholdings could vary widely
depending on the terms of the takeover the auditors might revise their judgement about the
reliability of management representations.
Whilst a formal communication is usually sent at the conclusion of the audit there may be a need
to communicate particular matters at other times to help meet the third objective, for example, if a
fraud is discovered.
Audit matters of governance interest include:
• Auditor's responsibilities in relation to the audit.
• Planned scope and timing of the audit.
• Significant findings from the audit:
– Auditor's views about qualitative aspects of the entity's accounting practices, policies, estimates
and disclosures.
– Significant difficulties encountered during the audit, e.g. unavailability of expected information.
– Significant matters discussed with management.
– Written representations requested.
– Circumstances that affect the form and content of the auditor's report, if any. This includes any
expected modifications to the audit report and key audit matters to be communicated in accordance
with ISA 701.
– Other matters arising significant to the oversight of the reporting process.
• Auditor independence.
Question 1
Green Co grows crops on a large farm according to strict organic principles that prohibits
the use of artificial pesticides and fertilizers. The farm has an organic certification, which
guarantees its products are organic. The certification has increased its sales of flour, potatoes
and other products, as customers seek to eat more healthily.
Green Co is run by two managers who are the only shareholders. Annual revenue is $50
million with a profit before tax of 5%. Both managers have run other businesses in the last
10 years. One business was closed due to a suspected tax fraud although no case was ever
brought to court.
Green Co’s current auditors provide audit services. Additional assurance on business
controls and the preparation of financial statements are provided by a different accountancy
firm.
Last year, a neighbouring farm, Black Co started growing genetically modified (GM) crops,
the pollen from which blows over Green Co’s fields on a regular basis. This is a threat to
Green Co’s organic status because organic crops must not be contaminated with GM
material. Green Co is considering court action against Black Co for loss of income and to
stop Black Co growing GM crops.
You are an audit partner in Lime & Co, a 15 partner firm of auditors and business advisors.
You have been friends with the managers of Green Co for the last 15 years, advising them
on an informal basis. The managers of Green Co have indicated that the audit will be put out
to tender next month and have asked your audit firm to tender for the audit and the provision
of other professional services.
Required:
(a) Using the information provided, identify and explain the ethical threats that could
affect Lime & Co. (8 marks)
(b) In respect of the going concern concept:
(i) Define ‘going concern’ and state two situations in which it should NOT be
applied in the preparation of financial statements; (3 marks)
(ii) Explain the directors’ responsibilities and the auditors’ responsibilities
regarding financial statements prepared on the going concern principle.
(4 marks)
(c) List the audit procedures that should be carried out to determine whether or not
the going concern basis is appropriate for Green Co. (5 marks)
(Total: 20 marks)
Question 2
You are auditing the financial statements of Hope Engineering for the year ending 31 March 2018.
The partner in charge of the audit instructs you to carry out a review of the company’s activities
since the financial year end. Mr Smith, the chief executive of Hope Engineering, overhears the
conversation with the partner and is surprised that you are examining accounting information
which relates to the next accounting period.
Mr Smith had been appointed on 1 March 2018 as a result of which the contract of the previous
Chief Executive, Mr Jones, was terminated. Compensation of $500,000 had been paid to Mr Jones
on 2 March 2018.
As a result of your investigations you find that the company is going to bring an action against Mr
Jones for the recovery of the compensation paid to him. It had come to light that two months prior
to his dismissal, he had contractually agreed to join the board of directors of a rival company. The
company’s solicitor had informed Hope Engineering that Mr Jones’ actions constituted a breach
of his contract with them, and that an action could be brought against the former Chief Executive
for the recovery of the moneys paid to him.
Required:
(a) List and explain the reason for the audit procedures which would be carried out in order
to identify subsequent events. (12 marks)
(b) Discuss the audit implications of the company’s decision to sue Mr Jones for the recovery
of the compensation paid to him. (8 marks)
(Total: 20 marks)
Question 3
Written representations are an important source of audit evidence. These representations may be
oral or written, and may be obtained either on an informal or formal basis. The auditor will include
information obtained in this manner in his audit working papers where it forms part of his total
audit evidence.
Required:
(a) Explain the nature and role of written representations. (6 marks)
(b) Explain why it is important for the auditor to discuss the contents of the letter of
representation at an early stage of the audit. (4 marks)
(c) Explain why standard letters of representation are becoming less frequently used
by the auditing profession. (4 marks)
(d) Discuss the implications for the auditor of a small company, if the directors refuse
to sign the letter of representation. (6 marks)
(Total: 20 marks)
CHAPTER 9
1. Whether the financial statements give a true and fair view (or present fairly in all material
respects).
2. Whether the financial statements have been properly prepared in accordance with relevant
rules, e.g. – International Accounting Standards,
– a particular country’s legal requirements.
These considerations are assessed on the basis of the audit work carried out and the evidence
obtained from this.In addition, certain other matters may have to be reported by exception. These
matters, which are also referred to as implied reporting, are laid down by a country’s laws.
• where Returns are not received from all branches of the company
• where Accounting records are inconsistent with the Financial statements
• where Proper accounting records have not been kept
• where all Information and explanations were not received
• where Director transactions with the company are missing from Financial Statements.
Reporting by exception is not the same as a qualification; however, as the matters dealt with are
usually legal requirements, non-compliance will probably lead to a qualification anyway. For
instance, if all informations and explanations have not been received, there will most likely be a
limitation of scope. This term is explained later in the chapter.
• Title
The title should be ‘appropriate’. The use of ‘Independent Auditor’s Report’ distinguishes this
report from any other report produced internally or by other non-statutory auditors.
• Addressee
• The report should be addressed to the intended user of the report which is usually the
shareholders, board of directors or other party defined in the engagement or local regulations.
This varies from country to country, but is usually addressed to the members of the company.
This is to prevent other parties relying on the report when it is not intended for their use.
• Opinion
- This covers the primary statements and associated notes referred to in the introductory
paragraph (even though only the first two are referred to explicitly).
- Truth and fairness (or presented fairly in all material respects).
- Preparation in accordance with the financial reporting framework – applicable legislation
and accounting standards.
• If applicable, any other matters required under a country’s regulations. Such a statement
would be made at the end of the opinion paragraph.
• Key Audit matters
• Other Information
• Statement of responsibilities of management
- Preparation of the financial statements which show a true and fair view or present
fairly in all material respects and in accordance with the applicable financial
framework.
The audit report should name a specific location, which is normally the city where the auditor
maintains the office that has responsibility for the audit.
Introductory paragraph
We have audited the accompanying financial statements of the XXX Company, which comprise
the statement of financial position as at 31 December, 20XX, and the income statement, statement
of changes in equity and statement of cash flow for the year then ended, and a summary of
significant accounting policies and explanatory notes.
Management is responsible for the preparation and fair presentation of these financial statements
in accordance with International Financial Reporting Standards (IFRS’s). This responsibility
includes, designing, implementing and maintaining internal control relevant to the preparation and
fair presentation of financial statements that are free from material misstatement, whether due to
fraud or error; selecting and applying appropriate accounting policies; and making accounting
estimates that are reasonable in the circumstances.
Auditor's responsibility
Our responsibility is to express an opinion on these financial statements based on our audit.
Scope paragraph
We conducted our audit in accordance with International Standards on Auditing. Those Standards
require that we comply with ethical requirements and plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement.
An audit involves performing procedures to obtain audit evidence about the amounts and
disclosures in the financial statements. The procedures selected depend on the auditor’s judgment,
including the assessment of the risks of material misstatement of the financial statements, whether
due to fraud or error. In making those risk assessments, the auditor considers internal control
relevant to the entity’s preparation and fair presentation of the financial statements in order to
design audit procedures that are appropriate in the circumstances, but not for the purpose of
expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes
evaluating the appropriateness of accounting policies used and the reasonableness of accounting
estimates made by management, as well as evaluating the overall financial statement presentation.
We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis
for our audit opinion.
Opinion
In our opinion, the financial statements give a true and fair view of (or ‘present fairly, in all material
respects',) the financial position of the Company as of31 December, 20XX, and of its financial
performance and its cash flows for the year then ended in accordance with International Financial
Reporting Standards.
[Form and content of this section of the auditor’s report will vary depending on the nature of the
auditor’s other reporting responsibilities.]
Auditor signature
AUDIT REPORT
UNMODIFIED/UNQUALIFIED
MODIFIED REPORT IS
/CLEAN AUDIT REPORT
REQUIRED
The opinion would be;
There are threepossibilities
-“do give a true and fair view”, when this kind of report is
or present in material respects”, given
• Where the financial statements have been prepared on a basis other than the going concern
basis.
• A significant subsequent event occurs between the date of the financial statements and the date
of the auditor's report.
• Major catastrophes that have had a significant effect on the entity's financial position.
• Where the financial statements have been recalled and reissued or when the auditor provides an
amended auditor's report.
The emphasis of matter paragraph is placed after the opinion paragraph.The paragraph is given a
separate heading.
The auditor makes it clear in the paragraph that the opinion is not qualified.
The sections of the report prior to the paragraph are unchanged. Where possible, the potential
financial effect on the financial statements should be quantified.
Where there are particular circumstances surrounding the financial statements and they are fully
disclosed, the auditors may wish to draw the reader’s attention to them in the audit report e.g.
• the financial statements have been prepared on a break up basis not a going concern.
‘Without qualifying our opinion we draw attention to Note X to the financial statements. The
Company is the defendant in a lawsuit alleging infringement of certain patent rights and claiming
royalties and punitive damages. The Company has filed a counter action, and preliminary hearings
and discovery proceedings on both actions are in progress. The ultimate outcome of the matter
cannot presently be determined, and no provision for any liability that may result has been made
in the financial statements.’
The result of these matters on the audit report is shown below. Note the circumstances given at the
top of the example reports that will give you an indication of when each type will be appropriate.
QUALIFIED REPORTS
If the auditor has been unable to obtain Evidence which should have been available then a
modified opinion will be given or where there is a disagreement with management regarding;
Opinion Opinion
ISA 700 uses the phrase “material and pervasive” we know that unless the matter is material, it
will not cause the report to be qualified at all. So the nature of the qualification depends on the
degree of effect that the auditor considers it may have on the financial statements.
To be considered pervasive, it must affect the view given by the financial statements as a whole.
As such;
- If the circumstance is a limitation of scope it will leave the auditor unable to form an
opinion at all
- If it is a disagreement, it will be of such significance that the financial statements do not
give a true and fair view
Class discussion
Auditor’s responsibility
Our responsibility is to express an opinion on these financial statements based on our audit. Except
as discussed in the following paragraph, we conducted our audit in accordance with …
We did not observe the counting of the physical inventories as of 31 December 20XX, since that
date was prior to the time we were initially engaged as auditors for the Company. Owing to the
nature of the company’s records, we were unable to satisfy ourselves as to inventory quantities by
other audit procedures.
Opinion
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
financialstatements give a true and …
‘We were engaged to audit the accompanying financial statements of the XXX Company, which
comprise the statement of financial position as of 31 December, 20XX and the income statement,
the statement of changes in equity and the cash flow statement for the year then ended, and a
summary of the significant accounting policies and other explanatory notes.
Management responsibility paragraph as per standard report (omit the sentence stating the
responsibility of the auditor).
(The paragraph discussing the scope of the audit would either be omitted or amended according to
the circumstances.)
We were not able to observe all physical inventories and confirm accounts receivable due to
limitations placed on the scope of our work by the Company.Because of the significance of the
matters discussed in the preceding paragraph, we do not express an opinion on the financial
statements.’
As discussed in Note X to the financial statements, no depreciation has been provided in the
financial statements which practice, in our opinion, is not in accordance with International
Financial Reporting Standards. The provision for the year ended 31 December, 20XX, should be
XXX based on the straight-line method of depreciation using annual rates of 5% for the building
and 20% for the equipment. Accordingly, the non-current assets should be reduced by accumulated
depreciation of XXX and the loss for the year and accumulated deficit should be increased by
XXX and XXX, respectively.
In our opinion, except for the effect on the financial statements of the matter referred to in the
preceding paragraph, the financial statements give a true and ...’
‘In our opinion, because of the effects of the matters discussed in the preceding paragraph(s), the
financial statements do not give a true and fair view of (or do not “present fairly”) the financial
position of the Company as of 31 December, 20XX, and of its financialperformance and its cash
flows for the year then ended in accordance withInternational Financial Reporting Standards.’
As you can see, there is a potentially difficult decision process to go through when deciding what
kind of modified audit report may be appropriate.
• This means the matter is material to the area of the financial statements affected but does not
affect the remainder of the financial statements.
• 'Except for' this matter, the financial statements give a true and fair view.
• Whilst significant to users' decision making, a material matter can be isolated whilst the
remainder of the financial statements may be relied upon.
• Nonconsolidation
of a subsidiary.
A disclaimer of opinion is issued when the auditor has not obtained sufficient appropriate evidence
and the effects of any possible misstatements could be pervasive. The auditor does not express an
opinion on the financial statements in this situation. Examples include:
If management refuse, the matter must be discussed with those charged with governance.
• The auditor should perform alternative audit procedures to obtain sufficient appropriate evidence,
if possible.
• If the auditor is unable to obtain sufficient appropriate evidence and the matter is material but
not pervasive, the auditor must issue a qualified audit opinion.
• If the matter is considered pervasive, the auditor must withdraw from the audit.
• If withdrawal is not possible before issuing the auditor's report, a disclaimer of opinion should
be issued.
• If the auditor decides to withdraw from the audit, the auditor must communicate any material
misstatements identified during the audit to those charged with governance before withdrawing.
The auditor must read and consider the other information to identify any materially inconsistencies
with the financial statements or the auditor’s knowledge obtained during the audit. Material
misstatements or inconsistencies in the other information may undermine the credibility of the
financial statements and the auditor’s report.
The auditor must not be knowingly associated with information which is misleading.
Other information refers to financial or nonfinancial information, other than the financial
statements and auditor's report thereon, included in the entity's annual report, that are not
necessarily subject to audit. Examples of other information include:
• Chairman's report
• Operating and financial review
• Social and environmental reports
• Corporate governance statements
Question 1
You are auditing the financial statements of Hope Engineering for the year ending 31 March
2018. During the audit you discover that the contract of the previous Chief Executive, Mr
Jones, was terminated during the year and compensation of $500,000 was paid to him on
2 March 2018. Mr Smith was appointed as his replacement in March 2018.
Mr Smith informs you that the company is going to bring an action against Mr Jones for the
recovery of the compensation paid to him. It has since been discovered that two months prior
to his dismissal, Mr Jones had contractually agreed to join the board of directors of a rival
company. The company’s solicitor has informed Hope Engineering that Mr Jones’ actions
constitute a breach of contract, and that an action could be brought against the former Chief
Executive for the recovery of the moneys paid to him. The solicitor has advised that it is
probable that this action will be successful.
Required:
(a) Describe FIVE audit procedures which should be performed with regard to the
dismissal of Mr Jones and the subsequent legal action. (5 marks)
(b) Explain THREE steps the auditor should take if Mr Smith announces that he is
going to amend the draft financial statements to include a gain of $500,000 with
regard to this legal action. (3 marks)
(c) Describe the impact on the auditor’s report if this gain is included in the financial
statements and the amount is considered material. (4 marks)
ISA 580 Written Representations requires the auditor to obtain written representations
towards the end of the audit.
(d) State FOUR matters that would be included in a written representation letter.
(4 marks)
(e) Explain the implications for the auditor’s report if the client fails to provide a
signed written representation letter. (4 marks)
(Total: 20 marks)
Question 2
Reddy and Co, Chartered Certified Accountants, are the external auditors of Drummoyne, a listed
company. On completing the audit for the year ended 30 September 2018 the following list of
matters was prepared for the partner’s attention.
(a) On 25 November 2018 Drummoyne agreed to a pay rise of 5% for all of its employees
backdated to 1 July 2018. No provision for this has been made in the financial
statements. (5 marks)
(b) The draft Chairman’s Statement, to be included in the Annual Report, states that profit
before tax has increased by 25%. It is true that operating profit has increased by 25%
but, after deducting reorganisation costs and losses on disposals of property, plant and
equipment profit before tax has increased by only 4% compared with the previous year.
(5 marks)
(c) The audit revealed a major control deficiency in the management of investments. The
company recently recruited a financial analyst, as an employee, to manage the
investment of surplus funds. Company policy is to invest in the shares of large quoted
companies. The audit discovered a number of situations where the financial analyst
had made substantial profits for the company by speculating in risky investments such
as derivatives. Such investments could result in massive losses. The matter was
reported verbally to the chief financial officer four months ago but no action has yet
been taken. (4 marks)
(d) One of the company’s oil tankers has just run aground off the coast of California. There
is a risk of a serious oil spill which could cost a significant amount to clear up as is
required by local legislation. This could have a significant effect on the future of the
company. Further information will not be available until after the auditors’ report has
been signed. (6 marks)
Assume that each of these matters is potentially material and is to be considered
independently of each of the others.
Required:
Consider what further actions Reddy and Co should take with respect to each of the
matters listed including the potential impact on the auditor’s report.(Total: 20 marks)